However as more retail hedge funds come onto the market, the minimum investment for some of these products has come down. Some funds now have a minimum initial investment of S$10,000 as opposed to the S$100,000 initial investment for the high-end hedge funds. As a result, more investors have taken a deeper interest in these funds yet still have little or no idea how they are managed. To them, investing in hedge funds is similar to putting money into a black box that churns returns. At the end of the article, we hope that investors will have a better idea about hedge funds and what is inside that black box.

Hedge funds have a wide variety of trading strategies at their disposal. They can use options, short selling and leverage. To 'hedge' literally means to diversify some forms of risk (such as currency risk or country risk). There are many strategies that can be used to diversify risk. Instruments such as options, forwards, and futures are usually used for this purpose (these strategies will be explained in detail later). It is thus ironic that many of the complicated strategies that hedge funds managers use can make their funds riskier than ordinary equity funds.

There are three basic kinds of hedge funds sold that are currently being marketed to retail investors: the single manager hedge funds, and fund of hedge funds and guaranteed hedge funds. A fund of hedge funds invests into a number of hedge funds managed by different fund managers. Usually by investing into different hedge funds, these 'fund of hedge funds' aim to diversify risks by investing in hedge funds with different strategies. Guaranteed hedge funds are funds that have given some form of guarantee to investors that they will pay back the principal amount invested at the end of the maturity period of the fund.

How do these kinds of hedge funds work? As the name implies, single manager hedge funds are managed by just one fund manager. That person maximizes returns by making use of different hedge strategies. This includes strategies such as equities long/short, option strategies and arbitrage strategies. Such hedge funds are usually not available for subscription to the general public. Instead, these funds are marketed to high net worth individuals, classified as sophisticated investors.

The 'fund of hedge funds" is more likely to be available to retail investors. This type of fund invests in a few hedge funds managed by the same or different hedge fund managers. The advantage of investing in these funds is that they are diversified across a spectrum of different hedge funds with different strategies. Being more diversified, fund of hedge funds will normally be less volatile than single manager hedge funds.

Conservative investors are more likely to be attracted to the capital guaranteed hedge funds. The protection of capital is an attractive feature for these investors. A capital guaranteed fund is able to guarantee 100% of the initial amount invested as a large part of the fund that is invested into safe assets such as bonds or zero-coupon bonds. (Zero coupon bonds are bonds that do not pay coupons. At the end of the maturity of the bond, you are able to get the full price of the bond). About 70% to 90% of the hedge fund is invested into zero coupon bonds. The rest of the fund is invested into risky assets such as options, equities or futures. The hedge fund manager may use leverage for these capital guaranteed hedge funds.

Read the full article in the latest Fundsupermart magazine.

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