Hedge funds, or absolute return funds, have gained popularity as the investment vehicle of choice especially among pension funds, endowments and other institutional investors in both Europe and North America. It has been estimated that global investments in hedge funds exceeded three trillion (thousand billion) Euros in 2008.

The main distinction between hedge funds and the traditional mutual funds is that hedge funds do not try to benchmark their performance against any market index, but strive to create actual, or absolute, return that is not dependent on the market environment. This is possible through use of derivatives and short selling of securities, which is allowed to hedge funds. With this characteristic, they don’t require rising markets to give positive returns to investors and can benefit from situations where mutual funds lose their value.

Another material distinction of hedge funds to mutual funds is their objective to measure and control risks. Thus the performance of hedge funds is not necessarily correlated with shocks and fluctuations in the markets. Changes in value are smoothed out with adjustments to investment portfolio, so the investors know quite accurately what the risk level of their investments is.

Hedge funds tend to attract as portfolio managers the best talents in industry. Their ability to get exceptional talent is largely due to the fact that the investment advisor gets a performance fee on top of the fixed management fee. This way the compensation the portfolio manager receives is largely based on the performance he or she can deliver. Furthermore, portfolio managers typically invest a large portion of their wealth in the fund they manage.

Benefits of Allocating into Hedge Funds The advantage that investing into hedge funds brings is based on two facts: exceptional risk-adjusted returns and performance independent of the markets.

At their best, hedge funds offer very good returns after accounting for the low volatility that they in many cases exhibit. This is due to the exceptional individuals that hedge funds attract and the tool they are given.

Equally important positive effect to an investment portfolio is the risk dampening effect of hedge funds. Over time, their low correlation to the market works to limit the fluctuation of the whole portfolio, which increases the overall return-to-risk ratio. The scale of this effect is naturally connected to the proportion of assets invested into hedge funds as well as composition of the portfolio in general. In effect, this means that investing into a high risk hedge fund may in some cases pull down the risk at the portfolio level.

Printed from www.3cfund.com at 30.07.2010.