Hedge Funds – Introduction, definition, risks and returns of a hedge fund

What investors should know about investing in hedge funds to maximize returns and eliminate risk

Hedge funds have a reputation for being somewhat mysterious, and at times controversial. However, they can serve an important function within a diversified investment portfolio. Hedge funds can not only generate returns when other asset classes don’t, but they can improve the overall returns of a portfolio while reducing its volatility.

Hedge Funds
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In this article we will look at exactly what a hedge fund is, how they operate and the different types of hedge funds. We will also discuss some of the aspects of hedge funds to be aware of when considering investing in them.

What is a hedge fund?

Fund Performance
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A hedge fund is a type of investment in which client funds are pooled and managed, with the goal of generating investment returns. They differ from mutual funds and exchange traded funds (ETFs) in several ways, most notably in that they often have more flexibility in the way they operate.

Most hedge funds make use of leverage or short selling to generate relative returns and magnify their returns. Many also make use of derivative instruments. Most hedge funds are only open to accredited investors, including high net worth individuals and institutional investors like pension funds. They also differ in terms of the legal structure they take. Hedge funds often aim to generate absolute returns, or alpha, rather than relative returns or market returns (beta). For this reason, hedge fund investors often pay performance fees as well as management fees.

How do hedge funds work?

Hedge funds are generally managed by a professional money manager with substantial investment experience. Most commonly a hedge fund will be structured as a limited partnership or as a limited liability company.

Managing Hedge Funds
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A mandate will give the fund manager parameters within which they can operate. This will limit the amount of leverage they can use, the markets they can invest in, and the maximum exposure they can hold in a single instrument or sector. The mandate will also specify the annual management fee and the incentive fee they can charge, the benchmark, and the hurdle rate against which performance is measured.

Performance fees are generally charged on returns over and above a hurdle rate. In addition, performance fees are usually only applicable when the fund’s value is not below a high-water mark which is the highest value that the fund has reached. To achieve leverage, hedge funds can either use derivative instruments or borrowed money.

The fund’s investments can be used as collateral when money is borrowed. Derivatives can also be used to open short positions, or securities can be borrowed and then sold short. Trades are based on a specific strategy, or on multiple strategies. Hedge fund strategies are often based on inefficiencies within the market, or slightly obscure opportunities.

Benefits and objectives of investing in hedge funds

Investing in Hedge Funds
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Hedge funds can use their flexible structures and the ability to use leverage and short positions to earn returns that are uncorrelated with other asset classes. Unlike traditional equity funds, hedge funds are not dependent on overall market sentiment and on rising equity values. This opens a new opportunity set for investors to profit from.

While the stock market can provide good long-term returns, bear markets of over 30%, and as much as 80%, do occur and can impair a portfolio for many years. For this reason, a typical investment portfolio’s asset allocation framework will include stocks, bonds and cash. Further portfolio diversification can be achieved by adding alternative assets like real estate, private equity and hedge funds. These asset classes are less correlated with the stock market and can help to reduce the risk within a fund.

Hedge funds in particular can be designed to have low correlation with equity indices, and even to perform well during bear markets. Market neutral hedge funds can avoid losing value during a bear market, and other types of hedge funds can actually generate significant returns during a bear market.

Key characteristics of a hedge fund

Hedge Fund Characteristics
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Most hedge funds are structured as limited partnerships or companies. Some are however structured as trusts or trusts that issue notes backed by an institution. Hedge fund regulations vary from country to country. They are not always required to be registered – for example, in the US, only hedge funds with assets under management in excess of $100 million are required to register with the Securities and Exchange Commission (SEC). In most cases, they are not allowed to solicit investment or advertise their services. Hedge funds are generally only available to accredited investors – those with incomes or wealth above a certain amount.

Types of hedge funds

There are numerous different types of hedge funds and hedge fund strategies. Hedge funds can focus on a single strategy or use multiple strategies, and on a single asset class or multiple asset classes. For the most part, equity hedge funds can be divided into two board categories which describe their risk profile.

Long / Short Trading Strategies
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A market neutral long / short hedge fund is structured to remove most of the market risk. While some market neutral funds do use leverage, the net exposure is usually very low. A fund may have just 50% exposure to long positions and 50% exposure to short positions, or the exposure could be 300% long and 300% short – but ultimately the net exposure is close to zero. Positions are usually weighted according to their beta rather than nominal exposure – so a long position in a stock with a high beta may be offset by a much larger short position in a stock with a low beta. Market neutral funds only aim to generate alpha rather beta, or market performance. This means they have a very low correlation with the overall market and lower risk.

By contrast, a long / short hedge fund is not structured to remove market exposure, but to maximise gains. Depending on the maximum leverage permitted, the net exposure of such a fund can be anywhere from maximum long to maximum short. For example, a fund permitted to use 3x gearing could have net long exposure of 300% of the fund’s assets, or net short exposure of 300% of the fund’s assets. This enables a fund manager to take full advantage of bull or bear markets, but also increases risk.

Hedge fund strategies

The following are some hedge fund strategies used either on their own or as part of a portfolio of strategies.

Event Driven Trading Strategies
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Event driven strategies seek to profit from corporate events such as mergers, acquisitions, management buyouts and restructuring. In many cases a combination of long and short positions are used, as are convertible debt instruments.

Relative value strategies profit from potential mispricing of similar investments. A long position is opened in the undervalued security while a short position is opened in the overvalued security. In theory, the gap between two mispriced investments should close at some point. This strategy can be used for equity and bond markets.

Similar long short strategies include statistical arbitrage and convertible arbitrage.

Activist investors build positions in a company that are large enough to give them influence at board level. They then attempt to alter the company’s strategy to unlock value. This can be done by restructuring a company, selling non-core assets, spinning off subsidiary companies or replacing the management team

Global Macro Funds
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Global macro funds use long and short positions across multiple asset classes to profit from themes in the global macro economy. Fund managers speculate on central bank policy, economic growth, consumer spending, trade relations and regulatory changes, and then build long and short positions around their thesis.

Distressed debt and turnaround investors look to buy debt and convertible debt when a company is in the process of restructuring or emerging from bankruptcy protection. The idea is that buying debt well below intrinsic value compensates buyers for the risk they are taking.

CTAs, or commodity trading advisors and managed futures funds use systematic trading strategies to ride long term trends in index and commodity futures and currency markets. These funds follow classic trend following strategies which can be very profitable but can also have substantial drawdowns.

Quantitative Hedge Funds
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Quantitative hedge funds encompass a wide range of strategies, generally using statistical techniques, algorithms and computer processing power. Some of the top hedge funds of the last two decades, including Renaissance Technologies’ Medallion Fund, are run using quantitative investing strategies. Funds like Catana Capital’s Data Intelligence Fund take a quantitative approach to using big data and market sentiment to find trading opportunities.

Fund of funds, or funds of hedge funds, are funds that invest in other hedge funds to diversify risk and smooth returns. Funds of funds are often created for the retail market, and in some jurisdictions, they can be structured as mutual funds or equivalent investment funds.

How to pick a hedge fund

Pick a Hedge Fund
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Before deciding to invest in a hedge fund, it’s important to do a fair amount of due diligence. If the fund has a reasonably long track record this will probably be the major factor in your decision-making process. A hedge funds returns can be compared to a hedge fund index for similar funds published on sites like BarclayHedge and HFR. An index will probably have lower volatility than any one fund but will give you an idea of comparative hedge fund performance over longer time horizons.

The objective should not be to look for the highest hedge fund returns, but for positive returns that are not correlated with other assets, specifically equities. Also consider whether the performance makes sense for the strategy being employed. If a market neutral fund has positive performance during bull markets and negative performance during bear markets, it’s not doing what it’s supposed to! Likewise, some funds are only designed to perform during bear markets, so poor performance during a bull market should be expected.

Hedge Fund Performance
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If a fund has a short track record, the experience of the fund manager and the investment process and strategy are more relevant than performance. A hedge fund’s performance over a short period actually means very little, unless the strategy clearly should have generated good returns during that period. Another important aspect to consider is whether or not the fund has a unique edge or is using original research and proprietary knowledge. Whenever a particular strategy seems to do well, new funds are launched to cater to growing demand. When market conditions change, or the industry becomes more competitive, these funds are left with no edge.

Finally, make sure you are aware of and understand the fee structure, the hurdle rate and any restrictions on redemptions. Hedge funds do not need to adhere to the same standardized frameworks retail funds do, so it’s up to the investor to make sure they are aware of the small print.

Disadvantages and risks of investing in hedge funds

Risk / Reward Ratio
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Most of the risks and disadvantages associated with hedge funds apply in individual cases rather than to the asset class as a whole. This highlights the need for due diligence and diversification of investments.

  • Potential for large losses: If a hedge fund uses excessive leverage and holds concentrated positions, it can lose far more than more traditional investments might.
  • Illiquid: Some funds have lengthy lockup periods or require lengthy notice for redemptions. Hedge funds that invest in very illiquid securities can also find themselves struggling to liquidate positions when volatility increases, which hurts performance.
  • Limited access: Hedge funds are often only available to high net worth investors and institutional investors.
  • High fees: Investing in a hedge fund is usually more expensive than investing in mutual funds or ETFs. Performance fees are only paid on positive performance, but management fees of up to 2% are relatively high.
  • Taxes: Depending on the jurisdiction and the way a fund is structured; hedge fund investors may have to pay income rather than capital gains tax.

Controversies around hedge funds

Hedge Fund Controversies
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Hedge fund investing has had its share of controversies ever since hedge funds emerged. George Soros gained infamy as a hedge fund manager in 1992 when he took on the Bank of England. Soros and other speculators shorted the British Pound believing that the BOE was supporting it. When the GBP did collapse, Soros is alleged to have made over $1 billion.

LTCM (Long Term Capital Management) was an early quant hedge fund run by a team of highly respected managers including two Nobel laureates. The fund used high levels of leverage to profit from mispricing in the global bond market. After nearly doubling in value between 1995 and 1997 the fund was worth $126 billion. The managers were caught off guard by the Russian financial crisis in 1998, with large positions they could not liquidate. Ultimately the New York Fed and 15 banks had to bail out the fund to prevent damage to the financial system. There are lots of lessons about liquidity and leverage to be learnt from this episode.

Bernie Madoff was a hedge fund manager whose fund turned out to be a Ponzi Scheme with fictious returns. His track record stood out in the industry due to consistent positive returns, which caused famous and high-profile investors to give him money to manage. Despite warning signs as early as 2003, the fund continued until it finally collapsed in 2008. In total the fraud was worth over $64 billion. The lesson here is that very few hedge funds make money every single month.

Outlook: Hedge funds as part of diversified investment portfolios

Despite the controversies, hedge funds serve an important function in diversified investment portfolios. While hedge funds have been around for over 50 years, the industry is still evolving, and innovators will continue to launch new types of hedge funds and strategies. New fields like artificial intelligence and big data may well dominate the hedge fund industry in the future, as funds compete to find new edges in the market. Hedge funds are not just for the institutional investor, and new products for the retail market will be another area of focus for hedge fund firms.

About Richard Bowman
Richard Bowman is a writer at Catana Capital, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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