All the world’s a hedge fund now

The boundary between hedge funds and conventional funds is becoming increasingly blurred. As James Teasdale shows in this week’s cover story, the advent of Ucits III has allowed retail funds to switch increasingly to absolute return mandates.

Until recently the search for absolute returns was virtually a defining feature of hedge funds. In contrast, retail funds would aim for relative returns in relation to a particular benchmark or asset class. For example, a UK equity fund might use the FTSE 100 as a benchmark – following, to a greater or lesser extent, the fortunes of the market.

Relative returns are attractive in an environment of rapidly rising asset prices, but less so when markets have no clear trend. In such circumstances absolute return funds, which are designed to make money in all market conditions, come into their own.

To achieve absolute returns it is also necessary for mainstream funds to use techniques or instruments that were once largely limited to hedge funds. These can include derivatives, the use of leverage and short selling.

The rise of absolute return retail funds has made matters more complicated for investors and regulators alike. Investors have a wider choice of products to choose from, but their characteristics can be hard to understand. This leaves regulators pondering how best to deal with such products. The Financial Services Authority has responded, as is its way, by issuing a consultation paper on the subject.

But the blurring of the lines between hedge funds and other vehicles goes beyond the retail fund market. Mainstream companies – outside the financial sector – are increasingly involved in “financial engineering”. In other words they are using advanced financial techniques and instruments to manage their balance sheets and their income flows.

Enron, the American energy company that collapsed in one of the largest bankruptcies in American corporate history, took this development to its logical conclusion. Rather than working with physical energy, it became involved in dealing in energy contracts. This switch led the Economist to describe it as “in effect, a hedge fund with a gas pipeline on the side”.

This is not to imply that other companies have gone as far as Enron, or are involved in any disreputable activity. Rather, it is that the financial aspects of running businesses are becoming increasingly important relative to producing goods or services. Managing finances, and the related activity of managing risk, have in effect become the core activity of many businesses.

In such circumstances it is easy to see why the boundary between hedge funds and retail funds is becoming blurred. In today’s world the trend is for all businesses of any size to become increasingly like hedge funds.