Introduction to Hedge Fund Strategies
A hedge fund is an investment partnership between the fund manager (called the general partner) and investors in the hedge fund (called limited partners). Hedge funds strategies can carry a huge risk of investment, and be chasing the bull market or following a herd mentality can get you trampled financially. Plunging cash into a high performing fund without doing your homework can result in a poor grade at the end of the trading session. So, here’s your financial market survival toolkit with handy tips to guide you through the ins and outs of hedge fund strategies.
Meaning of a Hedge Fund strategies
What is hedge fund strategies? A hedge fund is a term for investments made by limited partners who contribute money which is then managed by the general partner.
Hedge fund Definition operates on one key principle:
Maximize returns and minimize risks. Hence it is referred to as “hedge” fund management.
History Behind Hedge Fund strategies
Hedge fund strategies came into existence because this partnership’s purpose was to make money, regardless of whether there is a bull market or a bear. Managers hedge themselves against losses by following a number of hedge fund strategies.
Structure of a Hedge Fund strategies
Hedge Fund Vs Mutual Funds
A hedge fund strategies have certain points in common with a mutual fund which are as follows:
- Both are pooled investment vehicles.
- You can use either to invest in securities such as equities, options, and bonds.
- Hedge fund strategies are run by separate manages, while sub-advisors run the mutual fund.
General / Limited Partnership Model
- The typical hedge fund strategies structure is two-tier, comprising the general/limited partnership model.
- Within this structure, the funds are operated by the general partner, and there should be a minimum of one limited partner as well who makes investments and have limited liability/liability for paid in money.
- Such a partnership can have multiple general and limited partners. However, there are some SEC rules which limit the number of investors barred from registration.
- A typical structure of the partnership is a limited liability company, or LLC, called so because it is a flow-through tax unit, and investors can be held in limited liability equalling their amount of investment.
- General partner markets and manages the funds, including the hiring of a fund manager and administration of fund operations.
One Partner or Many?
Hedge Funds Take the High Road and MF the Low
The fee structure is one of the chief points of difference between Hedge Funds vs Mutual Funds. Mutual Funds involve lower fees, while fees paid by investors in the case of hedge funds strategies are higher and include additional fees not charged by an MF.
Hedge Fund: Term Structure
Terms offered by each fund are unique, making it a tangible point of difference. Terms are linked to the following factors:
Subscriptions and redemptions
Some funds require a lock-up commitment which can either be a hard lock (preventing withdrawal of funds by an investor for a full-time period) or a soft lock (fund withdrawal is possible following payment of a penalty ranging from 2 to 10%).
Distinctive Features of Hedge Fund strategies
No Regulation- Hedge fund strategies are not under any regulation apart from limits on the number of investors they can have or advertise to the general public.
Riskier- Hedge fund strategies are riskier than traditional mutual fund investments. This is because hedge fund strategies do not have to report their underlying positions to any regulatory agency or members of the public.
Seeing is Believing: The Need for Transparency
Investors have demanded more transparency from hedge funds strategies, even though top hedge fund managers do not want to show their cards and reveal their position.
Below are the important Hedge Fund Strategies
Equity Market Neutral
- In this hedge fund strategy, funds identify (or at least try to) over and undervalued equity securities while there is the neutralization of portfolio exposure to market risk through a combination of short and long positions.
- Portfolios are neutral with respect to market, sector, industry and currency/dollar and a portfolio beta of 0 value.
- How is this ensured? Well, the long and short positions are held with equal potential for related market or sector factors.
The thumb rule: Overvaluation is slower to correct than undervaluation
Reason: Many investors face limitations pertaining to shorting of stocks
Benefiting from Mis Pricing: Convertible Arbitrage
- These hedge fund strategies can help capitalists on mis-pricing in convertible securities such as convertible bonds, warrants, and preferred stock.
- Managers buy/sell a security and hedge part/all of risks linked to it
- Example: Buying a convertible bond and shorting the associated stock to lower risk
Fixed Income Arbitrage-Over and Undervalued Bonds Important
- Here, the funds seek to identify over as well as undervalued bonds on the basis of expected changes in term structure and credit quality of issues/market sectors
- This type of portfolio is neutralized against directional market movements through a combination of long and short positions
Profit in the Face of Default: Distressed Securities
- Portfolios of distressed securities are invested in debt and equity of companies facing or undergoing liquidation
- When there is a danger of default, traditional investors prefer to transfer risks, so funds are held long in an account of the non-liquidity of distressed debt and equity, making shorting difficult.
Catching the Price Spread: Merger/deal Arbitrage
- This type of hedge fund strategy can capture the price spread between current prices of the securities and their expected value following a positive event such as a takeover, M&A, spinoff or more associated with multiple hedge fund companies.
- Merger arbitrage involves purchasing the stock of the target firm following a merger announcement and shorting the revenant mount of the acquirer’s stocks.
Merger arbitrage derives a return from news of acquisitions and mergers
- A deal is subject to the following conditions:
- Regulatory Approvals
- A positive vote by target company shareholders
- No adverse change in material terms in the target’s financial position
Non-Neutral Portfolios: Hedged/Long-Short Equity
- This hedge fund example aims to identify over as well as undervalued securities, thereby dealing in highly concentrated, typically non-neutral portfolios. The value of the short position may be a fraction of the long, and the portfolio may have a net exposure to the equity market in the long term.
- The first hedge fund in financial history launched by A.W. Jones in the late 1940s used these hedge fund strategies.
- It still accounts for a massive share of equity hedge fund assets in current times.
- Concept= Investment means encashing on WINNERS as well as LOSERS
- Mantra– Pledge long positions in winners as collateral to fund short positions in losers
- Result: Combined portfolio creates more profit than loss and lowers the market risk
Seeing the Bigger Picture: Global Macro
This type of hedge fund examples encashes on systematic movements in financial as well as non-financial markets via trading in the following:
Global Macro = Major Market Trends,
Individual Security Opportunities
Emerging Markets Strategy: Spotlight on Less Mature Markets
These are funds linked to emerging, less mature markets
Short selling is not permitted in such markets as futures and options are not possible
Funds are long in such a strategy
FOF: A Money Mammoth
FOF or Funds of funds is a fund which makes investments in multiple underlying top hedge funds (typically 10 to 30)
Some FOFs are even more diversified; these are liquid and available to individual investors.
Learning from Management Masters: How Hedge Fund Managers Operate
- This is when hybrid securities are used, combining a bond with an equity option.
- Managers maintain a delta neutral position where bonds and stocks offset each other as the market fluctuates.
- This hedge fund strategy thrives on volatility; the higher the stakes, the more the profit.
- Such hedge fund strategies are used by managers when the biggest hedge funds purchase company debt from firms facing financial bankruptcy.
- In this type of hedge fund example, managers typically focus on senior debt and in case a company has already filed for bankruptcy, the junior class of debt may be a wiser hedge.
- In such a strategy of hedge fund definition, investors need to be patient. This is because corporate reorganization can take a lot of time.
Credit or Capital Structure Arbitrage
- In this credit strategy, managers watch out for relative value between senior and junior securities of a single corporate issuer.
- Securities of equivalent credit quality are taken from different issuers
Credit hedge funds = Focus on Credit, Not Interest
- These funds grow when credit spreads narrow during strong economic growth and vice versa
Fixed Income Arbitrage
- Managers glean returns from risk-free government bonds, making a leveraged guess on the way the yield curve’s shape will change.
- High leverage is used to capitalize returns. The flipped? Leverage causes a greater risk if the manager is incorrect.
- This type of plan involves analyzing how macroeconomic trends will impact interest rates, currencies, commodities or equities.
- Future and currency forwards are most commonly traded in this form of hedge fund careers.
This is one of the best (and worst) tactics employed by managers over time. It is the best because strong trading or investment returns are possible. It is also the worse if it forces a sell-off as hedge funds receive margin calls and are forced to engage in the sale of positions to meet them.
These hedge fund strategies are used when a hedge fund owns long positions in stocks, other assets looking for an alpha to the upside to outdo benchmarks. For the hedge fund example, if S&P500 is the benchmark, it is up 10%, and the hedge fund is up 12%; an extra 2% difference between the two is an alpha generated by a portfolio manager.
In this hedge fund strategy, the manager sells stocks shorts. Portfolio managers who engage in shorting have been crushed given the rising tide of the market, which has uplifted sentiments. An example of a Short Only strategy is MySpace, once a leader in social networking and now a virtual non-entity in the social media space.
Fair Trade/Long/Short Strategy
When the fund matches stocks in the same sector, and it is long or owns stocks and also engages in shorting, fair trade is the result.
Net exposure to funds=0 if long and short positions are equally invested in.
The flipside: Massive moves upward or downward will negate the other side
Relative Value Arbitrage
A strategy used to hedge funds trading debt
Man Vs Machine: Quantitative Hedge Fund Management
In this type of hedge fund definition, computer programming uses statistical models and data to locate the alpha camouflaged by market abnormalities.
Risk Measures Used in Hedge Fund strategies.
SD or Standard Deviation: Defined as a level of volatility of returns measured in terms of percentage provided on an annual basis.
Decoding the Results: Variability of annual returns and funds can be compared with SD.
If 2 funds of the same annual returns have different SDs, the one with the lower SD will be more attractive and vice versa.
- Value At Risk/VaR: measures dollar loss expectation occurring with a probability of 5 in 100 or 5%.
- Downside capture: Degree of correlation of fund to markets which are sliding
- Rule of thumb: Lower the downside capture, better the fund is at preserving wealth in the face of meltdown or vice versa
- Drawdown: Maximum drawdown is a measurement of percentage fall in cumulative return from previous highs. You can assess which funds preserve wealth…these will be the ones that minimize drawdowns.
- Leverage: If this increases, funds sell assets at massive discounts to cover margin calls. This serves as a good measure of the health of the hedge fund. Lower leverage is just what the doctor ordered.
- Qualitative indices: These include assessment of manager, a scale of operations, back-office administration, to name just a few.
- Soft Close Versus Hard Close: Soft close means no additional investors will be allowed, while hard close means there will be absolutely no additional investments.
Why Invest in Hedge Funds?
- Risk reduction
- Flexible mandates
- Return Enhancement
What to Watch Out For Due Diligence/Caveat Emptor?
- A low volatility hedge fund can explode (courtesy of the subprime mortgage crisis of 2007 and its associated market meltdown in 2008). So allocation considerations are very important
- The allocation should consider the overall risk.
- Another important point to look out for is the level of gross as well as net exposure of the overall portfolio when adding hedge funds to a portfolio.
- Definition of the measurement criteria in quantitative and qualitative terms is vital.
Define Measurement Criteria
Criteria should be defined in both quantitative and qualitative metrics.
- Usually, hedge fund managers send a pitch book describing the firm and its many aspects, such as strategy, principals, and performance. Analysts and investors should make sure they have accessed the pitch book for data.
- Compare the hedge fund strategies to those within a similar category to assess how funds performed.
- Additional analysis can then be made to decide whether the hedge fund strategies should be invested in or not.
- A background check of the firm and an assessment of its back-office operations are some of the qualitative aspects of due diligence.
Hedge fund definition is all about securing gains and cutting down on the losses. Effective hedge funds perform well based on concrete parameters and associated criteria for tangible reasons. Financial wizardry requires the right formula for success. Investors need to be aware and alert to get maximum returns and minimum losses from hedge funds. Capitalizing on markets (whether bull or bear) has never been easier.
This has been a basic guide to hedge fund strategies; here, we have discussed the various strategy of the hedge fund, which is useful for the hedge fund managers. you may also look at the following article to learn more –