Access to Islamic Hedge Funds - Incisive Media

investing in hedge funds
Funds offer investment strategies
for wide range of market conditions
While hedge funds were originally attractive only to a high net worth individuals
and family offices, institutional investors are also keen to take advantage of the
higher returns uncorrelated to markets that hedge funds represent.
Alfred Jones is credited with the creation
of the first hedge fund in 1949. To
neutralise the effect of overall market
movement, he balanced his portfolio
by buying stocks he expected to rise
and selling short the ones he thought
would drop in price. The effect was to
‘hedge’ part of the risk due to overall
market movements.
The industry has grown rapidly
with an estimated $3 trillion in
assets under management. Hedge
funds now account for close to half
the trading on the New York and
London stock exchanges, according
to some sources.
Even with the recent market
instability and financial turmoil,
few believe hedge funds will disappear.
On the contrary, this alternative
investment sector is one of the
fastest growing and most attractive
to investors, despite a recent spate of
redemptions for some strategies.
The attractiveness of hedge funds
to investors lies in their generally
uncorrelated returns to traditional
markets. Returns of many hedge
fund investments are not too closely
related to the ups and downs of
Assets ($MM)
2,000,000
1,750,000
1,500,000
1,250,000
1,000,000
750,000
500,000
250,000
38,910
0
58,370
Estimated assets
Net asset flow
8,463
95,720
27,861 167,790
36,918 167,360
(1,141) 185,750
14,698 256,720
57,407 367,560
91,431
374,770
4,406 456,430
55,340 490,580
0
90 91 92 93 94 95 96
Source: Hedge Fund Research
estimated growth of assets/net asset flow
equity hedge (total) 1990–Q2 2008
23,336 539,060
99,436
46,545 625,554
820,009
972,608
1,105,385
70,635
73,585
1,464,526
1,868,419
46,907
126,474
194,515
1,875,708
1,931,438
16,469
12,515
97 98 99 00 01 02 03 04 05 06 07 Q1 Q2
08 08
traditional markets. The funds can
operate in almost any market. They
can invest long, like a traditional
mutual fund, or short, profiting if the
value of the underlying asset falls.
Although some question whether
hedge fund managers will be able to
continue to produce alpha – returns
over and above those on the broad
market in which they operate, generated
due to the fund manager’s skill in
exploiting inefficiencies in the market
– even those achieving only market
returns (beta) are in high demand.
The reason is that even a relatively
poor hedge fund performance is likely
to be better than anything the more
traditional long-only and mutual fund
sector can offer. Even compared with
private equity and real estate funds,
the returns are potentially high.
Hedge fund investing is not for the
faint-hearted. Investors need to understand
the risk they take. Historically
hedge funds offer a unique source of
return drivers that have generated
high risk-adjusted returns with relatively
low correlations to other assets.
In traditional asset classes such as
equities or fixed income, active managers
have essentially two components
to this performance: the market
(beta) and excess return versus the
benchmark (alpha).
In traditional portfolios, alpha can
be generated only by overweighting
stocks considered undervalued within
the benchmark and underweighting
securities considered overvalued.
Hedge funds, unlike long-only managers
whose total returns are dominated
by benchmark movements,
can achieve returns independent of
normal market cycles.
Having an alpha focus, hedge fund
strategies try to exploit market inefficiencies
in a variety of ways. These
include buying undervalued securities
and selling overvalued ones at
the same time, making macro bets or
by relying on tactical trading skills.
These techniques provide a source of
return different from a portfolio of traditional
market-driven investments.
This absence of correlation with
the markets is what many investors
want in order to boost their returns
on investment.
Hedge funds started out as a tool
for high net worth individuals to
boost the performance of their private
offices. Now hedge funds are a
tool for institutional investors, particularly
pension funds and endowments,
used not only to diversify
portfolios but also to help increase
investment returns.
Over time hedge fund strategies
tend to exhibit fairly low correlations
to equities and low or negative correlation
to fixed income. It is no surprise
that investors are keen to add
hedge funds to a traditional asset
mix to reduce overall volatility and
generate better returns.
Large corporate treasuries are
also using alternative investments as
a diversifier, often together with protected
structured products for large
cash holdings. This is one of the key
drivers of the significantly increased
net inflows to hedge funds.
While there are a plethora of
hedge fund strategies, the most
common is long/short equity. It is
certainly considered the largest category
in terms of the numbers of
hedge funds. But even this relatively
simple and common strategy runs
into significant problems for any
investor applying Shariah principles.
While the conventional long/short
strategy is outside the precepts of
Shariah law, it has taken considerable
time and money to find a way
to match the Shariah principles with
the way in which the hedge fund
strategy operates (article, page 17).
In the aftermath of the credit
crisis and the financial market chaos,
hedge funds are expected to continue
to play an even stronger role in creating
liquidity and making markets
more efficient, according to some
market observers. Finding ways to
enable hedge funds to operate in a
Shariah-compliant way will open
this alternative investment vehicle to
more investors.
Hedge fund managers for their
part are eager to find ways to modify
strategies and the way they create
alpha in order to adhere to Shariah
principles so that investors in the
Islamic community can take advantage
of this alternative investment
strategy.
It is also likely that hedge funds
will become more transparent following
the financial turmoil of recent
months. Regulators will be paying
more attention to their activities, as
will investors, keen to ensure that
operational and counterparty risks,
for example, are addressed.
Analysis of operational risks
involved with hedge funds includes
issues such as safe custody of
assets, pricing policy and checks and
balances within the investment management
company. The assessment
of credit and market risks is another
area investors will want to see managed
better in future. n
www.hedgefundsreview.com November 2008 | Access to Islamic Hedge Funds Supplement | 17