On one hand, even A-rated banks have trouble raising debt funds because issuers are not sure of their credit quality due to the US sub-prime crisis. On the other hand, the same sub-prime crisis has negatively impacted the equity holders of corporations worldwide even more.

Types of alternate assets
During times such as these, investors often flee to alternate assets such as real estate, commodities, precious metals, private equity and so on. There are several ways of getting exposure to alternate assets:

(1) One could invest directly in the commodity. For example, you could purchase a bar of gold. For most investors, this is difficult or impossible. Further the storage costs of the commodity may preclude outright buying even if one could afford to purchase it.

(2) One could invest of the equity of companies that are involved in alternate assets. This is possible, however, the stock of a given alternate asset company, say an oil company is correlated both with the price movements of the underlying oil, as well as many other factors. For example, between the beginning of March in 2007 till the end of February of 2008, British Petroleum’s stock price increased from $61.00 to $64.08, a price increase of around 5% (based on Yahoo Finance). In addition to this, the stock paid a total dividend of around $2.73 per share which corresponds to a total return of around 9.5% (inclusive of dividends). Over this same time period, the average world spot price of crude oil increased from $54.46 to $93.51, giving an investor that invested directly in purchasing crude oil a return of around 71% (based on US Government Energy Information Administration). Thus, investing in an oil company stock is probably not the best way of investing in the underlying oil.

(3) A third way to access markets in alternate assets is to invest in a special class of pooled investment vehicles called ‘hedge funds’.

What are hedge funds?
While there is no formal or generally accepted definition of a hedge fund, they are generally regarded as mutual funds (or unit trusts) that have (1) little regulation or disclosure as compared to regular unit trusts (2) can take on highly risky strategies including unrestricted use leverage, short positions and option contracts, and (3) usually charge fees based on assets under management as well as performance fees. Hedge funds achieved prominence, some may say notoriety, in the late 80’s and 90’s. The Quantum fund (now closed), run by billionaire George Soros, became famous for betting on and making money on the depreciation of the British pound in 1991. Soros’ fund was also blamed for the Asian Financial Crisis although this contention has been questioned by subsequent research by Prof Stephen Brown, a Professor of Finance at NYU. Long Term Capital Management, a hedge fund with two Nobel laureates among its partners, was responsible for a crisis in the bond markets in 1998. The fund was subsequently liquidated but the incident led to several calls for greater regulation and hedge funds and reinforced their image as shadowy investment vehicles suitable only for institutional investors.  

Looking with a different perspective
While the eye-catching headlines as well as the lack of regulatory supervision of hedge funds may seem to make them inappropriate investment vehicles for small investors, I will argue that this is not necessarily the case for all types of hedge funds. Most of the headlines were made by the so-called global–macro funds, funds that have wide latitude of investing in almost any type of security anywhere in the world with few restrictions on risk that they take. On the other hand, there are many other types of hedge funds that could potentially benefit retail investors. Further, the regulation in Singapore for hedge funds that can be bought by retail investors, provides some safeguards against the LTCM type of collapses. Further, hedge funds like unit trusts are now available for sale at several banks in Singapore.

One of the oldest types of hedge funds are the so-called market neutral hedge funds. This type of hedge fund typically invests in public equities.  Their goal is to get a positive return that is independent of market conditions. The market neutral hedge funds try to achieve this goal by taking a long position in a stock that they perceive to be undervalued and a short position in a security that they perceive to be overvalued. If the fund manager is correct in the choice of under and/or overvalued stocks, the fund will yield a positive return when the market prices of the underlying securities correct for the mis-pricing.  Any market wide movement would impact both the stock that the hedge fund has taken a long position in as well as a stock that the fund has taken a short position in. In an ideal world, the impact of a market wide movement on both these stocks would be equal and thus the fund would be unaffected by whether the overall market is on a rising trend or the overall market is falling.  Thus, a market neutral hedge fund can provide a positive return in both bull and in bear markets. Needless to say, the ability of the manager in picking the long and short positions is critical in achieving market neutrality, as well in securing a positive return. Other hedge funds specialise in commodity investment by investing in futures and options contracts on the underlying commodities. This could provide exposure to commodity markets.

Other Issues
To the extent that hedge funds are genuinely successful in achieving a low correlation with the stock or bond markets which are the only ones available to retail investors worldwide, investments in hedge funds provide diversification benefits relative to stock or bond investments. Academic research indicates that hedge fund indices have a lower correlation with stock markets relative to normal mutual funds. However, there are still a number of issues with regard to investment in hedge funds that merit caution. First, standard portfolio performance measures such as the Sharpe ratio or the portfolio volatility used as a proxy for risk in the case of unit trusts are not good measures to evaluate the risk or performance of hedge funds. Although a number of alternate performance measures have been proposed, all of them have problems and as a result are not widely accepted. A second issue is that hedge funds typically charge performance fees. Thus, when investing in a hedge fund, the investor pays a fixed fee for assets under management (as with mutual funds) and in addition, pays a performance fee that usually ranges between 10% and 20%. Again, current research does not allow one to have a clear picture of whether these performance fees are worthwhile or not. To the extent of research into mutual funds indicates, funds with higher fees tend to underperform. If this research on mutual funds is applicable to hedge funds, any diversification benefits would have to be weighed against possible underperformance due to high fees.

Conclusion
To summarise, I believe that certain type of hedge funds that invest in commodities or attempt to be market neutral would be a good diversification tool to invest a small portion of one’s portfolio. One would need further research to correctly quantify the benefits in terms of diversification as well as risk and performance measures that are more appropriate for the hedge fund industry.