With hedge funds gaining popularity, a high-profile forum will be discussing the benefits and trends seen in the market Mention hedge funds to any investor and you will be snowed under by an avalanche of definitions. 'All are wrong and all are right,' says Matthew Dillon, regional manager for Asia Pacific at Man Investments (Hong Kong). The problem is that there are many hedge funds each using a different strategy. 'In my definition, hedge funds have lower volatility and liquidity; there is less use of option-based structures and 'exotic' derivatives, and index-related products,' says Mr Dillon. The Hedge Funds World Asia 2003 forum will be aiming to dispel incorrect assumptions and discuss trends in this fledgling US$60 billion industry. About 10 per cent of managers of the world's top hedge funds will be speaking at the forum, which runs from today until Wednesday at the Conrad Hotel at Pacific Place. 'There is a need to discuss the benefits and the trends seen in the market as hedge funds gain popularity in this part of the world,' says Mr Dillon. It is easier to understand hedge funds by knowing what they are not. In any investment, the return is usually defined as the percentage change in the value of the investment over a given period of time. 'Returns have three main components,' says Mr Dillon. 'They are the investment strategy, the skill of the manager and the asset class.' Stocks and bonds have a measurable asset class return. They are single-asset classes with recognised risk-and-return characteristics. 'This is the same for fixed-income products and mutual funds. In fact, some people argue that the difference between these and traditional investment products is that most of the return comes from the asset class itself.' The return from the asset class will depend on the market itself. 'This means that when the market goes up, your [traditional] investments will make money; and when the market goes down, they will not,' says Mr Dillon. He estimates that 80 to 90 per cent of all returns from traditional mutual funds come from the asset class. For hedge funds, it is the other way around. 'Most returns are dependent on the strategy you use, since you can assess different asset classes including stocks, bonds, currencies and commodities,' says Mr Dillon. 'They will also depend heavily on the skill of the manager.' He estimates that 80 to 90 per cent of hedge funds' returns depend on these two factors, instead of the nature of the asset class. This fundamental difference has one major repercussion: since the source of return is different, the source of risk is also different. 'For example, for traditional mutual funds and fixed-income products, it is mainly market risk because that is where most of the return is coming from,' he says. 'For [most] hedge funds, since there is less exposure to market risk, the risk is inherent in the particular hedge fund strategy that you take and the skills of the manager.' Risk assessment and management of traditional investments is done through what is now standard risk analysis. However, hedge funds use a variety of asset classes, rendering standard risk analysis inappropriate. There are 14 to 15 strategies (depending on who you are talking to) for hedge funds and many are not correlated. Each has its own idiosyncratic risk profile, says Mr Dillon. For example, the risk characteristics of long/short equities and convertible arbitrage differ significantly, although both are strategies used in hedge funds. A variety of uncorrelated hedge fund investment styles provides investors with a wide choice of strategies, says Mr Dillon. For many investors, this provides an ideal long-term investment solution. Manager risk is much more subjective. Since hedge funds depend heavily on the skills of the managers, it is prudent for investors to pick the right people. Different strategies can expose a manager's weaknesses and strengths. 'For instance looking at the dispersion between the best manager, the average manager and the worst manager in long/short equities, which is based on stock-picking skills, you will see a wide dispersion,' says Mr Dillon. 'In fixed-income arbitrage, because it is a quantitative strategy and everyone is doing it in the same way, the difference between the best, the average and the worst is not much.' It is essential that these risks are understood when investing in hedge funds, says Mr Dillon.