Description:
‘HEDGE; to reduce one's risk of loss on (a bet or speculation) by compensating transactions on the other side'. Concise Oxford Dictionary
The term " hedge fund " is ambiguously defined and does not always imply a hedging technique is being used. Hedge funds today employ all manner of strategies, and the appropriate description could simply be conveyed as “ A ny P rivately- O ffered, M anaged P ool O f M oney for wealthy, financially sophisticated investors.” A POMPOM . Hedge funds are usually structured as partnerships, with the general partner being the portfolio manager, making the investment decisions, and the limited partners as the investors.
History:
It is widely recognized that Alfred Winslow Jones, a sociologist, was working on an assignment for Fortune magazine investigating fundamental and technical research on forecasting the stock market. The article reported on a new class of stock market timer, in addition to unorthodox methods of investing, all to achieve positive returns and call the market. Jones was very intrigued by these trading methods and became absolutely consumed with his own concept of an investment fund.
Prior to the release of his Fortune article, Jones setup an investment fund with himself as general partner. The fund was designed as a market-neutral strategy, whereby the long positions in undervalued equities would be offset by short positions in others. This “hedged” position would allow capital to be leveraged, while also enabling large wagers to be made with limited resources. Another genius feature was having an incentive fee amounting to 20% of any realized profits or gains with no fixed fees.
However, Jones' greatest notoriety stems from his innovation that specific limited partnerships, if structured correctly, are exempt from regulatory control under the Investment Company Act of 1940. This exemption allows managers to utilize techniques, such as leverage and short-selling which typically binds other mutual funds and investment companies. Consequently, many copy -cats mimicked the fee structure, but not the “hedge” mentality and philosophy that Jones inspired. It was not until another Fortune magazine article, in 1966, which branded the market-neutral strategy that Jones' designed as a “ hedge fund”.
Typical Strategies:
Long/Short or Hedged Equity Strategies
Probably the largest category of Hedge funds in terms of numbers, Long/Short Equity Strategies combine long (a 'long' position in a portfolio is when the manager has ownership of the security.)and short (a 'short' position in a portfolio occurs when the manager has sold shares it does not own. To make a profit, the stock must go down in order for the manager to buy it back more cheaply.) positions, primarily in equities and bonds to exploit under and overvalued securities. The volatility of returns can vary significantly between managers. This is largely due to the level of direct market exposure held in the fund.
Relative Value Strategies
Relative Value strategy managers seek returns by trying to identify price discrepancies and inefficiencies in the market between related investment instruments or combination of instruments. This is called 'arbitraging'. These funds are often regarded as 'market neutral' because there is little or no market-related element to their returns.
However, they are not without risk and can be adversely affected during periods of low market liquidity. Arbitrage* instruments can include Convertible Bonds, Fixed Income, Mortgage-Backed Securities and equities.
Event Driven Strategies
This type of strategy seeks to anticipate and profit from price movements that arise from specific corporate events, such as takeovers or mergers. Although these strategies show lower correlation with equity and bond market movements they tend to do better in strong market conditions where there is greater liquidity in the market. Events may include;
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Merger Arbitrage . The normal strategy is to go short on the acquiring company and long on the target as there will usually be a margin in pricing to to reflect the risk of the deal falling through. |
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Distressed Securities . The stock of companies facing bankruptcy or major reorganisation may trade at a substantial discount to the underlying assets and often represents a good opportunity for profit. |
Tactical Trading Strategies
Arguably, tactical strategies are the highest risk of all Hedge funds as a sector and sometimes make headline news as anyone familiar with George Soros will know. They tend to be more volatile because in many cases the manager uses leveraging to enhance the returns from directional trading strategies employed. The different styles include;
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Global Macro . The fund manager uses his judgement of global macro-economic factors in taking positions across asset classes. Global Macro funds may also gear heavily, which adds to the volatility. |
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Systematic Traders . The fund manager uses quantitative models to identify pricing anomalies. The focus tends to be on trading shorter term with the use of stop losses to limit capital risk.
It is generally believed that the two safest types of Hedge funds with less volatile returns are Relative Value (Market Neutral) and Event Driven funds. Long/Short strategies tend to move in the same direction as the market as a whole because they tend to go long more often than they go short. They do still tend to outperform traditional funds when markets fall since traditional funds can only go long. Tactical Trading strategies tend to be the most volatile of all Hedge funds, because they heavily on the predictive and intuitive skills of the manager.
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Hedge 'Fund of Funds'
The range of investment returns between individual Hedge funds can be very wide. This is even true within strategies as well as between different strategies. One of the main reasons is the enormous range of techniques employed by Hedge funds to generate profits. At the individual fund level, the investment profile is typically dominated by the use of relatively small number of 'alpha generation'** strategies. often resulting from the expertise and ideas of only one or two people.
However,, when pooled, the volatility or risk profile of a portfolio of Hedge funds tends to fall dramatically, reflecting the extraordinarily low correlation between the returns of individual Hedge fund strategies. Furthermore, Hedge funds can be used as part of an overall portfolio to offer diversification and reduced risk.
In summary, a Hedge 'fund of funds"
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Provides an investment portfolio with lower levels of risk and can deliver returns not correlated with the performance of the stock market. |
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Significantly reduces individual fund and manager risk |
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Allows access to a broader spectrum of leading Hedge funds that may otherwise be unavailable to the private investor due to high minimum investment requirements |
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Hedge funds can be included within an existing traditional portfolio of stocks and shares or mutual funds to diversify and reduce risk. |
* Arbitrage - The nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies or, the purchase of a stock of a takeover target especially with a view to selling it profitably to the raider.
** Alpha is a measure of how the fund is performing under the assumption that the market return is zero. For example, a fund with an alpha of 1, based on the S&P index would have returned 1% if the market had returned zero.
