Introduction to Hedge Funds

Michiel Timmerman, Co-head, Investments, Royal Bank of Scotland Asset Management

Hedge funds have attracted some negative interest in the financial press because of the perception that they are high risk, which is not necessarily the case.

Yet the reality is that hedge funds have proved highly successful investments that Michiel Timmerman, believes should be considered by charities keen to diversify their investment portfolios.

‘A hedge fund is an investment fund that is not measured against a benchmark, but is dedicated to absolute returns,’ explains Timmerman.  A traditional fund manager is focussed on outperforming an index and, to achieve that, usually adopts a long-only stance.

‘The manager will be unwilling to take much risk against the benchmark because it is difficult to recover any significant underperformance,’ adds Timmerman. ‘For example, a large cap fund manager is unlikely to own many small cap companies because this makes the risk profile against his benchmark too high.’

These restrictions do not apply to a hedge fund manager. ‘He makes his money by investing across a much wider range of opportunities,’ explains Timmerman.

Hedge fund managers will use a range of investment strategies to make money, including directional market exposure, stockpicking and arbitrage. He will also ‘sell shares short’. ‘If the share price falls, he buys back the shares in the market at the lower price and so makes money when a stock falls.,’ explains Timmerman.

Sometimes a hedge fund manager will simultaneously adopt long and short positions in two companies as a form of hedge against unexpected market price movements. ‘They can engage in M&A arbitrage, isolating the risk of the deal not attaining completion,’ explains Timmerman. ‘This often involves taking a long position in the target company and a short position in the acquirer.’

Hedge funds have historically usually generated better risk-adjusted returns than exposure to long-only equities or bonds.  Added to a portfolio of stocks and bonds, they boost the return achieved per unit of risk.

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