Hedge Funds - How They Work For Investors

Posted on Friday, August 24th, 2018 MarketBeat Staff

The phrase “hedge your bets” is often understood to mean covering your bases to guard against predictable risk. Regardless of the law, individuals would want auto insurance to guard against the risk of getting into an accident. Another example is flood insurance. In some areas where flooding is not just a risk, but a predictable risk, the government mandates flood insurance, because it’s not a matter of if it will flood, but when.

To investors, hedge funds can be, as their name implies, a hedge against risk. In fact, that is what they were originally created to be. Since it’s not a matter of if the market has downturns, but when, hedge fund managers combined bull-market and bear-market techniques for even greater diversification. They used tried-and-true stock picking strategies combined with hedging strategies, such as shorting stocks or using put options. However, as investors saw the opportunity for increased returns, many hedge funds began to use their arsenal of techniques in riskier ways.

In this article, we’ll explain what a hedge fund is, the most common types of hedge funds, key characteristics of hedge funds, the difference between absolute return and relative return when it comes to hedge funds, and common techniques used by hedge funds.

What is a hedge fund?

A hedge fund is an alternative to traditional forms of investing. Hedge funds use a pool of funds from investors who meet certain criteria in an effort to achieve a positive absolute return (referred to as alpha) for their investors. Hedge funds are considered a high-risk investment that also provides the potential for an above-average reward.

Because of their focus on a positive absolute return, hedge funds are usually very popular in bear markets. However, because hedge funds require less regulation than other investment products such as mutual funds, they are generally only available to investors who meet certain criteria. 

What are common types of hedge funds?

A hedge fund, like a mutual fund, is created to profit from a distinct market opportunity. Hedge funds can generally be broken down into one of nine categories:

  • Long-short funds – combines flexible, balanced strategies where long and short positions are held at the same time.
  • Event-driven funds – as the name implies, these funds speculate on how geopolitical events may impact market prices and attempt to generate outsized returns based on price inefficiencies.
  • Macro funds – these are similar to event-driven funds with the exception that they are focused on macroeconomic events driven by research as opposed to geopolitical events which may be based more on speculation.
  • Distressed securities funds – these funds invest in troubled companies. The risk is that if the company goes bankrupt, the shares will become worthless.
  • Emerging-market funds – these funds invest in securities in developing countries. The risk is that the development process can be very volatile, increasing the risk.
  • Long-only funds – these funds focus on stocks whose price is expected to increase. While similar to a mutual fund, their focus on the positive absolute return can be a pretty big risk in long bear markets. 
  • Short-only funds – the opposite of long-only funds, these funds focus on stocks that are expected to decrease in price.
  • Fixed-income arbitrage funds – a type of fund that seeks to profit from a price difference between fixed-income securities such as bonds, treasuries, and credit default swaps.
  • Merger arbitrage funds – these funds buy and sell a stock of companies that are going through a merger. The theory is that in many cases, the stock price of the target company (moving up) and acquiring company (moving down) will move in opposite directions.

What are the key characteristics of hedge funds?

Because of the risk associated with hedge funds, these funds are typically only open to qualified investors. These investors are deemed by the Securities and Exchange Commission to have an annual income or net worth that is sufficient to manage the risks. Hedge funds also can invest in virtually anything (i.e. real estate, currencies, and futures). In this way, they are different than mutual funds that can only invest in stocks and bonds. The third characteristic of hedge funds is their use of leverage or borrowed money to generate higher returns. They also have a different fee structure that includes both an expense ratio and a performance fee, which is known as a 2% asset management fee and a 20% cut of any profit.

Hedge funds are focused on absolute return

To understand how investing in a hedge fund is different from investing in a stock, bond, or mutual fund, it’s important to understand the concept of absolute return. Absolute return is the dollar value an asset has gained or lost over a set period of time. Absolute return is calculated independently of any competitive products or market benchmarks. 

As an example, let’s say you invested $80,000 in a particular asset. In 12 months, the value of your investment was $88,000. Your absolute return would be $8,000. If the value of your investment fell to $72,000, your absolute return would be -$8,000.

Many mutual fund advisors will talk about an absolute return in conjunction with an investment’s relative return. The relative return measures how a particular investment did in relation to a competitor or market benchmark such as the S&P 500.

Going back to our example above, if your $80,000 investment increased to $88,000, you might feel it performed well – unless you were to find out that the same investment would have increased to $90,000 if invested with the S&P 500 Index. In that case, your investment performed at 10%, but the broader market performed at over 12%.

Where relative return becomes more relevant to understanding hedge funds is when an asset loses value. In our example, if your investment lost $8,000, but investing in the broader market would have shown a loss of $10,000, your investment advisor will be happy to let you know that he helped you “beat the market” because your loss was not as big in comparison to other benchmarks.

The difference between absolute and relative return is the primary difference between hedge funds and other forms of investments such as mutual funds. Hedge fund managers are interested in only a positive absolute return. Those involved want to see positive returns even in a bear market - a good relative return is just not good enough. The potential loss of principal is what hedge funds work hard to avoid, and what gives them the prospect of spectacular returns and the potential for enormous risk.

A former National Football League coach once uttered the phrase “You play to win the game!” That statement, in effect, sums up the risk – and the potential reward – of a hedge fund.

What are common hedge fund techniques?

Hedge funds focus on achieving a positive absolute return regardless of market conditions in a given asset class. To do this, they will employ a variety of techniques including short-selling, futures, options, convertible arbitrage, and leverage.  A brief description of these techniques is listed below.

  • Short Selling: Short selling is done to take advantage of a predicted decline in an asset. To conduct a short sale, an investor reverses the traditional order of buying and then selling. They borrow stock from a broker and immediately sell it. If the price of the stock drops as anticipated, they can buy the new shares at the cheaper price, replace the borrowed shares, and keep the profits. The risk of short selling is that the stock price might rise, in which case, the investor will now have to lose money to be able to repay the shares to the

    A basic example, excluding commissions and interest on things like a margin account, is as follows:

    A hedge fund believes Company XYZ’s shares are currently valued too high at $75 per share. They borrow 100 shares of their stock from a broker and sell them immediately, leaving them “short” 100 shares. If the stock drops as predicted to $65 per share, the fund can decide to close their short position by buying the 100 shares at the new price to repay the shares they borrowed. Because the shares went down, they would realize a profit of $35 times 100 shares, or $3500.

  • Futures: Futures are a common way investors trade commodities (gold, soybeans, oil) or financial instruments (Treasury bills or foreign currencies). When investors trade in the futures market they are making a legal agreement to buy or sell an amount of that commodity at a stipulated price during a specified month (in the “future”). This time period could be one month or as far away as nine months. During the time the futures contract is held, the actual price of the investment may move closer or further away from the contract price.

    A good way to understand futures is to think about what we tend to do as consumers. When we “lock in” a great rate, we are agreeing to pay for service, for a fixed period of time, at a specific rate. The same is true of a futures contract. If an investor believes the price of wheat will be significantly higher in three months. They can agree to buy it at its current price three months in the future. If the price of wheat rises in that time, they are making money on their lower-priced shares.

  • Options: An options contract is similar to a futures contract because it is an agreement between two parties that gives an investor the right to buy or sell a security from or to another investor at a predetermined price within a certain time frame in the future. However, unlike a futures contract, the owner of the option does not have to make the transaction. They have the “option” to decline. Options can be expressed in terms of calls (when an investor predicts an asset will increase in value) or puts (when an investor predicts an asset will decrease in value).

    Another way to understand the concept of options is in terms of the contracts of professional athletes. Players may sign a three-year contract with a fourth-year option. If the option is a player option, that means the player can “opt out” of the contract without penalty. If it’s a team option, the team can opt out of the contract with no penalty. Because the salary for the option year is predetermined, the player or team can make a judgment of whether picking up the option is a smart decision.

    The risk with options is that the options cost money. If the stock price never gets to a level where exercising the option would be advantageous, the options buyer simply loses the money that they used to purchase the options.

  • Convertible Arbitrage – this technique is used when an investor believes that a company’s convertible bonds (bonds that can be converted to stock at a predetermined time and at a predetermined price) are priced inefficiently to that same company’s stock. By employing convertible arbitrage, a hedge fund will buy convertible bonds in a company while at the same time creating a short position in the company’s stock. The idea is that as the price of the stock falls, they will profit from their short position. If the stock price begins to rise, the fund can convert its bonds to stocks and profit from their long position, which theoretically will cover any losses in their short position.

    The risk of convertible arbitrage is that convertible bonds must be held for a specific period of time before they can be converted to stock. This introduces an element of market timing that may make the potential reward not worth the risk.

  • Leverage – this is the riskiest technique used by hedge funds and the one they are probably most known for. Using leverage means simply that the hedge funds use borrowed money to finance part of their investments with the hope of multiplying their gains. In simple terms, if an investor puts $100,000 of their own money into an investment that increases by $10,000, they have made a 10 percent return. If they only use $50,000 of their own money by borrowing the other half, that same $10,000return would be a 20 percent return (minus whatever interest was agreed upon for the loan). Of course, this also presents the risk of using leverage. If the price of the security decreases in price, the negative return to the leveraged owner is greater.

The bottom line on hedge funds

To cynics who would equate investing to legalized gambling, hedge funds would be their star witness. Often misunderstood, hedge funds play a role in the way markets work. They can provide diversification to a portfolio and create the potential for growth when markets are lagging. However, they are not without risk. One such risk is that investments are locked into the hedge fund for a specific period of time. If you are not happy with how the fund is being managed, you cannot pull it out until the end of the lock-up period. Depending on the type of hedge fund, this could mean that you would be at significantly more risk of losing your principal if the market shifts in a negative direction. Individual investors should pay attention to the particular objective of the hedge fund they are considering investing in.

 

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