The term Hedge Fund comes from the fact that they employ strategies that hedge risk. Where as a traditional Emerging Market Equity Fund would be focused on trying on replicate or slightly beat the performance of its index by using long only strategies, the Emerging Market Hedge Fund would use strategies such as going shorting, using leverage or options to try to create absolute returns.
The traditional equity or bond funds performance will be generated by Beta, or the performance of the market as a whole. The phrase “a rising tide raises all ships” adequately sums up that when buying a traditional fund, being in the right asset class is a lot more important than whom the manger is. The risk you take on is basically the market risk.
Hedge Funds however employ strategies to create value in rising and falling markets. They are able to do this because the focus on generating Alpha, or market outperformance. With a Hedge Fund the manager will be focused on absolute returns. That is not to say that this eliminates market risk, but it will be reduced. The risk that will be more evident is the strategic risk or risk inherent in the strategy. That is why manager selection is a critical part of investing in Hedge Funds and why most funds have some sort of performance fee in their management charges.
A common misconception is that Hedge Funds are more risky. This is not necessarily true. While some funds will be extremely volatile and will magnify market swings through the use of leverage, most Hedge Funds tend to be less volatile than their equity and bond fund counterparts.
Another misconception is that Hedge Funds are only for the Ultra Rich. This may have been true in the past but there are some very good Hedge Funds that have minimum investments as little as $5,000 while a $50,000 minimum is more the norm.
By using Hedge Funds as an uncorrelated counter weight within a tradition portfolio you can reduce the overall volatility of the portfolio and generate better returns. The key is to work with an adviser who understands the role of Hedge Funds and the performance attributes of the various types, but most importantly he should have a good understanding of the individual managers and the strategies that they employ.
Since there has been a lot of interest in Alternative Investment Strategies that can help diversify your portfolio and reduce the volatility, especially given current market conditions. I thought it would be helpful to give a roundup of the different types of Hedge Funds.
Global Macro
Global Macro funds focus on identifying extreme price valuations and leverage is often applied on the anticipated price movements in equity, currency, interest rate and commodity markets. Managers typically employ a top down global approach to concentrate on forecasting how political trends and global macroeconomic events affect the valuation of financial instruments. Profits are made by correctly anticipating price movements in global markets and having the flexibility to use a broad investment mandate, with the ability to hold positions in practically any market with any instrument. These approaches may be systematic trend following models, or discretionary.
Convertible Arbitrage
Convertible Arbitrage funds aim to profit from the purchase of convertible securities and the subsequent shorting of the corresponding stock when there is a pricing error made in the conversion factor of the security. Managers typically build long positions of convertible and other equity hybrid securities and then hedge the equity component of the long securities positions by shorting the underlying stock or options. The number of shares sold short usually reflects a delta neutral or market neutral ratio. As a result, under normal market conditions, the arbitrageur generally expects the combined position to be insensitive to fluctuations in the price of the underlying stock.
Dedicated Short Bias
Dedicated Short Bias funds take more short positions than long positions and earn returns by maintaining net short exposure in long and short equities. Detailed individual company research typically forms the core alpha generation driver of dedicated short bias managers, and a focus on companies with weak cash flow generation is common. To affect the short sale, the manager borrows the stock from a counter-party and sells it in the market. Short positions are sometimes implemented by selling forward. Risk management consists of offsetting long positions and stop-loss strategies.
Equity Market Neutral
Equity Market Neutral funds take both long and short positions in stocks while minimizing exposure to the systematic risk of the market (i.e., a beta of zero is desired). Funds seek to exploit investment opportunities unique to a specific group of stocks, while maintaining a neutral exposure to broad groups of stocks defined for example by sector, industry, market capitalization, country, or region. There are a number of sub-sectors including statistical arbitrage, quantitative long/short, fundamental long/short and index arbitrage. Managers often apply leverage to enhance returns.
Emerging Markets
Emerging Markets funds invest in currencies, debt instruments, equities and other instruments of countries with emerging or developing markets (typically measured by GDP per capita). Such countries are considered to be in a transitional phase between developing and developed status. Examples of emerging markets include China, India, Latin America, much of Southeast Asia, parts of Eastern Europe, and parts of Africa. There are a number of sub-sectors, including arbitrage, credit and event driven, fixed income bias, and equity bias.
Event Driven
Event Driven funds invest in various asset classes and seek to profit from potential mispricing of securities related to a specific corporate or market event. Such events can include: mergers, bankruptcies, financial or operational stress, restructurings, asset sales, recapitalizations, spin-offs, litigation, regulatory and legislative changes as well as other types of corporate events. Event Driven funds can invest in equities, fixed income instruments (investment grade, high yield, bank debt, convertible debt and distressed), options and various other derivatives. Many managers use a combination of strategies and adjust exposures based on the opportunity sets in each sub-sector.
Fixed Income Arbitrage
Fixed Income Arbitrage funds attempt to generate profits by exploiting inefficiencies and price anomalies between related fixed income securities. Funds limit volatility by hedging out exposure to the market and interest rate risk. Strategies include leveraging long and short positions in similar fixed income securities that are related either mathematically or economically. The sector includes credit yield curve relative value trading involving interest rate swaps, government securities and futures; volatility trading involving options; and mortgage-backed securities arbitrage (the mortgage-backed market is primarily US based and over-the-counter).
Long/Short Equity
Long/Short Equity funds invest on both long and short sides of equity markets, generally focusing on diversifying or hedging across particular sectors, regions or market capitalizations. Managers have the flexibility to shift from value to growth; small to medium to large capitalization stocks; and net long to net short. Managers can also trade equity futures and options as well as equity related securities and debt or build portfolios that are more concentrated than traditional long-only equity funds.
Managed Futures
Managed Futures funds (often referred to as CTAs or Commodity Trading Advisors) focus on investing in listed bond, equity, commodity futures and currency markets, globally. Managers tend to employ systematic trading programs that largely rely upon historical price data and market trends. A significant amount of leverage is employed since the strategy involves the use of futures contracts. CTAs do not have a particular biased towards being net long or net short any particular market.
Multi-Strategy
Multi-Strategy funds are characterized by their ability to allocate capital based on perceived opportunities among several hedge fund strategies. Through the diversification of capital, managers seek to deliver consistently positive returns regardless of the directional movement in equity, interest rate or currency markets. The added diversification benefits reduce the risk profile and help to smooth returns, reduce volatility and decrease asset-class and single-strategy risks. Strategies adopted in a multi-strategy fund may include, but are not limited to, convertible bond arbitrage, equity long/short, statistical arbitrage and merger arbitrage.
I have been investing in Hedge Funds for many years and understand their importance in both reducing risk and enhancing performance. If you would like more information about how Hedge Funds can help your portfolio, please contact me at; callum.roxburgh@gmail.com
Comments
Write New Comment ▼
Write New Comment
Sorry! This knol's owner(s) have blocked you from editing, making suggestions, or commenting here.