The ABCs of Hedge Funds

Introduction

Hedge funds are one of the most common forms of investment available. They are used by individuals and organizations to diversify their portfolios and make conservative investments. A hedge fund is an investment fund that pools other investors' money to purchase stocks, bonds, derivatives, currencies, commodities, or other investments. The funds are managed by a professional investment team with the aim of generating additional returns.

The purpose of hedge funds is to reduce the risk of losing capital, as well as enhance returns. Hedge funds can also be used in conjunction with other investments to stabilize a portfolio and reduce the overall risk. Most hedge funds are actively managed, meaning the fund manager makes decisions about what investments to buy and sell on behalf of their investors.

Advantages of Hedge Funds

Hedge funds offer numerous advantages for investors that can lead to increased profitability and protection from market downturns. Some of the most notable benefits of hedge funds include low correlation to public markets, and the ability to preserve capital during market downturns.

Increased Profitability

Hedge funds are attractive to many investors as they often offer financial incentives such as higher potential returns than other types of investments. By allocating capital in multiple asset classes and taking calculated risks, hedge funds can often yield higher profits than other types of investments. Hedge funds may also employ the use of advanced trading strategies such as short-selling, derivatives, and leverage to capitalize on market movements.

Low correlation to public markets

Hedge funds typically offer a low correlation to public markets, as they are actively managed, and may have an overall lower volatility than public markets. Low volatility often translates to lower risk, providing investors with the opportunity for increased returns that are not as closely tied to market performance.

Preserves capital in down markets

Hedge funds commonly employ strategies such as short-selling to generate returns in down markets. By taking advantage of select opportunities in down markets, hedge funds can often reduce overall losses and provide investors with greater protection and security when compared to other types of investments.

Disadvantages of Hedge Funds

Hedge funds can be a powerful and lucrative investment vehicle, however there are some potential drawbacks to consider as well. These potential drawbacks include potential for poor performance, high fees, and a complex regulatory structure.

Potential for Poor Performance

Hedge fund managers use sophisticated strategies to hedge portfolio risk and to generate returns. However, these strategies do not always work as expected and can be a source of underperformance or loss in the portfolio. Investment strategies that rely too heavily on leveraging can result in even greater losses as the market may move against the fund's positions.

High Fees

Many hedge funds charge high management fees, often 2-3% of the underlying assets under management. In addition to the management fee, a performance fee is also charged based on the amount of profit achieved by the fund. This can be a significant cost to investors, depending on the fund's performance and the size of the investment.

Complex Regulatory Structure

Hedge funds are subject to complex regulatory guidelines that vary from country to country. This complexity can be an obstacle to investors as rules and regulations may change frequently. In addition, many regulations carry heavy compliance costs and may require added expertise to understand and remain current on regulations.

Different Types of Hedge Funds

Hedge funds are complex and varied, and there are a range of fund types that each utilizes different strategies for investment. In this chapter, we will look at the main types of hedge funds, including macro funds, event-driven fundamental funds, and long/short equity funds, and discuss their distinct features.

Macro Funds

Macro funds focus their efforts primarily on macroeconomic investments, taking advantage of global economic trends by buying and selling assets. They are often heavily reliant on derivatives, such as futures and options, and they often use highly sophisticated quantitative strategies. The main aim of macro funds is to make profits by exploiting discrepancies between markets, currencies, and economic sectors.

Event Driven Fundamental Funds

Event driven funds place a focus on analyzing corporate developments and the impact on a company’s stock. They track corporate news before investing or divesting from particular stocks. They focus on opportunities created by mergers, bankruptcies, or restructuring, taking short positions on stocks when it is likely that stock prices will decline, and long positions when it is likely that stock prices will rise. Many event driven funds also focus on distressed debt, investing in corporate debt when it is undervalued.

Long/Short Equity Funds

Long/short equity funds are among the most common hedge funds and they typically focus on marked-to-market investments. These funds invest in stocks, taking both long and short positions simultaneously. Long positions mean buying stocks with the intention of selling them later at a higher price; short positions involve selling stocks borrowed from a broker and then repurchasing them at a lower price. Through this strategy, hedge fund managers attempt to make profits regardless of the direction of the stock market.

Strategies Used By Hedge Funds

Hedge funds utilize many strategies in order to optimize their portfolios and achieve their desired return targets. Understanding these strategies can be key in understanding how hedge funds work and operate.

A. Arbitrage

Arbitrage is a financial strategy in which a hedge fund will take advantage of mispricing in securities on different markets. This can result in an opportunity for the hedge fund to make a profit on the difference between the prices. By buying the security at a lower price and selling it at a higher price, hedge funds can take advantage of the mispricing in order to generate a profit.

B. Long/Short Investing

Long/short investing is a strategy in which a hedge fund will buy securities with the expectation that the price will go up and sell securities with the expectation that the price will go down. By taking both a long and short position in the market, a hedge fund can profit if either its long positions or short positions turn out to be correct.

C. Leverage

Leverage is a tool used by hedge funds to amplify their return on investment. Through the use of derivatives such as futures or options, hedge funds can use leverage to increase their exposure to a certain security in order to generate a higher return.

How to Evaluate Hedge Funds

Evaluating hedge funds can be difficult, but understanding the basics can help you decide which funds to invest in. When evaluating hedge funds, there are three key factors that you should look at: track record, portfolio management and fees.

A. Track Record

The track record of the fund is one of the most important elements of evaluation. A fund’s track record should demonstrate its long-term performance, rather than just its short-term results. Investing in a fund with a strong track record of consistent performance can help ensure that you get a positive return on your investment.

B. Portfolio Management

You should also consider the management style of the fund and its portfolio. Hedge funds typically have a team of experienced portfolio managers that specialize in different sectors and industries. Understanding the team’s expertise and how they manage the portfolio can help you determine if the fund is the right fit for your investment goals.

C. Fees

Finally, be aware of the fees associated with the fund. Many hedge funds charge a management fee, as well as performance fees, which can eat into your returns. Make sure to compare the overall fees with those of other funds, to ensure that you’re getting the best value for your money.

Conclusion

Hedge funds can be a great tool to diversify a portfolio and increase returns, but it is important to do the necessary research and due diligence when evaluating a fund. In the ABCs of Hedge Funds, we have taken a look at how open-ended and closed-ended funds operate, what the advantages and disadvantages are, and how fund of funds can help you diversify your investments. We also reviewed the key elements and roles of the investment manager, what the performance in terms of fund benchmarks and risk is, and the types of fees charged – from management and performance fees to dealing fees.

Before making any investment decision, an objective analysis of the risks and rewards must be completed to ensures the decision is most advantageous for a portfolio. With the right resources and knowledge, hedge funds can be an effective tool for diversifying a portfolio and bringing in greater returns. As with any financial decision, due diligence should be heavily weighed when evaluating a hedge fund.