Hedge funds – a useful insurance policy for volatile times

Hedge funds promise investors two valuable, easy-to-understand benefits for their portfolio. The first is diversified returns they help to spread your risk. The second is absolute returns they promise to make at least some money, regardless of market conditions.

If we want to get technical, we could add a third characteristic: an ability to profit from trends', that can be captured using clever strategies. In short, hedge funds are meant to be a good insurance policy against the sort of volatility we've seen in markets recently. Sadly, the reality is a little different.

Last time, I highlighted the small number of London-listed single-company hedge funds. The table below shows these funds with recent price returns data, courtesy of Numis. In theory, despite a near-5% drop in the benchmark MSCI World index, hedge funds' returns should have been positive over the month.

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What are we to make of these largely disappointing results? I'd argue that they are slightly unrepresentative in some cases, especially the big BH funds. Both BH Global and Macro have produced very solid results over the last five years and these recent poor numbers are hopefully a blip both funds invest exclusively in in-house funds, following a range of different strategies. A smart move might also be to add some exposure to the BH Credit Catalysts fund, which could be ideally positioned for any bond-market upheaval.

The loss by Third Point is also not entirely surprising. Run by legendary Wall Street investor Dan Loeb, this US-based fund also runs a number of different strategies, including credit investing (buying good-value debt) and equities, plus a smattering of top-down macro-investing (analysing big picture' data to uncover trades). The BH funds have a well-deserved reputation for macro investing, but Third Point also has a good recent record in this space.

However, scratch beneath the surface and there's another story that Third Point's returns are likely closely to mirror those from US financial assets, including shares and bonds. I wouldn't go so far as to say that Third Point is a straight US beta play (this is where a fund's return almost exactly mirrors the return of a benchmark index such as the S&P 500), but it is true that if US assets do well in the next few years, Third Point should benefit.

As it happens, I think US assets will do rather well, so I've quietly upped my holding of shares in the fund in recent weeks. The CQS Diversified Fund, meanwhile, ticks most of the usual boxes for a listed hedge fund it runs a series of internal strategies, with relatively steady, boring returns, from a well-respected house.

The exception is BlueCrest's funds, and especially the trend-following BlueLine, which had an awful month. Yet I have actually increased my holding in this fund. I think trend-following trading strategies will come into their own eventually. The idea with outfits like BlueTrend is that they find technical trends in the markets, then go long or short these opportunities. On paper, the recent turbulence should have thrown up lots of opportunities but clearly they were the wrong' sort of trends!

For example, BlueTrend must have lost a slug of money on its fixed-income strategies, which just goes to show that second-guessing central bankers is a tough job, even for trend-seeking hedge-fund investors. When a major twist comes long (in this case, the Federal Reserve signalling a tapering of intervention), they're blind-sided, just as you or I would be.

So why am I buying more? Because I think trend-followers remain a potentially great insurance policy in the event of truly unknown, bad stuff happening. Overall, if you are interested in listed hedge-fund exposure, you should diversify across strategies and managers. A core mini-portfolio of BH Macro, BH Credit Catalysts, Third Point, BlueTrend and CQS ticks most boxes. But monitor the performance data to ensure they are delivering over time: even when hedge funds lose their edge, they still charge a packet for the privilege of investing.

One last thing: there are many rivals to listedhedge funds over in the conventional absolute-returns sector. Standard Life (with their GARS vehicle) and GLG, as well as smaller groups like Odey, run funds that are basically retail-friendly versions of hedge funds. Their performance in recent weeks has been little different to their listed rivals.

The average Investment Management Association (IMA) Targeted Absolute Return fund lost 1% over the last month. The big GARS fund fell 3.2%, and Newton Real Return shed more than 4%. Some less well-known managers, by contrast, did turn in half decent numbers, including GLG (its Alpha Select fund was up over 3%) and Odey (its CF Absolute Return fund was up 2.9%).

These latter two funds have excellent reputations both would sit nicely in a diversified portfolio alongside the listed versions.