The majority of hedge funds are offshore, unregulated, open-ended vehicles, though in practice the underlying manager often operates within a regulated jurisdiction such as London. The number of investors in each fund may be limited and the minimum investment amount is liable to be substantial. The fees paid by investors are usually aligned to the profits made by the fund. As a result, direct investment in individual hedge funds is also beyond the reach of most private investors.
But all is not lost. Private investors can still gain exposure to hedge funds by investing in a fund of hedge funds. This is simply another collective fund that itself invests in a variety of individual hedge funds. In this way, through participation in a portfolio of uncorrelated alternative investment strategies, a private investor has the potential to achieve absolute returns within specific risk boundaries, regardless of the underlying stock market. A fund of funds structure also enhances transparency and liquidity, gives manager diversification, reduces the cost of due diligence and may also optimise the pay-off between risk and reward.
As every hedge fund is different, itâ€™s difficult to generalise but three broad strategy types are often identified: relative value or arbritage; event-driven; and opportunistic or directional. Many funds of hedge funds managers combine these types to improve diversification.
Relative value strategies aim to take advantage of pricing discrepancies between related securities to make a profit, often relying upon complex mathematical models. Most strategies involve the hedging our of broader market risks. As a result, relative strategies are generally regarded as non-directional and are more conservative and less volatile than other strategies.
Event driven strategies seek to profit from share price movements around the time of such corporate activities as mergers and acquisitions, takeovers, spin-offs, liquidations, recapitalisations or other such situations. Event-driven strategies typically incur greater market risk than relative value strategies.
Opportunistic or directional strategies are used by the largest group of hedge funds and come in many different shapes and sizes but basically attempt to identify profitable trends either in particular securities or in entire markets. The resulting trades are usually hedged to some content; that is long positions are counterbalances by short positions, the extent of any hedging determining the riskiness of the strategy. By their very nature, the performance of such funds is not well correlated with those of other funds employing other strategies and their inclusion within a fund of hedge funds can bring welcome diversification benefits.