Do you know what a hedge fund is? Find out how to invest in one

When you think of a hedge fund, you may picture cold-faced businessmen staring intently at large computer screens dotted with numbers and graphs.

Hedge funds have an air of being out of reach and only being applicable to the uber rich. But this may not be true. We look at what a hedge fund really is and we consider how you can invest in one.

Tip: A unit trust is also a good investment vehicle if you’re just starting out.

The history of hedge funds

According to Yonela Makwetu, portfolio manager of Multi Manager at Sanlam Investments, the first hedge fund was founded by a US investor in 1949 and it was called the Jones Hedge Fund.

The first hedge fund in South Africa, Makwetu says, was founded in 1998. At the time these investments were only available to institutional investors and high net worth individuals. 

“As of 2015, South African hedge funds are regulated under the Collective Investment Scheme Act (CISCA), which introduced two types of hedge funds: the qualified investor hedge fund (QIHF) and the retail investor hedge fund (RIHF),” says Makwetu. 

She explains that once this legislation was passed, hedge funds were made available to retail investors for the first time.

What makes hedge funds different from traditional investments?

Makwetu explains that a hedge fund is an investment fund with more tools to generate returns than the traditional collective investment schemes.

“Traditional funds can only make money when the value of the security they hold increases in price, thus being a 'long' position. Hedge funds, on the other hand, can make money when the price of a security declines in value; this is known as a ‘short’ position,” says Makwetu.

She lists the following characteristics of hedge funds:

• They employ the same strategy as traditional funds by buying an undervalued share in the hope that it will go up in value.
• Hedge fund managers can borrow an overvalued share, sell it at a high price, and then repurchase it at a lower price in future to lock in the gains.
• Hedge funds use these tools to generate excess returns for their portfolios.

To further illustrate how hedge funds work, Sheldon Friedericksen, CFO at Fedgroup, says that they are subject to the same rules as other unit trust funds – with one important relaxation.

“Like traditional investments, a hedge fund enables you to invest money, or other assets, which could result in gains on your investment. But it also includes losses, which could exceed the money invested at any point in time,” says Friedericksen.

He explains that this can occur through the manager of a hedge fund leveraging a position with debt or taking a net short position in particular investments.

To explain this, Friedericksen says, a short position is when a commodity is sold in the future at a certain price. The company that then buys it will take the long position. This method is used in many commodity markets, such as copper, corn, natural gas, and gold.

“A hedge fund structure enables the investment portfolio manager to invest in a wider range of assets within the market than is allowed in a regular unit trust fund. This enables an investor to diversify their holdings further, often in assets not held in their traditional pension funds or unit trust funds,” says Friedericksen.

He explains that this does not necessarily mean that each of these investments holds higher risk, or will result in higher returns or greater losses.

“However, as with all investments, you as the investor should understand the underlying investment and the philosophy applied by the manager,” says Friedericksen.

READ MORE: The perks of investing in student accommodation

How to get started with hedge funds

Friedericksen says that there are a number of offerings, both locally and internationally, that can be purchased through financial advisors, or directly on the financial service companies’ websites.

As an investor, he says that it’s important that you understand:

• What each investment is,
• What the goal or benchmark of the investment is,
• What the strategy is that the manager is applying to achieve their fund goal, and
• How liquid the investment is (how quickly you can withdraw your investment).

“As with all investments, historical performance is not indicative of future performance, and your investment capital is at risk of fluctuations or volatility,” says Friedericksen.

“What should be kept in mind with hedge funds is that these fluctuations can be amplified through the nature of the investments, increasing the potential for you to lose more than usual. However, this also results in the potential for you to earn more than usual,” he explains.

Friedericksen believes that balancing your full investment portfolio in line with your risk appetite is a difficult undertaking. It is well worthwhile to obtain expert financial advice from a trusted advisor.

If you’re interested in more traditional investments, consider a unit trust.