Markets volatile? So what's the alternative?

Many investors have taken to investing in index tracking funds over the last few years. These are so called "no-brain" investments, as they need no real fund management process as they work simply by following the index investors decided to track. This typically might be the UK FTSE 100, FTSE Allshare, EUROSTOXX 50 or the US S&P 500. Simply put, if the indices rise you will make money and if the indices fall you will lose money. Since over the longer term the indices have always risen and over the period since 1905 the UK index has risen by an average of 12.3% pa, equity investment in major markets has proved itself to be the best form of investment open to the common person. This is called "passive investment" and has worked well over the years. Barclays Global Investors focuses on this type of investment and are the largest managers of tracker funds in the World.

However, over the last few years the main indices of the UK and US have gone absolutely nowhere, and at the time of writing Japan is still on the ropes from a 13 year bear market. They went up very nicely and then they went down again and since then have been bouncing between a narrow range. This is fine if you have held your investment for several years, as you have profits made some years ago as a cushion, but it is hell if you invested at the top of the recent range and then immediately lost money. This should not, but might well deter you from investing further and although cash might be a short-term solution, with interest rates on deposits as they are, by the time you take off inflation it really is a poor investment in the longer term.

So instead we can use a fund manager who picks and chooses our investments for us. This is also fine and many of these have way out-performed the indices since the bubble burst in March 2000. However, these can only make money when the markets are rising and at present most are not. Buying and selling as these managers do is called "Active management". Picking the cream of these is very difficult but in fact crucial, as over the longer term 80% of these fail to outperform the index trackers. So, if index trackers are stuck in a rut and many active managers doing little better, what do we do? We can just take a long-term view and say that "now is the period when the sales are on" and actually plunge into the markets as this makes more sense than waiting for the prices to rise again before we buy. But this involves some bravery and there are no guarantees as to when the tide will turn. Or we can look at some alternative investment funds known as hedge funds.

Hedge funds come in all shapes and sizes and different guises. Some are very aggressive and have attracted much publicity over the years. George Soros is probably the World's best-known Hedge Fund manager, famous because he out bid the Bank of England in 1992 as the UK vainly tried to keep Sterling pegged to the Deutsche Mark because of the ERM. While the Bank of England spent much of its foreign reserves buying the Pound, Soros' Quantum Fund (now closed) kept on selling it using derivatives, and eventually made a Billion for his investors from this strategy. This was high-risk high profile stuff, but there are in fact many managers, quietly and successfully employing alternative techniques to make low-risk and consistently steady returns for their investors.

So what do I mean? The traditional funds as mentioned above, be they trackers or actively managed are known as "long only" funds. This means that they can only buy an asset in the hope that it will increase in value. These managers can only do this as they are constrained by the articles under which the fund is set up. These articles probably state that the fund manager must be at least (say) 85% invested at all times. This is to stop him remaining in cash when you have invested your money in (say) the Japanese Market. If he is in cash and the market rises he will have missed the boat and you would be unhappy not to have been on it. Of course this also means he must just cope as best he can when markets are falling and your money will go with it as he cannot sell out under the articles of the fund. This in turn means long-only investors are largely hostage to market sentiment regardless of their manager's stock picking skills.

However a hedge fund manager has no such constraints and usually manages his own money along with his investor's funds. He tends to operate in secrecy as he can plot and scheme his tactics. He may be fully invested or even all in cash, he can also "short" the market which means he sells options that at a specific date in the future the purchaser may buy from him a share at a pre-agreed price on that date. He is then hoping that he can buy the share at a lower price then than it is today for when he must deliver it. It is a classic hedge fund tactic to "go long" the best prospects you can find and "go short" the companies most likely to have a rough time and falling share price.

This strategy means he can profit on those stocks that fall as well as those that rise. Some of the funds however do not actually have any correlation to market direction at all. Some such as Momentum Allweather Fund has virtually zero stockmarket correlation as it invests in areas unrelated to stockmarket movement. These include asset-backed lending (taking collateral in exchange for a loan), Distressed Securities (buying a company's debt for less than the value of the assets securing the debt, and either selling the assets, or forcing a turnaround in the company's fortunes and selling it on), Arbitrage (exploiting small pricing differences as prices take a few minutes to catch up on globally traded assets or commodities) and merger opportunities which mean watching for merger opportunities. Typically this means the target company's shares will rise and the bidder's will fall. This then gives the hedge fund manager the opportunity to go long the target and short the bidder. When the deal goes through, the deal will close at the offered price for the target, which must be higher than the previous market price, and usually the bidder's price falls because it has just spent its cash or incurred debt. The manager then pockets the profits as the gulf between the prices comes together.

The above is a very simplistic view as strategies vary in execution as well as diversity, and there are a good many hedge funds out there. However since recent market activity has spawned a whole host of new ones, some with less experienced managers, clearly they are not all the same so the skill is finding which are the best ones and which of them match your individual needs. Having worked with some of these managers for a good number of years now, Offshore-Rebates.com house view is that we have identified some well worthy of your consideration.

I mention in particular Pioneer's Momentum Allweather as it has been run very successfully indeed. It is a fund of funds, which is designed to cover every aspect of the investment cycle through boom to bust and be profitable regardless of which period we are in. It has 6 complimentary strategies and currently invests with 32 different managers.

Since the fund was launched in May 1995 it has had just 8 losing months. Only one of these as of 31.12.03 was greater than 0.6% and most considerably less. Click the link for comparison with traditional indices. I believe you will be most impressed:

Pioneer Reports (Formerly Momentum Alternative Strategies Ltd)

As at 31st December 2003, 104 months after launch, Allweather has notched up 96 profitable months. In comparison the JP Morgan Govt Bond Index, (bonds being the traditional investor's shelter in times of volatility) has had just 59 profitable months. The annual volatility on Allweather has been 3.40% which is 48% less that the 6.48% on the bond index. Its annualised return to date has been 9.40% as against 6.44% in government bonds.

The 1st of March 2001 brought us a Euro version of Allweather. It is invested in exactly the same assets as Allweather Dollar but with the currency fully hedged into Euros and 1st January 2004 brings us a Sterling version.

Man Investments also offers some very decent products. These tend to have an initial launch period of a couple of months and then close to new investors. They tend to have capital guarantees and launch about 4 times per annum. They also have a similar fund to Allweather called Man Glenwood. Man Glenwood is a little more aggressive than Allweather with a little more volatility, perhaps more in line with bonds. The Glenwood fund has run since 1987 and averaged 12% per annum. Remember that this was achieved with bond-like low volatility and low direct market correlation. This underlines these type of investments to be well worthy of serious consideration for part of an overall portfolio. It is worth asking to see what Man is launching when you read this.

We also have a lot of time for Thames River Capital. Thames River operate a range of traditional long only funds and compliment these by also running hedged versions of the same funds run by the same managers. Thames' reports are posted on this site, and it is interesting to compare Hillside Apex with High Income, and Kingsway with European to see what I mean about the same managers and same underlying investments but with a different strategy employed. However whilst it is a good exercise to compare these, Thames River's funds are a bit more aggressive than Allweather for example and tend to have large minimum investment amounts of US$100,000. It is therefore plain these are not designed with everyone in mind. Indeed many of Thames River's investors are corporate pension schemes etc. However Pioneer's Momentum Allweather fund and Man Investments are more geared to individual retail investors and can usually be bought into with a minimum of US$25,000. Henderson have also just launched a hedge fund with a minimum of US$15-20,000. We believe that the careful use of hedge funds makes a useful addition to most people's portfolio and by increasing diversification will reduce risk while it should improve overall performance.

  Capacity in the hedge fund industry - is this the right time to invest?
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  Demystifying Hedge Funds

Discounts are available as per our normal policy. Past performance is no guarantee of the future of course but these funds are non-market correlated and perhaps worthy of a look in the interests of diversifying your investments. This prudence might help you sleep easier at night, particularly in a period of high stockmarket volatility such as we are seeing just now. Do you have questions? invest@offshore-rebates.com

Aurum is a privately owned investment management group focusing on alternative investment strategies. Aurum's investment approach is based on independent thought and objective research.

Formalised in 1994, Aurum is a culmination of over 15 years hedge fund investment experience by each of the firm's principals.

Aurum manages a range of 14 different fund of funds investment vehicles which provide access to some of the world's best hedge fund managers and strategies. Some of these fund managers may otherwise be closed to new investors.

The objective of Aurum Funds is to provide investors with capital appreciation whilst focusing on capital preservation, with the benefit of diversification between markets, currencies, countries and asset classes to spread risk and reduce volatility.

Aurum Funds have been nominated for and won awards for Best Performing Hedge Fund of Funds over 5 years on a risk adjusted basis, Most Innovative Fund of Funds and Best Newcomer Hedge Fund of Funds started in the last 12 months.

Gross assets under management now amount to over USD 1.6 billion.