Last time around we examined one of the original yet still most persistent strategies; equity long/short. But Hedge funds are also linked to takeovers and other big trades in financial markets.
Indeed it has been claimed that these privately owned investment companies are responsible for half the daily turnover of shares on the London Stock Exchange.
They offer their investment capabilities primarily to very wealthy individuals or to professional investors. We tend to call this group sophisticated or qualified investors. Note to self, having money does not prequalify you as an expert, especially within financial markets! We digress.
Put simply they invest in anything that they will think will make profits and typically focus on generating positive absolute returns or returns greater than 0. The fancy term they like to use for this is Alpha – oooooh! “we create Alpha”.
Really – how?
Hedge funds embrace a wide variety of skills and strategies, often grouped under four headings;
We covered these in last week’s article and these types of funds aim to profit from superior research and stock picking skills by buying the best ideas and reducing the resulting stock market exposure by shorting those that they believe will perform less well.
They seek investment opportunities surrounding corporate events. For example investing in bankrupt or merging companies.
They attempt to profit from broad market swings caused by political or economic events. For example, taking positions on the direction of markets currencies and commodities.
Generally they use computer systems to calculate the fair value of one asset relative to another and then short the more expensive asset and buy the cheaper one.
Hedge fund managers are therefore a group of active investment managers who invest in a variety of asset classes with a rather unique toolkit.
What is special about them?
The return achieved by a given hedge fund manager will, in theory, largely be driven by the manager’s ability or skill rather than by underlying economic or market conditions.
They apply their personal expertise to achieve returns with relatively low volatility and largely unrelated to whether a particular investment market such as shares, or bonds is going up or down.
Sounds great but how do they do it?
Hedge fund managers generally try to remove some market exposure and aim to produce a positive return irrespective of market direction.
As we saw last week with the Nintendo/Sony pair this will involve making an offsetting bet to hedge against losing money on the original investment position.
It is often cited that they operate as unregulated investors, but let’s get a few things straight – there is not a wild west in finance where hedge funds and only hedge funds rule the financial town.
You can think of hedge funds in two parts:
The Investment Manager
The investment Manager describes the day-to-day operations of the fund. It’s where the staff of the hedge funds work; the traders, the portfolio managers, the analysts and the support staff. Most hedge funds are set up in financial capitals around the world, such as London and New York, and given the nature of the financial services industry, they are strictly regulated by the local regulator – this being determined by where the management who actually run the business are based (in the UK this is the FCA).
However, the fund itself is just a legal vehicle. The fund holds the assets, and typically it will be based somewhere that has a nice tax-efficient domicile for extracting profits. For example, hedge funds will often have their legal domicile in Bermuda or the Cayman Islands.
And let’s be clear – hedge funds do not operate in a unique way where they can do as they please. In fact, since the financial crisis hedge funds have come under greater scrutiny and are now subject to more regulatory pressures than ever before.
The use of Derivatives
One feature often attributed to hedge funds is the widespread use of derivatives – sophisticated bets on the future direction of an underlying asset such as a share, a currency or even the whole financial market.
Some hedge fund managers will use derivatives almost exclusively, such as contracts for differences or equity swaps, rather than buying the underlying asset directly.
We see this with many hedge funds who invest into UK markets. If you buy shares of UK companies you must pay stamp duty. However, if you use a contract for difference or equity swap you still get the same exposure without holding the underlying (this is called the synthetic exposure). Of course this is also useful from a capital point of view as you don’t have to buy the stocks outright, and instead you only have to put up margin against the synthetic position which is a fraction of the cash outlay of buying the underlying.
In some cases, a hedge fund may do this to build up a larger investment position than they could afford to directly, which of course is known as leverage.
Now combine the use of derivatives and the ability to sell short and you have a rather interesting trading approach.
Limited capital down, lots of exposure and the ability to play the market in both directions without holding any underlying assets.
No wonder CEOs like Elon Musk like to publicly trash HFs! Short selling + herd mentality = only one thing … share price down.
Despite having a large concentration of investment expertise, hedge funds can still lose money for themselves and their clients (or provide rather disappointing returns) so choosing the right one is key.
Remember, the return from investing in a given hedge fund is largely driven by the manager’s ability or skill.
Many hedge funds restrict how much of investors’ new money they are willing to invest as they need to sensibly manage the funds they already have, and it is not uncommon for the most skilled, and hence desirable, managers to be closed to new investors.
Another factor for investors to research is the hedge fund management fee. These fees can be very high – indeed high enough to erode any outperformance achieved by the manager.
Hedge fund indices – another way?
As the interest in hedge funds has grown, a similar trend has developed to copy the mainstream financial markets – the investable index.
These indices, rather like the FTSE 100 share index, allow investors to allocate money across a range of strategies and managers, with the aim of generating returns that match one of the well-known indices. They go some way to replicate strategies of hedge funds that have, in the past, been very secretive in what they do.
Some hedge funds simply won’t reveal to anyone except their clients what their general trading strategies are, or how well or how badly they have been doing.
Over time, others have become more transparent, publishing investment updates, quarterly or even monthly, that anyone can read.
So an investor needs to decide if an index return is really the right solution and whether the managers included are truly representative of the underlying managers in each strategy.
Hedge funds remain an interesting yet rather unique investment class of their own.
Restricted to certain investors they are able to operate and use tools that would be abhorrent to our pension fund monies.
Leverage, derivatives and short selling – get it right and generate high returns, but get it wrong and lose big!