In 1949, a man named Alfred Winslow Jones launched an investment vehicle designed to protect against declines in the equity market. His creation, novel at the time, is what we now refer to as a hedge fund. Today, hedge funds collectively manage over $3 trillion in assets, making them a very popular alternative investment and indeed a force in global markets.
It’s important to point out that the term “hedge fund” is a very broad one, and one that captures a whole host of strategies that really aren’t even related to each other. In broad strokes, though, these vehicles are pooled, actively managed investment funds that are typically only available to accredited investors.
A key characteristic that sets hedge funds apart from, say, mutual funds, is their flexibility. Mutual funds usually are restricted to being long publicly-traded equities. By contrast, hedge funds, depending on their particular strategy, can take long or short positions, use derivatives for hedging or speculative purposes, and also employ leverage to amplify returns. This wide latitude offers hedge funds investment options that many money managers simply cannot take advantage of.
Key Strategies
There are thousands of hedge funds with an array of strategies, but here are some of the more common approaches:
- Long/Short Equity: As the name implies, a long/short equity fund seeks to outperform by taking long positions in certain stocks and short positions in other ones. This is the most popular hedge fund strategy. As the CFA Institute notes, a long/short fund usually aims to achieve the kind of returns associated with long-only funds, but with much lower portfolio volatility. Moreover, these funds’ holdings tend to be fairly liquid. Long/Short hedge funds may focus on one particular sector or the market as a whole, and they can use positions in an index to offset single-name holdings in their portfolio.
- Global Macro: These have been some of the most famous hedge funds historically (think George Soros’ Quantum Fund). Global macro funds seek to outperform by taking positions in interest rates, currencies, commodities, and equities. Trades can either be directional (e.g. long a particular commodity) or relative value (e.g. long natural gas and short oil). They are big picture funds focused on macroeconomic trends, and can search the world in the hopes of finding the next winning trade.
- Quantitative: So-called quant funds make trades in various markets based on proprietary mathematical models. One notable quant fund, Renaissance Technologies, has posted returns that rival or exceed those of famed investor Warren Buffett.
- Fixed Income/Credit: These hedge funds can invest in anything from investment-grade corporate debt to government bonds. They may also take positions in the bonds of companies in the midst of financial distress.
- Commodity Funds: Hedge funds that specialize in commodity markets can trade a number of listed natural resources (such as West Texas Intermediate oil), or even obscure raw materials that aren’t even traded on a recognized exchange. Commodity hedge funds usually stick to derivatives such as futures and options, although some funds in the past have also dealt in physical markets as well.
- Merger Arbitrage: Funds that are focused on merger arbitrage usually take a long position in the company being acquired and pair it with a short position in the acquiring firm.
The Investment Case for Hedge Funds
There are a few key reasons that hedge funds as a whole are attractive to investors:
- Flexibility: As mentioned, many strategies, especially in the mutual fund, ETF, and index fund world, are effectively long-only and tend to deal in listed equity markets. Hedge funds aren’t often restricted to this kind of approach. They can profit no matter the market environment, and they can use tools such as leverage and derivatives that may either dampen their own volatility or enhance their returns. Plus, they can trade in a number of markets not fully accessible to non-accredited investors.
- Lack of Correlation to Major Indices: An investor looking to put money into a hedge fund may do so because the fund’s strategies are not correlated to the performance of the overall equity market. In fact, it may be the case that the rationale for investing in a specific fund is that it takes short positions against stocks. In this regard, an investor in the fund can lower the volatility of their overall portfolio by adding this alternative.
- Outperformance in Bear Markets: Markets have climbed relentlessly since the depths of the global financial crisis in 2009. As such, many investors may look to hedge funds if they believe a significant bear market is around the corner.
What are the Risks?
Despite the word “Hedge” in their name, hedge funds aren’t necessarily without significant risks. Some of the major risks that can come with a hedge fund investment include:
- Liquidity: Redemptions for hedge funds are typically only allowed quarterly. Contrast this with mutual funds where an investor may redeem their units at any point. Furthermore, some hedge funds are allowed to restrict redemptions if they are in an adverse environment.
- Leverage Cuts Both Ways: Using leverage is a double-edged sword. It can lead to greater returns but can also lead to significant losses. Over the years, there have been funds (such as Long-Term Capital Management) that failed because of leveraged trades that went awry.
- Losses due to Short Positions: As the recent saga regarding GameStop and an army of retail traders illustrates, short positions taken by hedge funds can go badly wrong and inflict huge losses on a hedge fund.
Common Fee Structures
Historically, the name of the hedge fund game fee-wise has been 2 and 20. That is to say, a 2% management fee based on assets, and a 20% performance fee (subject to what’s known as a high-water mark). While the general approach of pairing a management fee and an incentive fee persists, the structure is evolving. Management fees are being compressed, but on the flip side, performance fees can now be even higher than 20% in some cases.
What to Look for in a Good Manager
Investors should consider a number of factors when choosing a hedge fund manager to invest with. For starters, it’s helpful to look at their track record managing money. Along these lines, how a manager performed in different market conditions is also instructive. Perhaps they do very well in bear markets but then severely underperform in bull markets. Alternatively, maybe a particular manager is able to outperform no matter what the broader markets are doing.
Investors can also look for managers that do well without taking on excess risk. Using various measures of volatility (such as a Sharpe ratio), it’s possible to assess whether or not the returns generated by a fund are being produced by wild swings from month to month.
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