Hedge funds use investment strategies that are more complex than other managed funds. Many aim for positive or less volatile returns, in both rising and falling markets.

A hedge fund is a complex investment and risks vary. Read the product disclosure statement and consider getting financial advice before you invest.

How hedge funds work

Hedge funds ('absolute return' funds) use pooled funds to invest in alternative assets or strategies. This may include the use of derivatives, alternative investments or leverage in domestic and international markets.

Hedge fund returns may depend less on traditional assets, like shares and bonds. This can make it a good way to diversify a portfolio.

A hedge fund may aim to deliver positive or less volatile returns, in both rising and falling markets. It could try to outperform a benchmark, such as a market index or interest rate. Or achieve a benchmark return with less volatility.

Hedge fund features

There are different types of hedge funds. The features and risks of each depend on:

• fund strategy
• what assets it invests in
• where assets are
• investment tools used
• fund manager's knowledge and skill

See the fund's product disclosure statement (PDS).

Investment tools

Common investment tools include:

• Leverage — When a fund increases its exposure to certain assets or strategies, usually through borrowing. Leverage can increase returns, and increase losses.
• Derivatives — Securities whose value depends on an underlying asset such as a share, commodity or index. Used to manage risk. And gain or reduce exposure to assets, markets or events. Enables an investor to buy or sell an asset in the future, based on an agreed price.
• Short selling — An investor borrows a security from another party (a broker), then sells it on the market. The investor aims to buy an identical security at a lower price and return it to the lender. And hopes to profit from the difference between buy and sell prices.
• Alternative investments — Investing in assets such as high yield bonds, synthetic assets, derivatives, unlisted shares or other hedge funds.
• Active management — The fund manager decides what to invest in, and how much. The manager's expertise is crucial to the fund's success.

Fund of hedge funds

A 'fund of hedge funds' is a fund that invests in other hedge funds. It may invest all or some money in other hedge funds.

When a fund invests in another hedge fund, the underlying fund is usually not open to retail investors. The underlying fund may be offshore, with less monitoring.

A fund of hedge funds may have extra risks. For example, it may invest in multiple hedge funds, across assets and markets. This can make it harder to know where the fund invests your money, and what the risks are. You may also have to pay more fees.

Pros and cons of hedge funds

To decide if investing in hedge funds is right for you, consider the following:

Pros

• Targeted strategies — A fund may target less volatile returns, so it loses less in a down market. This may be at the expense of gains in a rising market. Or mean a risk of greater losses. So consider your appetite for risk when choosing a fund.
• Asset diversification — Can expose you to a broader range of asset classes and markets. This can help diversify your portfolio. And reduce exposure to downturns in some asset classes or markets.

Cons

• Leverage risk — A fund may have an exposure greater than 100% of the assets invested. So, if markets move against the fund's position, it could lose a lot. Derivatives and short selling both involve leverage risk.
• Liquidity risk — Investing in assets not traded on an open market makes them harder to sell or value. If an asset devalues, it may be hard to sell fast if you want to get your money back. A fund of hedge funds may not be able to exit the underlying funds quickly. This makes it harder to redeem your money at short notice.
• Concentration risk — Concentrating assets in a single market means a greater risk of losses, if that market underperforms.
• Complex structure risk — May be hard to work out how the fund invests your money. And the risks you are taking on.
• Counterparty risk — Derivatives could be purchased 'over the counter' by agreement with another party. That party may fail to honour the agreement.

What to check before you invest in a hedge fund

Read the product disclosure statement

Hedge funds vary in risk and complexity. The fund manager will give you a PDS before you invest. This sets out the features, benefits, costs and risks of the fund. Make sure you understand the investment before you go ahead.

Check your understanding of the fund

Use these questions to check your understanding of the fund:

• Strategy — What are the investment goals? How will the fund achieve these goals?
• Investment manager — Who manages the fund? Does the manager have relevant skills and experience?
• Local or international — Does the fund invest in Australian or overseas assets? If overseas, have foreign currency risks been hedged?
• Past performance — Past performance is not a reliable indicator of future performance. But it can give you an idea of how the fund has performed, in rising and falling markets. Look at medium to long-term performance (over 5 to 10 years).
• Third party service providers — Does the fund uses third party service providers? If so, are they licensed in Australia? Or elsewhere, where financial regulations may be less strict?
• Fees — How are fees charged? Does this offer an incentive for the fund manager to take extra risks? Does charging of a performance fee depend on the fund outperforming a benchmark? If so, is the benchmark appropriate? Will returns, after fees, justify any additional risks taken?
• Structure — How are the investments structured? As a test, how easily could you explain this to someone else?
• Redemptions — How quickly can you redeem your investment from the fund? Is there a minimum time your money must stay in the fund? Is there a minimum redemption amount? When you redeem, do you have to pay an exit fee?

Get advice if you need it

Talk to a financial adviser if you need help deciding if this investment is right for you.