Hedge funds and commodity futures funds now constitute an accepted "alternative assets" class, complementing the traditional asset classes of equities, property, fixed interest and cash in a well balanced, diversified investment portfolio. Generally, hedge funds and commodity futures can improve investment portfolio returns by providing access to a broad range of markets not readily accessible to the private investor, while lowering portfolio volatility through accessing markets with low correlation to returns from the traditional asset classes. Markets traded may include foreign currencies, precious metals, base metals, energy and oil, agricultural commodities, interest rates, share market indices and individual equities. A "Fund of funds" (such as the Man OM-IP series) will usually employ a range of fund managers, each one operating in a specialist field.



While many types of hedge and commodity funds exist, private investors should first consider the market trading funds such as those listed here on the Debex Hedge Funds Primary Market. These funds usually seek to profit by actively trading derivative markets such as futures and options, from both the "long" and "short" perspectives - "long" being a "bought" position, where the trader intends to profit from selling that position later at a higher price in a rising market, and "short" being a "sold" position, where the trader intends to profit from buying back that position later at a lower price in a falling market. In both cases a profit is achieved where the "Sell" price exceeds the "Buy" price as in any business transaction, but here the fund can profit in both rising and falling markets since the "sell" order can just as easily precede the "buy" order as follow it.

Although the principles of formalised market trading, including contracts for future delivery, go back centuries to ancient Greece and Rome, modern futures markets owe their origins to the American agricultural markets centred on Chicago in the mid 1800's. Quite literally the grain farmer, once in a position to estimate his forthcoming crop volume and quality from sheer experience and weather expectations, would mount his fastest horse and speed to Chicago, hoping to strike a committed forward deal for supply of his crop to an end user (perhaps a New York miller) before the annual arrival of competitors' crops flooded the market, greatly depressing prices. Later, standardisation of contract specifications, provision of adequate storage facilities, formalised arbitration processes and guarantees of payment through market structures such as the Chicago Board of Trade, saw the process of commodity futures trading greatly reduce the wastage and hardship caused by massive seasonal imbalances in supply and demand.

Early meat and grain contracts for forward delivery were essentially cash contracts - a seller seeking a buyer for cash. Later the hedging potential of contracts for future delivery was recognised by businesses whose profitability depended on being able to source raw materials at a set price at some time in the future. For example, the miller committed to supplying flour to bakeries later in the year or a meatworks successfully tendering for supply to butchers. Although the business would be currently "short" of the raw material - having no means of storage - a potentially damaging rise in the commodity price at the time of necessity could be offset through purchase of an opposite "long" position in the futures market. If prices overall rose for the raw product, profits on the futures contract, when liquidated for cash, could be used to meet the increased cost of the physical commodity needed for production. Conversely the raw product producer (farmer) could hedge his current "long" position in the cash market by selling or going "short" at some month in the future when his produce would be ready for sale. A drop in cash market ("spot") price at the time of delivery would be compensated for by a profit on the "short" contract (or perhaps the farmer could simply deliver at the higher price struck earlier under terms of his original "sell" contract provided his product quality closely matched the contract specifications).

Before long, speculators entered the markets, hoping to profit by trading futures contracts into the rise and fall of market volatility. Theoretically and practically, speculators came to play an essential part in the markets by providing a large pool of liquidity into which producers and end users could buy or sell. As only a small percentage of trades came to result in actual delivery, this large pool of liquidity tended to provide a smoothing function for prices overall. Speculators now play an essential part in the markets, providing the liquidity for an efficient market to function. Only a small portion of transactions result in actual delivery of the commodity.

Over the years a huge range of commodities including metals, forestry, oil and numerous agricultural products came to be traded on futures exchanges worldwide. The 1970's saw a major innovation in the form of financial futures where interest rates, currencies and share market indices came to be traded with settlement usually being made in the form of a cash payment, the amount being calculated as some multiple of an underlying interest rate or index. Using the same principle as those Midwestern farmers and merchants long ago, modern businesses are able to offset or hedge their current position in a market against unfavourable movements in the price of an essential input or output some time in the future by purchasing futures contracts of the opposite position. A clear example would be the importer wanting to ensure profitability by locking in today's local currency price of an overseas sourced product that must be paid for in a foreign currency at some time in the future.

Hedging an investment portfolio by fund managers is now commonly achieved using a variety of means including futures contracts, options, shorts and swaps. In this scenario the private investor can be left at a disadvantage, simply not having the time, financial and skill resources needed to manage an effective hedging program. The result is too often the private investor being forced or panicked into selling a "long only" portfolio at the most disadvantageous time as share markets collapse. Those too young to remember 1987 will have had an awakening experience during the months following October 2007. Although the private investor is perfectly entitled to operate his or her own hedging program through an individual futures trading account, difficulties are many and success is not assured. The need for constant market vigilance, a temptation to speculate through the high leverage available and difficulty in determining appropriate buy and sell points often combine to see many private futures traders losing money rather than effectively hedging a portfolio.

These days, buy and sell signals for successful hedge and commodity funds are nearly always generated by computer programs utilising a broad range of inputs covering both fundamental and technical factors. Apart from removing the otherwise massive human effort required to monitor continuously hundreds of markets worldwide, computer programs eliminate the human emotional factors that can prove so disastrous for many individual traders.

In practice it is unlikely that any investor will be able to find a single market to perfectly hedge his or her portfolio and even if this is found, difficulties abound in utilising it in a potential hedging role. However, the private investor is certainly able to achieve a very useful degree of protection for a broadly "long only" portfolio by including one, or preferably more, of the well performed hedge funds open to public subscription in his or her portfolio mix. Quite frankly, those restrictive jurisdictions limiting access to hedge funds do their citizens a severe disservice. Fortunately, in New Zealand, hedge funds are available to the investing public, subject to each fund meeting legislated formal offer documentation requirements. Many of these hedge funds are accessible to overseas investors provided the investor's home jurisdiction allows access.

As with any investment portfolio component, selection of an appropriate hedge fund is paramount. For the mainly equities investor, preference should be given to those hedge funds with a sound record of returning good profits during times when sharemarkets have plunged. We have all been warned often enough that "past returns are no guarantee of future profits" but a well performed hedge fund able to demonstrate such returns in the past can at least show it has the skills and processes that may well be applicable again under similar circumstances in the future. However, investors need to know that there are market circumstances when hedge funds may not perform favourably and hence a portfolio of hedge funds only is unlikely to prove satisfactory. As always, diversification is the key to investment success.

The ability of a private investor to avoid the worst of a sharemarket crash through incorporating hedge funds in a diversified portfolio can improve performance of that portfolio not just marginally, but very significantly indeed, resulting in a huge difference to returns over the long term.