Hedge Funds: Will They Stick Around When the Going Gets Tough
Hedge funds emerged in the 1950s as private investment partnerships that specialized in a combination of short selling and leverage to reduce market risk. The term hedge fund now applies to investment vehicles with a range of aggressive investment strategies and objectives, with less regulatory supervision than mutual funds.
The nature of hedge funds has changed significantly in the past decade, making them one of the fastest-growing investment alternatives to traditional equity and bond portfolios. Until recently, investing in hedge funds was considered high risk and was only recommended for the most sophisticated investors, with deep pockets. Investors may now join some hedge funds for as little as $1000.
The essential hedge fund equation is greater reward for greater risk than mutual funds. Although historically the defining characteristic of a hedge fund was to hedge against market risk and volatility, hedge funds today do not limit themselves simply to hedging.
They use many investment techniques, the latest of which is reinsurance, either directly or on a retrocessional basis. Hedge funds enjoy greater freedom of operation than mutual funds, in such areas as the range of investments they may make, the degree of illiquidity they may assume, the ability to leverage, and the redemption of shares in the fund.
"The volatile and uncorrelated nature of catastrophe reinsurance risk is an attractive feature for the larger hedge funds seeking to broaden their activities as returns from established investment strategies have decreased," says Benfield, the reinsurance brokerage, in an industry report.
"The extra diversity of capital adds to the reinsurance industry's strength, but the mettle of the hedge funds is untested and it remains to be seen how durable a source of capacity they will be following large catastrophe losses."
March 1, 2005
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