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.
There
are approximately 14 distinct investment strategies used by hedge funds,
each offering different degrees of risk and return. A macro hedge fund,
for example, invests in stock and bond markets and other investment opportunities,
such as currencies, in hopes of profiting on significant shifts in such
things as global interest rates and countries’ economic policies.
A macro hedge fund is more volatile but potentially faster growing than
a distressed-securities hedge fund that buys the equity or debt of companies
about to enter or exit financial distress. An equity hedge fund may be
global or country specific, hedging against downturns in equity markets
by shorting overvalued stocks or stock indexes. A relative value hedge
fund takes advantage of price or spread inefficiencies. Knowing and understanding
the characteristics of the many different hedge fund strategies is essential
to capitalizing on their variety of investment opportunities.
It
is important to understand the differences between the various hedge fund
strategies because all hedge funds are not the same -- investment returns,
volatility, and risk vary enormously among the different hedge fund strategies.
Some strategies which are not correlated to equity markets are able to
deliver consistent returns with extremely low risk of loss, while others
may be as or more volatile than mutual funds. A successful fund of funds
recognizes these differences and blends various strategies and asset classes
together to create more stable long-term investment returns than any of
the individual funds.
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Hedge
fund strategies vary enormously – many, but not all, hedge against
market downturns – especially important today with volatility
and anticipation of corrections in overheated stock markets.
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The
primary aim of most hedge funds is to reduce volatility and risk while
attempting to preserve capital and deliver positive (absolute) returns
under all market conditions.
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The
popular misconception is that all hedge funds are volatile -- that
they all use global macro strategies and place large directional bets
on stocks, currencies, bonds, commodities or gold, while using lots
of leverage. In reality, less than 5% of hedge funds are global macro
funds. Most hedge funds use derivatives only for hedging or don’t
use derivatives at all, and many use no leverage.
Key
Characteristics of Hedge Funds
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Hedge
funds utilize a variety of financial instruments to reduce risk, enhance
returns and minimize the correlation with equity and bond markets.
Many hedge funds are flexible in their investment options (can use
short selling, leverage, derivatives such as puts, calls, options,
futures, etc.).
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Hedge
funds vary enormously in terms of investment returns, volatility and
risk. Many, but not all, hedge fund strategies tend to hedge against
downturns in the markets being traded.
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Many
hedge funds have the ability to deliver non-market correlated returns.
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Many
hedge funds have as an objective consistency of returns and capital
preservation rather than magnitude of returns.
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Most
hedge funds are managed by experienced investment professionals who
are generally disciplined and diligent.
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Pension
funds, endowments, insurance companies, private banks and high net
worth individuals and families invest in hedge funds to minimize overall
portfolio volatility and enhance returns.
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Most
hedge fund managers are highly specialized and trade only within their
area of expertise and competitive advantage.
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Hedge
funds benefit by heavily weighting hedge fund managers’ remuneration
towards performance incentives, thus attracting the best brains in
the investment business. In addition, hedge fund managers usually
have their own money invested in their fund.
Facts
About the Hedge Fund Industry
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Estimated
to be a $300-$400 billion industry and growing at about 20% per year
with between 4,000 and 5,000 active hedge funds.
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Includes
a variety of investment strategies, some of which use leverage and
derivatives while others are more conservative and employ little or
no leverage. Many hedge fund strategies seek to reduce market risk
specifically by shorting equities or through the use of derivatives.
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Most
hedge funds are highly specialized, relying on the specific expertise
of the manager or management team.
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Performance
of many hedge fund strategies, particularly relative value strategies,
is not dependent on the direction of the bond or equity markets --
unlike conventional equity or mutual funds (unit trusts), which are
generally 100% exposed to market risk.
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Many
hedge fund strategies, particularly arbitrage strategies, are limited
as to how much capital they can successfully employ before returns
diminish. As a result, many successful hedge fund managers limit the
amount of capital they will accept.
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Hedge
fund managers are generally highly professional, disciplined and diligent.
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Their
returns over a sustained period of time have outperformed standard
equity and bond indexes with less volatility and less risk of loss
than equities.
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Beyond
the averages, there are some truly outstanding performers.
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Investing
in hedge funds tends to be favored by more sophisticated investors,
including many Swiss and other private banks, that have lived through,
and understand the consequences of, major stock market corrections.
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An
increasing number of endowments and pension funds allocate assets
to hedge funds.
Hedging
Strategies
A
wide range of hedging strategies are available to hedge funds. For example:
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selling
short - selling shares without owning them, hoping to buy them back
at a future date at a lower price in the expectation that their price
will drop.
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using
arbitrage - seeking to exploit pricing inefficiencies between related
securities - for example, can be long convertible bonds and short
the underlying issuers equity.
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trading
options or derivatives - contracts whose values are based on the performance
of any underlying financial asset, index or other investment.
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investing
in anticipation of a specific event - merger transaction, hostile
takeover, spin-off, exiting of bankruptcy proceedings, etc.
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investing
in deeply discounted securities - of companies about to enter or exit
financial distress or bankruptcy, often below liquidation value.
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Many
of the strategies used by hedge funds benefit from being non-correlated
to the direction of equity markets
Popular
Misconception
The
popular misconception is that all hedge funds are volatile -- that they
all use global macro strategies and place large directional bets on stocks,
currencies, bonds, commodities, and gold, while using lots of leverage.
In reality, less than 5% of hedge funds are global macro funds like. Most
hedge funds use derivatives only for hedging or don't use derivatives
at all, and many use no leverage.
Benefits
of Hedge Funds
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Many
hedge fund strategies have the ability to generate positive returns
in both rising and falling equity and bond markets.
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Inclusion
of hedge funds in a balanced portfolio reduces overall portfolio risk
and volatility and increases returns.
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Huge
variety of hedge fund investment styles – many uncorrelated with
each other – provides investors with a wide choice of hedge fund
strategies to meet their investment objectives.
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Academic
research proves hedge funds have higher returns and lower overall
risk than traditional investment funds.
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Hedge
funds provide an ideal long-term investment solution, eliminating
the need to correctly time entry and exit from markets.
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Adding
hedge funds to an investment portfolio provides diversification not
otherwise available in traditional investing.
Hedge
Fund Styles
The
predictability of future results shows a strong correlation with the volatility
of each strategy. Future performance of strategies with high volatility
is far less predictable than future performance from strategies experiencing
low or moderate volatility.
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. Tends to be "long-biased." Expected Volatility: High
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. Expected Volatility: Low - Moderate
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 under
followed 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
What
is a Fund of Hedge Funds?
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A
diversified portfolio of generally uncorrelated hedge funds.
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May
be widely diversified, or sector or geographically focused.
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Seeks
to deliver more consistent returns than stock portfolios, mutual funds,
unit trusts or individual hedge funds.
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Preferred
investment of choice for many pension funds, endowments, insurance
companies, private banks and high-net-worth families and individuals.
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Provides
access to a broad range of investment styles, strategies and hedge
fund managers for one easy-to-administer investment.
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Provides
more predictable returns than traditional investment funds.
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Provides
effective diversification for investment portfolios.
Benefits
of a Hedge Fund of Funds
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Provides
an investment portfolio with lower levels of risk and can deliver
returns uncorrelated with the performance of the stock market.
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Delivers
more stable returns under most market conditions due to the fund-of-fund
manager’s ability and understanding of the various hedge strategies.
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Significantly
reduces individual fund and manager risk.
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Eliminates
the need for time-consuming due diligence otherwise required for making
hedge fund investment decisions.
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Allows
for easier administration of widely diversified investments across
a large variety of hedge funds.
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Allows
access to a broader spectrum of leading hedge funds that may otherwise
be unavailable due to high minimum investment requirements.
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Is
an ideal way to gain access to a wide variety of hedge fund strategies,
managed by many of the world’s premier investment professionals,
for a relatively modest investment.
