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What is a Hedge Fund?

If you read my recent bio (and I don’t blame you if you didn’t) you might recall that I spent much of my career on the other end of a phone or email to Hedge Funds. My job was to be their main point of contact across every and any issue that they had aside from trading and as you can imagine there was never a dull moment.

I learned a lot during that time and naturally I tend keep a close and interested eye on all things Hedge Fund related.

So, I couldn’t resist digging into this one in a bit more detail

According to Bloomberg News, Hayman Capital Management’s Kyle Bass is launching a new fund that will use option contracts to leverage the assets by 200 times (yes 200!) in an “audacious” all-or-nothing position that will lose investors all their money if Hong Kong’s currency is still pegged to the U.S. dollar after 18 months.

His fund, however, will return outsized gains if his call for the demise of the peg, a prediction that has caught investors like George Soros on the wrong side in the past, comes to fruition.

Bass told investors that the fund could see a 64-fold return if the currency drops by 40%.

Bass, who has been shorting the currency for more than a year, has said he expects a “full-fledged banking crisis” in Hong Kong by the end of this year, due to high levels of financial leverage along the lines of those seen prior to implosions of the banking systems in Iceland and Ireland.

Wow, that’s a lot to decipher, let’s unpick it a little

Leverage –  friend or foe, answer = both!

The words of a song made famous by Bessie Smith are often best remembered here, leverage is your friend on the way up. Returns are good and everyone wants to know you when you can ‘afford to buy them champagne, whisky and wine’. But leverage is no longer your friend on the way down and making losses. ‘Nobody wants to know you when you’re down and out’. This fund is taking about the use of leverage 200 times. Great on the way up, horrendous on the way down magnifying your losses. Think of it like a rollercoaster, all the excitement on the way up, hoping for the best and then aaaaargghh!

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Short Selling

The ability to make a return on the play is also directly correlated to a drop in the currency which we note the fund has been shorting for over a year, i.e. exercising a view that it is overpriced. Nothing ‘evil’ in this as it often the criticism levelled, after all someone is on the other side buying. Both can’t be wrong can they?

Ultimately in order for this strategy to be a success Bass expects (in other words needs) a fully-fledged banking crisis. It’s a strange concept in order to make returns something bad has to happen. No wonder corporate CEO’s like Elon Mush tend to publicly shame those funds that short sell their stocks. Shorting tends to drive prices down and guess the impact when others jump on the same band wagon, yep next stop cheapsville.

Welcome the sometimes controversial world of hedge funds.

We’ve just met two of the founding principles of hedge funds, leverage and short selling.

Now as always we need to go back to basics to understand hedge funds and of course that means we need to take a little trip back in time. So strap in and let’s see what we can learn.

Hedge Funds – same but different

The 2nd of June marked the date in 1989 when Alfred Winslow Jones, widely considered the forefather of the Hedge Fund industry passed on at the ripe old age of 88. However, he continues to leave behind a legacy that both intrigues and confuses investors in equal measures.

Where it all started

His original Hedge Fund looked nothing like most of those in operation today. In fact, many may argue that the term ‘hedge’ is something of a misnomer, but we will come back to that.

AW Jones had no real investing experience and had previous careers in diplomacy, sociology, and journalism before settling on investing at age 48. Perhaps paving the way for what still remains an area of diverse intellect even today. Of course, Hedge Funds have many financial experts, but look deeper and as highlighted by the increasing advancement of technology it is not uncommon to now see experts from science, technology and political backgrounds now deeply entrenched in the strategies and operations of a Hedge Fund.

Back to Jones – he got the idea while researching a markets article for Fortune magazine.

Jones’ concept was simple: create a “hedge” by shorting stocks he thought would drop in value while going long, and sometimes using leverage, on stocks he thought would go up.

Whilst ground breaking at the time, this still remains the core element of funds today, regardless of the complex overlay that sits on top. The fundamentals of ‘shorting’ where you expect the value to fall and simultaneously ‘going long’ where you expect the value to rise, offers a unique advantage over other more traditional funds. 

A trade in action

For a Hedge Fund they can deploy this approach with little capital outlay, aiming to win on both sides of the trade. A rather unique proposition in itself.

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Let’s take an example, an oldie but a goodie. Nintendo – the $54 billion creator of everyone’s favourite plumber, Super Mario – saw its stock level up by 3% towards the end of May 2018 as it announced three new Pokémon games.

If prior to this price increase you were able to anticipate this – note this is not about having insider information not known to the market but simply being able to better harvest the available information. This is a game of TIMING and not just TIME IN! Clearly, the trade here is to go long. One option is to go ahead and buy the stock.

How about another approach is to combine this directional view with an opposing trade within the same sector? Perhaps the announcement of new games from Nintendo triggers an adverse reaction to a competitor such as Sony.  Remember a rising tide does not always lift all boats so the market may view this as good for Nintendo but not so for Sony. Here the directional play is to sell Sony, even better short it, i.e. sell stock you do not even own.

The short side

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Sell stock in SONY that you do not own at what you consider to be a market high, around 5119 JPY at the end of May 2018. The play here is that you expect the price to go below this level, in effect the reverse of the old adage to buy low sell high. Instead sell high, buy back low. Now since you are selling something you do not own you need to ‘borrow’ that stock in order to facilitate the transaction. Luckily there is a market for this exact purpose.

Commonly known as stock borrow lending or securities lending. Typically dominated by the bigger banks they utilise excess stock inventory or borrow themselves and on lend with a margin to the Hedge Fund. They may even have agreement with long only fund managers who are willing to lend their excess stock in return for some yield.

So, you sell 1mm shares @5119, borrow the stock and deliver to the other side of the trade. You as the Hedge Fund take in the cash, i.e. 1mm x 5119 JPY.

For the Hedge Fund your initial capital outlay is virtually flat. Yes, there will need to be some exchange of collateral for borrowing the shares and since banks are not usually in the charity business there will be a daily cost to borrow the stock. This is a key component to the final P&L of the trade when it is eventually unwound. However, you have exercised a short directional view on a stock, which has generated cash with no impact to the fund’s capital.

Going Long

Now the really smart bit, you can use the cash you have taken in from selling SONY to fund the purchase of NINTENDO @41,600 JPY. 

The premise here is that the stock is undervalued and we are back to buy low, sell high.

Closing Out

The skill is ultimately then in the timing and that you have the appropriate market catalyst that crucially causes one stock to rise and the other to fall. Even if only one side takes off you still win on that side but effectively lose on the other, this is a hedged transaction. To truly profit the stocks need to go in the correct opposite directions. Sounds simple but it is fraught with danger. Read into the VW/Porsche trade back in 2008 to see how this can go dramatically wrong. 

Remember on the short side there is in theory no upper limit on a stock price. Sell for 100 but if you are wrong and the stock rises there’s no upper limit to where it could go to, although often if stocks become too expensive there tends to be a stock split (see Apple in 2014 for an example of this in action). This means as soon as the stock rises beyond 100 each movement is an incremental loss whereby you can lose beyond what you originally invested. Compare to buying where its capped, the most you can lose is the initial capital outlay (number of shares x price). Leverage serves to compound meaning losses quickly escalate. A key reason short selling is reserved only for such sophisticated investors such as Hedge Funds.

So, at what point do you close out the pairs trade? 

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To close out the long NINTENDO it’s a case of looking for a buyer willing to pay beyond what you brought at 41,600 JPY. Once identified you collect the difference.

On the short side you need to find someone willing to sell to you at a price below your short (5119 JPY). You need to buy back the stock in order to return this to where you originally borrowed it from. The difference between these two creates your profit, however, there will be some borrow costs that have accrued so the true break even needs to account for this.

Why a traditional fund can’t compete with this play

Let’s take the same scenario but apply to a long only asset manager. They can’t exercise shorting and generally are restricted on leverage.

They could if already holding both stocks sell some stock in SONY (underweight) and use that capital to buy more stock in NINTENDO (overweight). However, they can only really make P&L on one side of the trade. Yes, they perhaps avoid a loss on the price falling on SONY but only share some of the upside on NINTENDO by holding more stock. Additionally, if tracking an underlying benchmark will need to remain broadly in line with their investment mandate.

Back to Jones

His strategy did phenomenally well and made lots of money for his clients. According to a 1966 Fortune article by legendary reporter Carol Loomis, Jones’s firm gained 670% in the preceding 10 years, compared with a 358% gain for the leading mutual fund of the period.

Jones spawned the modern hedge fund industry, which now accounts for somewhere in the region of 11,000 funds worldwide – though many hedge funds today look nothing like Jones’ original set up.

Today’s hedge funds adopt lots of different strategies, albeit often with a more complex long/short transaction at the heart of them and indeed some don’t even hedge at all.

Next up we will delve into some of the other HF strategies…

Stay safe, stay curious, keep learning

About this author

Matt Fotherby

Financial Markets, Compliance & Regulations

Matt Fotherby

Matt is our Founder and a passionate trainer.

His interest in education stems from his 10 years as an Account Executive looking after Global Hedge Fund and Asset Management clients. This led Matt to join the coveted Financial Markets Education team at UBS, a unique in-house education team that specialised in running a curriculum of financial market and product classes for both UBS employees and clients. Matt was responsible for building out the client offering; managing programs, creating content and teaching courses.

As financial markets entered a significant period of regulatory change Matt pivoted to take his client experience and market knowledge to focus on Regulations and Compliance topics.

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