It’s time to take shelter in a hedge fund

Just when you thought that markets were set to keep rising, hey presto, investors get the wobblies about the Federal Reserve tapering off its quantitative easing (QE) programme, markets slump and volatility spikes. You can’t expect markets to stay calm at the prospect of vast amounts of central-bank-funded liquidity being withdrawn. But out of chaos comes opportunity.

For example, when investors fear a sudden turn for the ‘worse’, they tend to offload assets they think will be hard to sell in a panic. That means illiquid assets are dumped on the market, regardless of their underlying quality. This provides opportunities for longer-term buyers. Panics also destroy carry trades (ie, where investors exploit differences in interest rates between countries).

Carry trades seem to generate almost risk-free returns in calmer times, but panics – or even mild bouts of concern – can see them break down, enabling investors to make money on the ‘short’ side of the trade (profiting as prices fall).

This volatility is meat and drink to hedge funds. Hedge funds aim to generate money in rising and falling markets, ideally with a return at least a few percentage points above cash interest rates. In a sense, they were the original ‘absolute returns’ funds. These latter have become hugely popular via outfits such as Standard Life’s GARS fund, a multi-asset-class fund for private investors and pension funds, which looks to exploit pricing opportunities across the world and between asset classes. But look inside the box of strategies employed by the likes of GARS and you’ll discover many ideas that were first developed by hedge funds.

What GARS does is bring them all together into one fund, and then sell it to private investors. Hedge funds, by contrast, have traditionally only been sold to high-net-worth individuals willing to take the risk of investing in complex, sometimes exotic, investment strategies.

Funds of funds

A few years ago, the idea of using different strategies within one fund was the preserve of the ‘fund of hedge funds’, which involved a single fund manager investing in several different underlying hedge funds, to produce a balanced approach using lots of different strategies.

On paper this sounded great, as most investors have no real sense of whether a particular hedge-fund strategy is a genius idea, or well past its sell-by date. So the in-house fund manager would research the range of strategies, then work out which hedge funds to buy. In reality, the approach simply added a layer of management costs on top of the already high individual hedge-fund fees. This wouldn’t have mattered if the underlying hedge funds had produced amazing returns – but most didn’t.

In markets, any successful strategy is usually discovered rapidly, then slowly traded away as everyone jumps in and exploits the opportunity. So most successful hedge funds make their profits from being disciplined, using small amounts for small trades, and taking lots of regular bite-sized profits. Over time, these trades add up, especially if you have leveraged up returns. But trading activity also introduces its own specific risk – the risk that the managers will regularly get their sums wrong and make losses.

Funds of hedge funds were caught in a double whammy. Many hedge funds suffered huge losses during the global financial crisis – they were meant to be ‘market neutral’, but in fact just shadowed equity markets lower. Yet they continued charging high fees, which were compounded by the fees of the fund of funds itself. As a result, these funds have become fairly unpopular with sophisticated investors, who would now rather focus on just one hedge-fund manager running a fund, but with many different strategies under the bonnet – like the Standard Life’s GARS fund.

Big traditional hedge funds have also pushed aggressively to make their funds available to sophisticated private investors via feeder funds on the London Stock Exchange. These closed-end funds have become popular. Costs are usually a tiny bit lower than standard hedge funds, and there’s even the chance of buying at a discount to net asset value. Many have also learned lessons from 2008 and use strict risk-control measures, mostly involving the use of more liquid underlying securities that can be easily sold if investors start to sell shares.

So why invest in these listed hedge funds? They can trade in lots of different asset classes, so that even if everyone is selling equities, for example, the managers can buy something else. But perhaps the most compelling selling point is that many hedge funds thrive on volatility – they make most of their money when markets are in turmoil and trends appear, which can be captured by a trading strategy.

The best sector to buy into

I’m particularly drawn to single- company hedge funds in the bonds sector. The fact is, sometimes a key asset class can become insanely overvalued, leaving it likely that sooner or later that market will take a sharp tumble. That’s how I’m feeling about the bond markets.

There’s an increasingly fevered debate about whether bonds, especially government bonds, are in a bubble. I believe they represent appalling value, as do most investment-grade corporate bonds. Sooner or later they will all fall fairly substantially in price, as bond market volatility starts picking up (it’s already up appreciably over the last year). But the problem is that this irrational pricing could carry on for months, or even years. Bonds might become even more expensive, and I might lose out on gains by avoiding them.

This is where bond-focused hedge funds like the Brevan Howard Credit Catalysts Fund (LSE: BHCG) come in. This is an absolute-returns hedge fund that can go long and short bonds across the full spectrum of issuers. It’s far from the only fund that does this – there are successful absolute-returns unit trusts in the bonds sector available from Threadneedle, Schroders, Ignis and boutique Tideway’s Global Navigator Fund. All can choose any strategy they want to invest in the bonds spectrum, and hopefully allow an investor to stay invested in bonds without putting all their capital at risk.

• In my last article, I talked about the merits of investing in America’s energy infrastructure through master limited partnerships (MLPs). Sadly, despite my enthusiasm, there’s a tax-based catch – as you have to buy dividend-paying US shares, you end up paying US withholding tax at 15% on those payouts. But a couple of weeks back, UK-based ETF provider Source cracked this problem by bringing out a London-listed ETF that invests in all these major infrastructure assets. Source Morningstar US Energy Infrastructure (LSE: MLPS) is structured so that you don’t have to worry about the tax treatment, although there is a swap charge of 0.75% to pay a US investment bank to hedge away that liability. I’ve bought some shares and aim to buy more.