What is Hedge Fund?
The term “Hedge Fund” is defined as “any unregistered, privately-offered, managed pool of capital for wealthy, financially sophisticated investors.” Hedge funds are usually structured as partnerships, with the general partner being the portfolio manager, making the investment decisions, and the limited partners as the investors. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.
Hedge funds are subject to the same market rules and regulations as any trader. The strategies they utilize are not as easily accessible, especially for other regulated entities, such as mutual funds. To achieve this “absolute return”, hedge fund managers have the flexibility to incorporate different strategies and techniques that may include:
Short-selling: Sale of a security that you do not own, with the anticipation of purchasing it in the future, at a reduced cost.
Arbitrage: Simultaneous buying and selling of a financial instrument in different markets to profit from the difference between the prices
Hedging: Buying/selling a security to offset a potential loss on an investment.
Leverage: Borrowing money for investment purposes.
Trading options or derivatives: contracts whose values are based on the performance of any underlying financial asset, index or other investment.
Investing in anticipation of a specific event: merger transaction, hostile takeover, spin-off, exiting of bankruptcy proceedings, etc.
Investing in deeply discounted securities: of companies about to enter or exit financial distress or bankruptcy, often below liquidation value.
Many of the strategies used by hedge funds benefit from being non-correlated to the direction of equity markets
A hedge fund may take long positions in certain stocks, and short positions in certain other stocks such that their portfolio beta is close to zero. A beta close to zero means that the portfolio will remain relatively unchanged due to the broad market movement. Such a portfolio will primarily change if the stocks move more than the broad market.
This would become clear with the example –
A stock trader believes that the stock price of IP Ltd. will rise over the next month, due to this company’s new and efficient method of producing gadgets. He wants to buy IP Ltd. shares to profit from their expected price increase. But IP Ltd. is part of the highly volatile gadget industry. If the trader simply bought the shares based on his belief that the IP Ltd. shares were underpriced, the trade would be a speculation.
Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of PANKAJ Ltd. direct competitor, PANKAJ Ltd.
The first day the trader’s portfolio is:
Long 1000 shares of IP Ltd. at Re1 each
Short 500 shares of PANKAJ Ltd. at Rs2 each
(Notice that the trader has sold short the same value of shares.)
On the second day, a favourable news story about the widgets industry is published and the value of all widgets stock goes up. IP Ltd., however, because it is a stronger company, goes up by 10%, while PANKAJ Ltd. goes up by just 5%:
Long 1000 shares of IP Ltd. at Rs.1.10 each — Rs100 profit
Short 500 shares of PANKAJ Ltd. at Rs.2.10 each — Rs50 loss
(In a short position, the investor loses money when the price goes up.)
The trader might regret the hedge on day two, since it reduced the profits on the IP Ltd. position. But on the third day, an unfavourable news story is published about the health effects of widgets, and all widgets stocks crash — 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since IP Ltd. is the better company, it suffers less than PANKAJ Ltd.:
Value of long position (IP Ltd.):
Day 1 — Rs1000
Day 2 — Rs1100
Day 3 — Rs550 => Rs450 loss
Value of short position (PANKAJ Ltd.):
Day 1 — Rs1000
Day 2 — Rs1050
Day 3 — Rs525
Without the hedge, the trader would have lost Rs450. But the hedge – the short sale of PANKAJ Ltd. – gives a profit of Rs475, for a net profit of Rs25 during a dramatic market collapse.
Another important characteristic is that hedge funds borrow heavily to increase their portfolio size.
To improve their security-specific returns, hedge funds leverage their portfolio. The fund may collect, say, Rs 100 crore from investors, borrow Rs 50 crore, and invest Rs 150 crore.
In the above instance, an unleveraged fund may have gained only 3 per cent of Rs 100 crore. But a hedge fund that has borrowed Rs 50 crore will gain 3 per cent on Rs 150 crore less interest cost on Rs 50 crore.
Who runs them?
A lot of hedge funds are run by former bankers or traditional investment managers who set up their own funds. They can make a lot of money out of them by charging high fees, typically a 2 per cent management fee as well as 20 per cent of the profits.
Who invests in them?
Because they are unregulated and risky, the managers will only accept investment from wealthy, sophisticated investors (High Net-Worth Individuals).Some banks, pension funds, and companies also invest.
There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return. A macro hedge fund, for example, invests in stock and bond markets and other investment opportunities, such as currencies, in hopes of profiting on significant shifts in such things as global interest rates and countries’ economic policies. A macro hedge fund is more volatile but potentially faster growing than a distressed-securities hedge fund that buys the equity or debt of companies about to enter or exit financial distress. An equity hedge fund may be global or country specific, hedging against downturns in equity markets by shorting overvalued stocks or stock indexes. A relative value hedge fund takes advantage of price or spread inefficiencies. Knowing and understanding the characteristics of the many different hedge fund strategies is essential to capitalizing on their variety of investment opportunities.
It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same — investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. A successful fund of funds recognizes these differences and blends various strategies and asset classes together to create more stable long-term investment returns than any of the individual funds.