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Hedge Fund

Page history last edited by Brian D Butler 11 years, 1 month ago








Hedge Fund

Pools of lightly regulated, highly mobile capital[1]


Hedge funds are not an asset class but rather highly specialized and talented players in a specific market. These people trade in derivatives (Options, currency ,EFTs, etc).   These are high risk, high potential return funds that are aimed at sophisticated investors.


A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously -- many hedge against downturns in the markets -- especially important today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.


Table of Contents:




     note:  this is a sub-topic of "asset management",  see also ETF exchange traded funds


Different types of Hedge Funds:


There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return.


Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks which are expected to experience rapid growth. Includes sector specialist funds such as technology, banking, or biotechnology. Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes.


Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market's lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities. (This selling pressure creates the deep discount.) Results generally not dependent on the direction of the markets.


Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available, although Brady debt can be partially hedged via U.S. Treasury futures and currency markets.

Expected Volatility: Very High


Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed.

Expected Volatility:Low - Moderate - High


Income: Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income.

Expected Volatility:Low


Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets -- equities, bonds, currencies and commodities -- though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves. Utilizes hedging, but the leveraged directional investments tend to make the largest impact on performance.

Expected Volatility:Very High






Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity. May also use futures to hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage.

Expected Volatility:Low


Market Neutral - Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns. Usually low or no correlation to the market. Sometimes uses market index futures to hedge out systematic (market) risk. Relative benchmark index usually T-bills.

Expected Volatility:Low


Market Timing: Allocates assets among different asset classes depending on the manager's view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy.

Expected Volatility: High


Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class.

Expected Volatility: Variable


Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities.

Expected Volatility: Variable


Short Selling: Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the manager's assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle.

High risk. Expected Volatility: Very High


Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company. May also utilize derivatives to leverage returns and to hedge out interest rate and/or market risk. Results generally not dependent on direction of market.

Expected Volatility: Moderate


Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favor or underfollowed by analysts. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market.

Expected Volatility: Low - Moderate



Various Hedging Strategies using options:


see more in our discussion about hedging and  Options




learn more here:  http://www.amex.com/?href=/options/eductn/index_education.html




Hedge fund trends


see our discussion on Hedge Fund trends





How much does it cost to invest in hedge funds?



Hedge Funds may charge 2% annually, and an additional 20% performance fee of all profits that they make.  So you will give away 20% of all profits plus 2% per year just of the right to have this person hold onto your money.  Ouch. They had better be really, really good to justify this very high take.  Some hedge funds charge even more, up to 5% annual fees, with up to 40% performance fees.




Seeking "alpha" in your investments


One of the main reasons that hedge funds grew in popularity after the 2000-2003 equity downturn was that pension funds sought asset classes that could return positive returns no matter if the market was going up or down.  This makes sense because they can not afford to loose money in stocks if they have fixed pension obligations due in the future.  But, if they are sooo worried about security , why not invest in more safe assets like Treasuries, or non-correlated assets like bonds?  Well, because those asset classes didn't have the promise of big enough returns.  So, they turned to hedge funds...and the industry (along with private equity, and "alternative assets") boomed (maybe leading to the financial crisis of 2008?). 



But, how much alpha do hedge funds really deliver?  and how much is really just beta (repackaged)?


As ETF's have become more sophisticated, and as ETF;s are used more and more by Hedge funds, how much do they really offer in addition to the standard Beta?  See our discussion about "active ETF's"


The problem:


As hedge funds become mainstream, their size is getting bigger.  As this happens, the correlation between them and the index is becoming greater.   In other words, they are starting to move with the markets, rather than in the opposite directions.  This means that they are losing their appeal as an alternative investment vehicle. 


More of a concern:  hedge funds have a high correlation with each other.  The brains behind the hedge funds themselves are showing signs of "group think", and may be exposed to the same kind of thinking, which is not good, and risks that the funds may all raise and fall together.   This is worrying enough...but, as they get bigger...this has the effect of moving the markets. 






Why Invest in Hedge Funds?


There are several possible reasons to invest in hedge funds. First, I would say that not all hedge funds are created equal. I would roughly divide them into low volatility (arbitrage type) and higher volatility.



For low volatility, I think they currently offer a great alternative to bonds, as yields are so low; you're better of buying a low-vol hedge fund. I've seen great funds of funds that will return 10% annually (in USD) with volatility of 3-4%.



For higher volatility, I guess it all depends on your risk profile. This is the original global-macro space with returns of 20%+ per year. Unfortunately, the global-macro funds have been steadily declining with so many new hedge funds coming into existence, thereby reducing any market inefficiencies quickly. I can still find some funds in this space, but most are closed to new investors.



The strategy is to use hedge funds to reduce the volatility of the overall portfolio by investing in an asset class much less correlated to stocks and bonds.  Contrary to what one other answerer stated, hedge funds do represent a separate asset class. A long/short hedge fund will be far less correlated to stocks than most anything else. The structure alone of a long/short strategy tells you it should not be that correlated if at all with a long strategy.  issues with hedge funds. First, the lack of liquidity as your funds are tied for long period of time. Second, the disclosure is lacking as this is supposedly proprietary information. As a result you really never know what you are invested into and can’t fully understand the risk you are assuming. Remember market neutral does not mean risk neutral. I learned that the hard way three times. Also, the standard compensation is nuts: 1% operating management fee plus 20% of returns when they are positive. Let’s say a stock index returns over time 10%. Just to break even with that the hedge fund has to generate a return before fees of 13.75%. In other words, it has to generate gross returns that are nearly 40% higher than a stock index fund that has near zero operating costs. Based on my firsthand experience, I’d stick with the index fund.



Are hedge funds really better in volatile markets?


some analysts would say "no".   See discussion here: 


" On the back of a dismal March for hedge funds, which has wounded several big names, something of a blogophere debate has broken out.  As so often, Felix Salmon started it: “Aren’t hedge funds precisely the asset class which is meant to benefit from volatility?”  Hedge fund managers, sick of being laughed at when their returns failed to match the equity indices during the bull run, were endlessly telling us that they’d come into their own once the market turned. Putting money into hedge funds was meant to position investors for exactly these kinds of troubled times, wasn’t it?. So the hedge fund reality fails, in part, to live up to the marketing hype. Most hedge funds want enduring trends with clear cues to take a position. They want a bog-standard bear market, one which more or less consistently moves down, rather than one that flies around erratically.  "  read more from FT.com



The "nerds" vs the "Barbarians":


more discussion from FT.com: 


" David Merkel though thinks you can’t generaliseHedge funds are limited partnerships that do a wide variety of things in the markets. Some aim for easily modelled consistent gains through arbitrage. Others aim for maximum advantage, no matter what. I call the first group the “nerds” and the second group the “barbarians.”  Nerds, along with funds of funds, get hurt in volatility, as simple arbitrages rely on calm markets and ample liquidity. Barbarians, in contrast, see opportunities, in the ‘noise’ of the market."  Apt to take big bets that may be right or wrong, the latter sounds rather binary: outsize returns or outright implosion. And the volatility this year has already caught out ample nerds, in the manner of Peloton or Endeavour. Sounds like hedge funds as an asset class offer scant protection in volatile times."





Fund of Funds


FoFs can be both multi-strategy and single-strategy. For somebody looking to replace a portion of their equity holdings a long-short equity fund of funds can make a lot of sense. Other investors may want the broad diversification of a multi-strategy fund, but should understand the FoF's broad allocation ranges.


For many investors a FoFs make the most sense. Maybe they do not have the time or expertise to source and conduct due diligence (and ongoing due diligence) on hedge funds. The FoFs allows them to get access to a well diversified portfolio of hedge funds (maybe using consultants and making direct hedge fund investments is initially less expensive, but you still have an ongoing due diligence problem).


Some people only want to allocate a small amount of money to hedge funds. Maybe this is not enough money to invest in multiple funds directly, but is enough to invest in a FoFs.


There is a place for fund of funds in the market; but I concur that if an investor has the money, time, and expertise to invest directly in a hedge fund or hedge funds that would be preferable to paying the extra layer of fees.  (an additional layer of 1-1.5%)


Problem with the Fund of Funds:


As many have said before, hedge funds are not an asset class but rather highly specialized and talented players in a specific market.


If you take this view, the additional layer of fund of hedge funds in 99% is a waste of money. Apart from the onerous fee-layering, FoF are very much trend-followers ("herd") and usually are not able to perform real strategy allocation they claim they are good at. Also, I believe that investing in FoF leads to over-diversification because it is unclear why would you want hedge funds operating in all asset classes in addition to already diversified portfolio that already has equity, bonds etc. Hedge funds are very much an alpha kicker for a diversified portfolio and should be bought with high conviction to actually affect the returns of portfolio.


Risk is not equal to volatility and actually understanding a few strategies can lead to less fundamental risk in long-term and good returns over time.


The Fund of Funds approach does provide you interesting diversification opportunities. However, it adds another layer of fees. Given that fees are already crippling as is, I’d really study closely if the added diversification is worth the additional cost. My sense is that more often than not it is not. That’s because the remainder of your portfolio should already provide solid diversification benefits relative to the hedge fund’s position.





Hedge fund management:


Strategic Issues for the future:


Some of the top strategic concerns for hedge funds are:


(1) Finding good investment ideas in an increasingly crowded market

(2) Demands of a client base which is shifting more towards institutional clients (transparency, reporting, compliance, etc.)

(3) Non-traditional competitors (long-only managers expanding into long/short or absolute return, hedge-like mutual funds, etc.)

(4) Fee compression ("2 and 20" isn't acceptable anymore unless you've got a track-record and pedigree in the industry)

(5) Regulation and improving the "legitimacy" of their industry - despite what lots of folks on here think, regulation isn't really a new issue (over 50% of hedge fund managers have already filed an ADV) but new oversight into things like side-letter agreements which are common practice today, will be a big issue.





Introduction to Hedge Funds


Link to original article



Hedge funds are like mutual funds in two respects: (1) they are pooled investment vehicles (i.e. several investors entrust their money to a manager) and (2) they invest in publicly traded securities. But there are important differences between a hedge fund and a mutual fund. These stem from and are best understood in light of the hedge fund's charter: investors give hedge funds the freedom to pursue absolute return strategies.



Mutual Funds Seek Relative Returns

Most mutual funds invest in a predefined style, such as "small cap value", or into a particular sector, such as the Internet sector. To measure performance, the mutual fund's returns are compared to a style-specific index or benchmark. For example, if you buy into a "small cap value" fund, the managers of that fund may try to outperform the S&P Small Cap 600 Index. Less active managers might construct the portfolio by following the index and then applying stock-picking skills to increase (over-weigh) favored stocks and decrease (under-weigh) less appealing stocks.


A mutual fund's goal is to beat the index or "beat the bogey", even if only modestly. If the index is down 10% while the mutual fund is down only 7%, the fund's performance would be called a success. On the passive-active spectrum, on which pure index investing is the passive extreme, mutual funds lie somewhere in the middle as they semi-actively aim to generate returns that are favorable compared to a benchmark.


Hedge Funds Actively Seek Absolute Returns

Hedge funds lie at the active end of the investing spectrum as they seek positive absolute returns, regardless of the performance of an index or sector benchmark. Unlike mutual funds, which are "long-only" (make only buy-sell decisions), a hedge fund engages in more aggressive strategies and positions, such as short selling, trading in derivative instruments like options and using leverage (borrowing) to enhance the risk/reward profile of their bets.


This activeness of hedge funds explains their popularity in bear markets. In a bull market, hedge funds may not perform as well as mutual funds, but in a bear market - taken as a group or asset class - they should do better than mutual funds because they hold short positions and hedges. The absolute return goals of hedge funds vary, but a goal might be stated as something like "6 to 9% annualized return regardless of the market conditions".


Investors, however, need to understand that the hedge-fund promise of pursuing absolute returns means hedge funds are "liberated" with respect to registration, investment positions, liquidity and fee structure. First, hedge funds in general are not registered with the SEC. They have been able to avoid registration by limiting the number of investors and requiring that their investors be accredited, which means they meet an income or net worth standard. Furthermore, hedge funds are prohibited from soliciting or advertising to a general audience, a prohibition that lends to their mystique.



In hedge funds, liquidity is a key concern for investors. Liquidity provisions vary, but invested funds may be difficult to withdraw "at will". For example, many funds have a lock-out period, which is an initial period of time during which investors cannot remove their money.


Lastly, hedge funds are more expensive even though a portion of the fees are performance-based. Typically, they charge an annual fee equal to 1% of assets managed (sometimes up to 2%), plus they receive a share - usually 20% - of the investment gains. The managers of many funds, however, invest their own money along with the other investors of the fund and, as such, may be said to "eat their own cooking".


Three Broad Categories and Many Strategies

Most hedge funds are entrepreneurial organizations that employ proprietary or well-guarded strategies. The three broad hedge fund categories are based on the types of strategies they use:


1. Arbitrage Strategies (A.K.A., Relative Value)

Arbitrage is the exploitation of an observable price inefficiency and, as such, pure arbitrage is considered riskless. Consider a very simple example. Say Acme stock currently trades at $10 and a single stock futures contract due in six months is priced at $14. The futures contract is a promise to buy or sell the stock at a predetermined price. So by purchasing the stock and simultaneously selling the futures contract, you can, without taking on any risk, lock in a $4 gain before transaction and borrowing costs.


In practice, arbitrage is more complicated, but three trends in investing practices have opened up the possibility of all sorts of arbitrage strategies: the use of (1) derivative instruments, (2) trading software, and (3) various trading exchanges (for example, electronic communication networks and foreign exchanges make it possible to take advantage of "exchange arbitrage", the arbitraging of prices among different exchanges).


Only a few hedge funds are pure arbitrageurs, but when they are, historical studies often prove they are a good source of low-risk reliably-moderate returns. But, because observable price inefficiencies tend to be quite small, pure arbitrage requires large, usually leveraged investments and high turnover. Further, arbitrage is perishable and self-defeating: if a strategy is too successful, it gets duplicated and gradually disappears.


Most so-called arbitrage strategies are better labeled "relative value". These strategies do try to capitalize on price differences, but they are not risk free. For example, convertible arbitrage entails buying a corporate convertible bond, which can be converted into common shares, while simultaneously selling short the common stock of the same company that issued the bond. This strategy tries to exploit the relative prices of the convertible bond and the stock: the arbitrageur of this strategy would think the bond is a little cheap and the stock is a little expensive. The idea is to make money from the bond's yield if the stock goes up but also make money from the short sale if the stock goes down. However, as the convertible bond and the stock can move independently, the arbitrageur can lose on both the bond and the stock, which means the position carries risk.



2. Event-Driven Strategies

Event-driven strategies take advantage of transaction announcements and other one-time events. One example is merger arbitrage, which is used in the event of an acquisition announcement and involves buying the stock of the target company and hedging the purchase by selling short the stock of the acquiring company. Usually at announcement, the purchase price that the acquiring company will pay to buy its target exceeds the current trading price of the target company. The merger arbitrageur bets the acquisition will happen and cause the target company's price to converge (rise) to the purchase price that the acquiring company pays. This also is not pure arbitrage. If the market happens to frown on the deal, the acquisition may unravel and send the stock of the acquirer up (in relief) and the target company's stock down (wiping out the temporary bump) which would cause a loss for the position.


There are various types of event-driven strategies. One other example is "distressed securities", which involves investing in companies that are re-organizing or have been unfairly beaten down. Another interesting type of event-driven fund is the activist fund, which is predatory in nature. This type takes sizeable positions in small, flawed companies and then uses its ownership to force management changes or a restructuring of the balance sheet.


3. Directional or Tactical Strategies

The largest group of hedge funds uses directional or tactical strategies. One example is the macro fund, made famous by George Soros and his Quantum Fund, which dominated the hedge fund universe and newspaper headlines in the 1990s. Macro funds are global, making "top-down" bets on currencies, interest rates, commodities or foreign economies. Because they are for "big picture" investors, macro funds often do not analyze individual companies.



Here are some other examples of directional or tactical strategies:



  • Long/short strategies combine purchases (long positions) with short sales. For example, a long/short manager might purchase a portfolio of core stocks that occupy the S&P 500 and hedge by selling (shorting) S&P 500 Index futures. If the S&P 500 goes down, the short position will offset the losses in the core portfolio, limiting overall losses.


  • Market neutral strategies are a specific type of long/short whose goal is to negate the impact and risk of general market movements, trying to isolate the pure returns of individual stocks. This type of strategy is a good example of how hedge funds can aim for positive, absolute returns even in a bear market. For example, a market neutral manager might purchase Lowe's and simultaneously short Home Depot, betting that the former will outperform the latter. The market could go down and both stocks could go down along with the market, but as long as Lowe's outperforms Home Depot, the short sale on Home Depot will produce a net profit for the position.


  • Dedicated short strategies specialize in the short sale of over-valued securities. Because losses on short-only positions are theoretically unlimited (because the stock can rise indefinitely), these strategies are particularly risky. Some of these dedicated short funds are among the first to foresee corporate collapses - the managers of these funds can be particularly skilled at scrutinizing company fundamentals and financial statements in search of red flags.


Link to original article




About hedge funds (from Wikipedia):


A hedge fund is a private investment fund charging a performance fee and typically open to only a limited range of qualified investors. In the United States, hedge funds are open to accredited investors only. Because of this restriction, they are usually exempt from any direct regulation by regulatory bodies.



As a hedge fund's investment activities are limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.


Appropriate to their name, hedge funds may often seek to offset potential losses in the principal markets they invest in by hedging via any number of methods. However, the term "hedge fund" has come in modern parlance to be overused and inappropriately applied to any absolute-return fund – many of these so-called "hedge funds" do not actually hedge their investments.


As a result of both legal constraints and self-interests surrounding the release of information to the general public, hedge funds have acquired a reputation for secrecy. Unlike open-to-the-public "retail" funds (e.g., U.S. mutual funds) which market freely to the public, in most countries hedge funds are specifically prohibited from marketing to investors who are not professional investors or individuals with sufficient private wealth. The release of a hedge fund's historical returns to the public, for example, could be construed as marketing. Moreover, the divulging of a hedge fund's methods for achieving its high returns could unreasonably compromise their business interests.


Since hedge fund assets can run into many billions of dollars and will usually be multiplied by leverage, their sway over markets, whether they succeed or fail, is potentially substantial and there is a continuing debate over whether they should be more thoroughly regulated.


see more...http://en.wikipedia.org/wiki/Hedge_fund





Derivatives are financial instruments whose value is derived from the value of something else. They generally take the form of contracts under which the parties agree to payments between them based upon the value of an underlying asset or other data at a particular point in time. The main types of derivatives are futures, forwards, Options, and swaps (see links below).


The main use of derivatives is to reduce risk for one party while offering the potential for a high return (at increased risk) to another. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds,interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the payoffs.



for more info:  http://en.wikipedia.org/wiki/Derivative_(finance)




Links from KookyPlan





Resources for more research:







Contributors to this Page:


page director: Brian D. Butler

contributors:   if you are interested in contributing see here 





  1. Niall Ferguson, "The Ascent of Money"

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