What is a hedge fund?

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The basics

Hedge funds are special investment companies with limited groups of investors, who tend to be high net-worth individuals, pension funds, or other well funded organizations (even other hedge funds). They are often incorporated in off-shore tax havens like Bermuda, the Cayman Islands or the British Virgin Islands. They generally use exotic investment strategies which are not allowed in more traditional organizations such as Mutual Funds . Hedge funds do everything from buying and liquidating Mom and Pop bagel stores to betting on the probability of Natural disasters . Many funds do traditional stock investment, but also tend to use short-selling (betting against a stock) to profit during bear markets. Hedge funds are also very international. Most hedge fund managers live in the Eastern United States, but London and Australia are also very popular. Many funds prohibit investors from the United States because doing so allows them to operate with less scrutiny from the notoriously nosy US Securities and Exchange Commission (SEC) . People invest in hedge funds because they tend to deliver greater returns for the amount of risk they add to their portfolio.

Hedge fund managers are generally not allowed to market their services, so the entire business relies heavily on networking and referrals. The managers often charge substantial performance fees, as opposed to the flat fee structure that many mutual funds stick to. When a hedge fund does poorly, the managers are often not allowed to take any bonuses until the fund has made up for the losses. When managers cannot get paid due to bad performance, we say their fund is "below the high water mark". Many hedge fund managers will close down their fund if it has stayed below the high water mark for more than a year. This leads to a trend known as "survivor bias". That is, only the good hedge funds stay in business. Because most active hedge funds are the ones which historically have done well, critics claim that hedge funds may not be the excellent investments they claim to be (of course the 'average' hedge fund does well when all the funds that died are not calculated in the average).

Do hedge funds have a meaningful impact on the economy? The Impact of Hedge Funds is diverse, but hedge fund managers help prevent asset bubbles and add intelligent liquidity to the market. Very few people or institutions short sell outside of hedge funds. Long-only investors can identify a bad company, but cannot express their view to the market in a meaningful way. Hedge funds prevent stocks from becoming overvalued. The tech bubble of 2001 shows how harmful overvaluation of stocks can be. Also, funds trade in markets that provide useful social functions. For example, coastal companies may want to go long on hurricane future contracts because when a hurricane hits, the futures contract will pay out much like an insurance policy. Hedge funds are often the counter-parties that allow this variation of insurance to exist. In 2009, hedge fund managers have provided much needed liquidity at distressed asset auctions. A successful sale of a distressed asset can prevent a company from going bankrupt, or help a bankrupt company take care of its stakeholders (e.g. GM's pension-plan holders).

Hedge funds are criticized by value investors like Warren Buffett for making short-term profits and selling out before adding meaningful economic value to the economy. Buffett also believes that hedge fund management fees are ridiculous, and has made a $1 million dollar bet with a hedge fund company called Protégé that the premier hedge funds will not outperform a simple Vanguard S&P 500 index fund over a 10 year period net of fees and taxes.

More seriously, hedge funds' use of borrowed money to invest can cause dangerous market volatility and wreak havoc on a global level. The 1998 Collapse of Long Term Capital Management (LTCM) destroyed hundred of billions, if not trillions of dollars of economic value and nearly unhinged the Russian economy. The famous hedge fund manager, George Soros, was accused of damaging the Thai economy with a speculative run on its currency, the Baht, that netted him over a $1 billion in profits.

Why invest in hedge funds?

Hedge funds are active money managers. People invest in them for two main reasons.

  1. Better returns from manager skill.
  2. Diversification from exotic investing strategies.

Manager skill refers to the ability to generate something called ‘Alpha ’. One way to profit from the stock market is to index and diversify. The risk of the particular firms in the market wash out (in theory), and you are left getting compensated for the risk of a market as a whole. Your exposure to the market’s risk is called your ‘Beta ’. Hedge fund managers claim that they have low Beta (market exposure) and high Alpha (skill). Let’s say Portfolio A is an indexed portfolio with a Beta of 1. Let’s say the hedge fund manages Portfolio B, which also has a beta of 1. If the indexed portfolio yields 10%, and the hedge fund yields 12%, the hedge fund has generated 2% alpha.

Alpha implies an ability to make good bets, and measures the skill of managers. Investors in Hedge Funds pay high premiums for manager skill, or the ability to generate a higher risk-adjusted return than passive investments.

If people are seeking better risk adjusted returns they want:

  1. Better returns with the same or less risk, and/or
  2. Less risk with the same, or more expected return.

Besides risk adjusted returns, fans of Diversification (like pension funds and college trusts) like the more exotic investing strategies of hedge funds. In a simple example, let’s say you start out holding a 2 stock portfolio of Coke and Pepsi . Realizing that both companies rely on the same markets, and the same consumer preferences, you decide to diversify. You buy many different and unrelated stocks, like Wells Fargo, Exxon Mobil, Nestle, and Google, and end up with a portfolio of 20 stocks from different industries. Unfortunately, when the market goes down a lot, you notice most of your stocks go down too. Even great investors like Warren Buffett get hit hard by bad market conditions. Pension plans that do not like to see their holdings jump up and down want to find securities that do well in down markets, and do better than risk free treasuries. Hedge funds claim to offer this.

For example, some hedge funds specialize in Short Selling stocks (betting that they will go down). A Pension plan may be interested in these hedge funds to protect them during tough market conditions.

Hedge funds have delivered higher risk-adjusted returns than the market

The Credit Suisse/Tremont Hedge Fund Index has been tracking hedge fund returns since 1993. It tells us how good specific types of hedge funds are at generating better risk adjusted returns than the market. The chart below shows that hedge funds, as a whole, have delivered quite well over the past 15 years. The length of the red bars show how risky the different types of funds have been. The blue bars shows how much they have returned. The best funds have much more blue than red.
Hedge Funds listed on the Credit Suisse/Tremont Index have outperformed market indexes year after year with lower volatility. This suggests that they are a superior investment, despite their high fees. Nonetheless, some hedge funds do better than others. Notice that the dedicated short-strategy hedge funds tend to do worse than the market index with higher volatilies
Hedge Funds listed on the Credit Suisse/Tremont Index have outperformed market indexes year after year with lower volatility. This suggests that they are a superior investment, despite their high fees. Nonetheless, some hedge funds do better than others. Notice that the dedicated short-strategy hedge funds tend to do worse than the market index with higher volatilies [1]

Convertible arbitrage

Total Return = Convertible bonds Coupons + Short Interest Proceeds – Stock Dividend Yield + Capital Gain/Loss From Stock + Change in Volatility of Option

While convertible bonds are often very complicated, they are basically a combination of a bond and a stock. More technically, convertible bonds are a combination of issuing debt and selling a call option. Let’s say Microsoft issues convertible bonds. They pay me an annual coupon, just like if they had issued a bond. However, if the stock price of Microsoft rises they will pay me back my principal by giving me stock instead of cash. If I wanted to Convertible-Bond Arbitrage in the above example, I would short Microsoft stock while holding its convertible bonds. The number of Microsoft shares I short depends on statistical analysis about Microsoft’s volatility, and my opinion on how Microsoft stock will do. Convertible bond arbitrage gives me two types of return: 1) a constant income, and 2) an arbitrage profit. Microsoft pays me coupons for holding its bond. When I short sell Microsoft stock, I have to put up collateral to borrow it, and then sell it. While I keep my short position, my collateral is invested at the risk free treasury rate, so I make a little money there. Whenever Microsoft issues dividends, I don’t get to keep them because I’m just borrowing the share. So:

Constant Income = Bond Coupon Payments + Short Proceeds – Stock Dividend Yield

The arbitrage return is more complicated. First, if Microsoft goes down then I make money. If it goes up, I lose money, because I am shorting its stock. Second, the convertible bond I am holding may increase in price, and become more valuable. Third, part of the convertible bond is the stock option. A arbitrageur likes volatility, because it gives him/her a chance to rebalance his positions and make money through the option. A change in volatility therefore equates with a positive return. So:

Arbitrage Profit = Capital Gain from Stock + Change in Volatility of Option

Arbitrage, by traditional definition, is risk free. Convertible bond arbitrage is therefore misnamed, because it is potentially risky. The successful convertible arbitrage manager has a good way to identify under and overpriced bonds and options. A good secondary skill is ability to call market direction, which helps set up the 'delta hedge' which gets rebalanced with each volatility change.

Dedicated short bias

Total Return = Capital Loss on Short Selling + Short Proceeds

There are not many hedge funds exclusively shorting stocks. Shorting has unlimited downside, and limited upside. People who invest in these funds would be primarily interested in their negative correlation with the market. If I hold a long portfolio of 20 stocks, it will probably rise with the market. I could, however, short the market in order to control my risk. Then I would be betting that I simply outperformed the market, not necessarily that the market did well or not. Unfortunately, shorting the market in the long run is not very profitable. Even over bad periods, doing so would lose you close to 5% per annum.

Dedicated short biases offer a better alternative to shorting the market. Even though they do not do well on average, they are not as volatile or as negative yielding as a short position on the market. Short-managers look for overvalued stocks. They may use statistical models, accounting fundamentals, or company characteristics to identify doomed companies before the market. Most hedge fund managers who use these strategies to short sell have long positions as well, so though hedge funds are known for short selling, dedicated short bias funds are rare.

Emerging Markets

Total Return = Capital Gain on Long Position + Capital Gain on Currency Hedge

Emerging Markets hedge fund strategy requires knowledge of a developing market that is difficult to come by. Companies in many developing nations may not release their annual financial reports in English. Reliable information about a country’s market may only be accessible to locals or natives. Most Emerging Markets do not allow short-selling, so most emerging market hedge funds tend to place bets that companies will do well. These bets are not very well correlated with other asset classes, and so are hard to actually hedge.

Nevertheless, because emerging market trades often take place in foreign currencies, funds may choose to hedge their position with foreign currency futures. For example, if a hedge fund with US investors was investing in Brazil, it would go short on Brazillian Real currency futures (or buy Real put options) to deal with exchange risk.

Equity Market Neutral

Total Return = Capital Gain on Long Position + Capital Loss on Short Position + Short Interest Proceeds + (optional) Futures Return

Using the highest yielding and most popular hedge fund strategy, Market neutral investing funds pick stocks to go up, and stocks to go down. While a mutual fund can often give positive returns simply when the market goes up, an equity market neutral hedge fund only does well when its long bets do well and its short bets do poorly. Thus, the term ‘market neutral’ arises because the fund’s performance should not be strongly related to the performance of the US stock market. This lack of relation to the market appeals to large institutional investors like pension funds and college endowments that want a diverse portfolio of non-correlated assets.

Generally, equity market neutral funds specialize in industries where stock returns are very different. For example, the technology industry is one in which some companies to extremely well while others get completely destroyed. A market neutral fund could go long on undervalued tech stocks, and go short on overvalued tech stocks, hopefully earning a double spread (good one goes up, bad one goes down). The funds risks are said to be hedged, because month to month, the tech companies will probably move together, just in different magnitudes. For example, during something like the dot-com bust, both the manager’s long and short tech positions collapse, but the manager makes a lot of money on the short position so things aren’t as bad. This wouldn’t work as well if he were holding a tech stock and shorting a lumber company, because the dotcom bust might have little effect on the world’s demand for timber. Incorrect hedging strategies can lead managers to lose significantly on both their long and short positions. Because these managers make money on spreads and not raw returns, they tend to focus on industries where there company skill goes farther than general business conditions. In the oil industry, for example, it often does not matter how skillful a company’s drillers are if the price of oil is bottomed out. Oilfield services stocks will fall due to physical global consumption patterns. Equity market neutral managers often have expertise in a specific industry that gives them insight on what makes a skillful company, and what makes an inept company. Then they place bets accordingly, and leverage their returns.

Of course, no self respecting hedge fund manager would want their strategy to sound overly simple, so they use ‘futures overlays’ and ‘portable alpha strategies’ to bolster their returns, and make a market neutral fund sound more attractive. Basically, because Market Neutral hedge funds have low volatility and high returns, they generate ‘alpha’. Holding an asset with a lot of ‘alpha’ is like owning a magical treasury bill that yields better returns than the US government gives. Let’s say the risk free rate is 3%, and has no correlation with market returns. If a hedge fund also has no correlation with market returns (or is Market Neutral), and yields 5%, you have 2% extra alpha. In financial modeling, it’s not a good idea to add a treasury type return to another treasury type return, because you’re not diversified. So hedge funds offer people to “transport the alpha” over to stocks, instead of t-bills. What the hedge fund does, then , is takes a long futures position on the stock market (S&P 500 futures, for example, can be purchased on exchanges like the Chicago Board of Trade). This tendency of buying futures contracts can explain why so called market neutral funds do poorly when the market falls.

Event Driven

When a hedge fund specializes in a specific kind of market opportunity that tends to arise, it is considered event driven. For example, mergers, bankruptcies and spin-offs generate stock price movements that can be predicted and modeled. There are several types of event driven hedge funds. The two most common types of even driven funds are Merger Arbitrage and Distressed, described below.

Merger (Risk) Arbitrage

Return = Gain on Long Target Stock + Loss on Short Acquirer Stock + Short Proceeds

Statistically, most mergers go through. That is to say, if firm A says it is going to buy firm B, history says that it probably will. The risk averse market often price things assuming that mergers will not go through, generating a stock price inefficiency which Merger Arbitrage claims to profit from. Basically, every merger has a target (the firm being bought) and an acquirer (the firm doing the buying). Once an acquirer announces its intended buyout, merger arbitrage says that you should buy stock in the target and short stock the acquirers stock. If the merger goes through, you’ll make money. This is because mergers often involve an eventual exchange of shares at a fixed rate. It becomes more clear in an example.

Let’s say Acquirer Corporation wants to buy out Target. Acquirer stock is trading at $100. Target stock is trading at $40. Now, in the merger deal, Acquirer agrees to exchange 1 of its shares for 2 Target stocks. Now you buy 5 target stocks, and short 2 acquirer stocks ($200 positions in each). Now it’s 6 months later, and the merger has just gone through.

Situation 1: (Merger went through, Target stayed the same). Acquirer is still trading at $100, so you only make $3 from your short proceeds and no gain or loss. But now, the market knows 2 Target shares have to equal one Acquirer share, so Target moves up to $50. You were holding 5 shares of target, and made $10 on each. So you pocketed $53 on your $400 position. Over 20%, not bad.

Situation 2: (Merger went through, Acquirer went up). You lost $20 on your short position, but got $3 of interest proceeds from your short. But now, Target stock MUST trade at $55 per share, because it mechanically is being traded at a 2:1 for Acquirer. So you locked in $15 * 5 shares, a tidy $75 gain. In total, you made $58 for $200 invested (you were borrowing your short). Congratulations, you just made 29% in 6 months.

If Acquirer went down, you’d still be covered, because your short would be profitable. Sounds like a win win? Think again. This all assumes the merger goes through. In mid 2008, a lot of merger arbitrage funds were obliterated by their double edged trading strategies. If a merger fails, it is often because the Target stock has fallen through the floor. That means you have already lost big on your long position. When news of the merger failing comes out, all the hedge funds rush to cover their shorts on the Acquirer, boosting the stock price, burning remaining shorters. This is only made worse, because this strategy only makes its big returns by borrowing ridiculous amounts. In real life, the spread between the Target and the Acquirer is not that big. Hedge fund managers make huge bets with borrowed money to chase returns. If a merger falls through, it can destroy a fund. Of course, you could hire a monkey to execute this strategy. Just teach Chim Chim to go long on all merger targets, and short all merger acquirers. Hedge fund managers claim to have superior skill at choosing the correct mergers to bet on.

Distressed

Total Return = Sale Price of Distressed Assets + Return of Distressed Assets During Holding Period – Purchase of Distressed Assets

You know those infomercials on TV that promise to make you millions if you just buy a video that tells you how to buy things at liquidation auctions? Buy for pennies, and sell for thousands! Well, that’s basically the strategy of distressed hedge funds. Many large institutional investors like pension or mutual funds have legal or other restrictions about holding investments which could soon go bankrupt. When a company gets in trouble, and is about to default on its debt, hedge funds swoop in to pick up potential bargains. Some hedge funds specialize in corporate debt, other specialize in stock (Distressed securities ).

For example, let’s say a hedge fund manages to pick up corporate bonds for 60% of their face value at the height of a firm’s distress. At the end of the bankruptcy proceedings, if things go well, the hedge fund can sell the bonds for 80% of face value and pocket the 20%.

These funds sometimes have problems attracting investment, because they are very correlated to market returns. Think about it. Distressed investments are not going to sell when you’re in the middle of a recession. This strategy works far better in good markets.

Fixed Income Arbitrage

Total Return = Capital Loss on Short Fixed Income + Capital Gains on Long Fixed Income

A proper and full description of fixed income arbitrage would take an entire textbook. Doing Fixed Income arbitrage properly requires in depth understanding of credit markets, derivatives, options, and statistical models. The problem is that many people try to trade fixed income without full understanding. The classic example is Long Term Capital Management who actually endangered the world economy in 1998 through leveraged trading of Russian bonds, despite employing two of the world’s most brilliant Finance professors. Additionally, the credit crunch which began plaguing the markets in 2007 was largely due to widespread misunderstanding of derivatives and credit markets. In the world of obscure finance, bonds are hardly the conservative investment many people assume they are.

The first goal of a fixed income arbitrage manager is to have something called “0 duration”. Basically, this makes the fund immune to the direction of interest rates. Secondly, the manager should be neutral to currencies. Many managers are even more cautious, and protect their funds about complex yield curve anomalies, which basically only happen when something seriously malfunctions in the credit market. Third, a good fixed income fund needs at least $50 million in assets to have access to something called the “repo market”, or repurchase market. This allows them to work through bond wholesalers to refinance their investments efficiently and at low cost. Fourth, a fixed income fund needs to use leverage to make money. Spreads are not very big, and one needs to multiply bond arbitrage returns before they become significant. Leverage multiples of 15, or even twenty are not unheard of in the world of fixed income arbitrage.

The actual arbitrage strategy involves making bets that bond spreads are mean reverting. That means when yield spreads on bonds are narrow, a hedge fund will bet that they will widen to return to historical averages. Likewise, when spreads are wider than historical averages, the manager will bet that they narrow. The skill comes in statistical analysis, diagnosis of current bond market conditions, and the ability to get good deals on trades.


Managed Futures

Total Return = Gain on Long Futures + Loss on Short Futures


Managed Futures hedge funds often trade on large futures exchanges, like the Goldman Sachs Commodity Index and other Commodity Exchanges. They may of course trade currency, equity, or bond futures as well. Because many large corporations use futures as a hedging tool, rather than a profit instrument, futures managers have an advantage because the market is somewhat inefficient. Hershey’s is not looking for profit when they go long on cocoa-futures- they are looking to cover themselves from an increase in cocoa prices that would hurt their business. Companies like to hedge their profits because investors like low-volatility, and oftentimes there are tax advantages to having futures. The Hedge Fund managers make money because they have no ulterior motives on the futures index. They are out to make money.

Many different strategies exist to dealing with futures. Futures are high leveraged, zero sum bets. If I win on my futures contract with you, you lose. Therefore, they are very high risk and often very volatile. Some futures funds use computers and black box trading systems to day-trade futures. Other funds might employ commodity or currency experts who make long term bets about their respective fields of expertise.

Managed futures funds seem appealing to investors because commodities and currency futures are often uncorrelated with the general stock market. A pension fund looking to diversify its assets might consider putting money in such a fund, despite historically lower returns than other types of hedge funds.

Global Macro

Total Return: (varies with strategy)

In the early days of hedge funds, Global Macro was the dominant mold. It did so well that the managers got too much money to invest profitably, and now Global Macro has become far less common. George Soros is by and far the most famous Global Macro hedge fund manager, and has helped to give these managers a reputation for taking large risks. Global Macro managers often do not hedge their positions, instead taking large long or short bets on specific international events, bonds, or companies.

But what do Global Macro managers actually do? They tend to use economics in order to identify large (global) trends. For example, a manager might find a strong statistical correlation between lagged unemployment rates in Eastern Europe and interest rates in the EU. If he saw that Eastern Europe’s unemployment had boomed, and the EU’s interest rates had stayed constant, he might choose to make a large bet on the EU’s interest rate going up. He could do this any number of ways, including the use of options, derivatives, or even stocks and bonds.

One example of a famous Global Macro trade was George Soros’ bet that Italy would join the EU. He decided to go long on Italian Fixed Income, and short German Fixed Income, betting they would converge when Italy joined. He made close to $1 billion doing this. Soros also made a correct bet that the Thai currency (Baht) would devalue, and raked in over $1 billion again.

A good global macro manager has a strong understanding of economics, and government fiscal and monetary policy. Also, a very strong understanding of the tools to make global bets is important.

Long/Short Equity

Long/Short Equity consists of equity-oriented investing, without being market neutral. These funds can implement various styles, value and growth, and small-cap and large-cap stocks with a net long or short position. Futures and options may be used for hedging. Investments may be related to a country, an industry or a sector.

Multi-Strategy

Total Return (Varies with strategy)

Multi-Strategy funds use their discretion to choose between the strategies listed above. Clearly, a multi-strategy manager must be good at predicting market trends. Multi-Strategy implements an investment approach diversifying by employing various strategies simultaneously to realize short- and long- term gains.

Fund of hedge funds

A fund of hedge funds is an investment company that invests in hedge funds. Some funds are registered with the SEC under the Investment Company Act of 1940 and must provide investors with a prospectus and the SEC with a quarterly report. Investment minimums can be lower than those of hedge funds. There two main categories of fund of hedge fund:

  • Diversied funds - assets are invested in various types of hedge funds
  • Niche funds - assets are invested in funds of a simailar type/strategy

Some funds may charge another 1% to 3% fee on top of the fees charged by underlying funds.

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