Hedge funds have long been shrouded in mystery, earning a reputation as lucrative yet elusive vehicles within the financial landscape.
Hedge funds have gained increased attention over the years, with their involvement in financial markets drawing interest from investors, media, and the general public. However, many people still struggle to grasp what exactly hedge funds are and how they operate.
In this article, we will start to unravel the mysteries surrounding hedge funds, exploring their nature, workings, and the strategies they employ to generate profits.
Their Purpose
A hedge fund is privately managed investment fund that employs various investment strategies with the aim of generating superior returns, striving to deliver positive returns even in adverse market conditions.
Generally structured as limited partnerships or limited liability companies (LLCs), hedge funds are subject to less regulatory oversight compared to mutual funds. This relative lack of regulation allows hedge fund managers to implement complex investment strategies and respond quickly to market opportunities.
The Hedge Fund Business Model
Hedge funds obtain investment funds from accredited investors. This may include individuals with a high income (usually over $200,000 annually) or a high net-worth (over $1 million), or large institutions such as banks, insurance companies, and investment funds.
Accredited investors are permitted to invest in hedge funds because they are considered to be sophisticated and able to bear the risks associated with these less regulated investment vehicles.
Hedge funds generate revenue from two main sources:
- Management fees – investors pay a percentage of assets under management each year to cover operational expenses.
- Performance fees – investors pay a percentage of profits generated as a reward for superior performance.
Investment Strategies
Hedge funds operate under the supervision of fund managers, who make investment decisions on behalf of the fund’s investors. These managers possess extensive financial expertise and employ a wide range of investment strategies to maximise returns while managing risk.
Hedge funds typically invest in traditional financial assets, stocks and bonds, as well as alternative instruments like options and futures contracts.
Investment strategies can be broadly categorised into directional and non-directional approaches.
1. Directional Strategies
1.1 Long/Short Equity
Long/short equity funds take long and short positions in stocks, aiming to profit from both rising and falling prices. By selecting undervalued stocks and simultaneously shorting overvalued stocks, hedge funds seek to generate positive returns regardless of the market’s overall direction.
Greenlight Capital, founded by David Einhorn, is known for its long/short equity strategy, and most notable for its short selling of Lehman Brothers prior to the bank’s collapse in 2008.
1.2 Global Macro
Global macro funds analyse macroeconomic trends and geopolitical events to identify opportunities across multiple asset classes, such as currencies, commodities, and equities. They take positions based on their predictions of broad economic shifts, including interest rate changes, political developments, or currency fluctuations.
George Soros‘s Quantum Fund is famous for its global macro strategy. In 1992, Soros famously shorted the British Pound and profited handsomely from the currency’s collapse. The UK had been part of the European Exchange Rate Mechanism, a system that aimed to maintain stable exchange rates in Europe. However, the British economy was in a recession, and Soros correctly bet that the Pound would have to be devalued.
1.3 Event-Driven
Event-driven funds focus on specific corporate events, such as mergers, acquisitions, bankruptcies, or restructuring, to profit from price discrepancies. By anticipating the impact of these events on stock prices, hedge funds aim to capture potential arbitrage opportunities.
Bill Ackman’s hedge fund Pershing Square is famous for its event-driven strategy. For example, in 2004 Ackman took a large stake in Wendys, the fast-food chain, and successfully pressured management to spin off its Tim Hortons brand. This allowed Ackman to exit the trade with a substantial profit.
2. Non-Directional Strategies
2.1 Arbitrage
Arbitrage funds exploit price differentials between related assets, such as convertible bonds and their underlying stocks, to generate profits. By simultaneously buying and selling related instruments, they seek to capture the price discrepancy while minimising exposure to market movements.
Long Term Capital Management famously specialised in fixed income arbitrage, aiming to exploit price differences in the bond market. They would look for small price differences between similar bonds, and then buy the undervalued bond and short sell the overvalued bond, expecting the price of the bonds to converge over time. Since the price differences were tiny, and believing their strategy to be essentially risk free, LTCM used massive amounts of financial leverage to increase their expected returns. Unfortunately for them, LTCM was heavily exposed to the Russian bond market. When the 1998 Russian financial crisis caused bond price differences to widen rather than converge as expected, LTCM suffered huge losses, and required a multi-billion dollar bailout before ceasing operations.
2.2 Distressed Securities
Distressed asset or distressed debt funds invest in distressed companies or debt instruments that are trading below intrinsic value, with the potential for significant upside upon recovery. They conduct in-depth analysis to identify undervalued securities and aim to profit from their eventual price appreciation.
Oaktree Capital Management, co-founded by Howard Marks, is well known for its distressed debt investment strategy, often investing in companies undergoing bankruptcy or financial restructuring. For instance, in 2007 OCM invested in debt securities issued by Pierre Foods, a company in distress. During the restructuring process, OCM was able to convert the debt into a controlling equity stake in the company.
2.3 Quantitative
Quant funds employ mathematical models and statistical analysis to identify patterns and execute trades, often relying on computer algorithms for decision-making. These systematic strategies rely on quantitative models to identify market inefficiencies and generate trading signals.
Jim Simons‘ Medallion Fund is well-known for its quantitative investment strategy, and is reputedly one of the most successful hedge funds in history with an average annual return exceeding 35% since 1988. Unfortunately, the fund has been closed to outside investors since 2005, and is focused on building wealth for its current partners and employees.
2.4 Relative Value
Relative value funds seek to profit from pricing discrepancies between related securities, such as bonds and their derivatives, by taking advantage of market mispricing. They identify and exploit relative price disparities to generate returns.
Risk Management Strategies
Hedge funds employ risk management strategies to mitigate potential losses. They often use leverage to enhance returns but must carefully manage the associated risks. Risk management techniques may include:
- Diversification: Spreading investments to reduce vulnerability to a single investment. Funds could diversify in various ways, such as across asset classes, industries, regions, currencies, or management styles.
- Stop-losses: Predetermined points to sell an asset, preventing further loss.
- Hedging: Using derivative instruments to offset potential losses in other investments.
- Position Monitoring: Regularly reviewing and adjusting investment positions to manage the amount of capital at risk in any given investment.
Additionally, hedge funds typically have risk management teams that assess and analyse the risk exposures of the fund’s portfolio, implementing controls to limit downside risk.
The Bottom Line
Hedge funds serve as alternative investment vehicles that aim to generate superior returns for accredited investors. They typically do this by employing a combination of extensive financial expertise, a diverse range of investment strategies, the ability to adapt quickly in changing markets, and significant amounts of financial leverage.
Zuhair Imaduddin is an Innovation Development Analyst at JPMorgan Chase. He studied Industrial and Labor Relations at Cornell University. Zuhair is interested in leveraging technology to solve problems.
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