HEDGE FUNDS
EXPLAINED

Hedge fund investing represents one of the more sophisticated corners of the financial markets, it can involve applying complex strategies and substantial resources to generate returns regardless of market conditions.

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For retail investors, understanding how hedge funds operate offers valuable insights into advanced portfolio management techniques and risk mitigation strategies. Incorporating hedge fund investment methodologies into your own trading processes can help to develop your own overall approach.

What Are Hedge Funds?

Hedge funds are investment vehicles that pool capital from accredited investors to pursue diverse strategies. The way they stand out from traditional funds and the reason they are know as “alternative investments” is that they aim to generate positive returns in both rising and falling markets.

Unlike traditional mutual funds, hedge funds enjoy greater flexibility in their investment approaches, often employing leverage, derivatives, and short selling to achieve their objectives.

Hedge funds aim to make a return regardless of whether the broader market goes up or down. This market-neutral approach could result in hedge funds not benefitting as much as long-only funds during bull markets. But during a bear market, hedge funds might be the only part of an investor’s portfolio not making losses. That ability to reduce volatility in overall returns is what has made hedge funds attractive to high-net-worth individuals looking to diversify their portfolio and smooth out returns.

Hedge funds typically require substantial minimum investments – often $500,000 or more – and are generally restricted to institutional investors and high-net-worth individuals. There is an obligation on hedge funds to verify that any potential investors meet strict criteria in terms of their wealth and understanding of investment risks, and are able to afford substantial losses.

The defining characteristics of hedge funds include:

• The fee structure – traditionally a 2% management fee plus 20% of profits.
• Limited regulatory oversight compared to retail funds
• Lock-up periods that restrict investor withdrawals
• Potential to invest in illiquid or exotic assets such as derivatives
• The use of advanced and high-risk investment techniques such as leverage and short-selling

This structure allows fund managers significant scope and some are known for pursuing aggressive strategies that wouldn’t be possible in more regulated investment vehicles.

How Do Hedge Funds Work?

The operational mechanics of hedge funds revolve around their unique structure and investment flexibility. Fund managers raise capital from qualified investors, then deploy strategies across multiple asset classes, often udiversifysing borrowed money to amplify returns through leverage.

Performance measurement in hedge funds differs from traditional investments. Rather than benchmarking against market indices, hedge funds often target absolute returns – aiming for positive performance regardless of broader market movements. This approach requires sophisticated risk management systems and often involves teams of analysts, traders, and quantitative specialists working to identify and exploit market inefficiencies.

Key Hedge Fund Strategies Explained

The diversity of hedge fund strategies reflects the sector’s innovative approach to generating returns. While hundreds of variations exist, several core strategies dominate the industry and offer valuable lessons for individual investors seeking to diversify their portfolios.

Long/Short Equity Strategy

The long/short equity strategy is possibly the one most associated with hedge funds. Pioneered in 1949, this approach involves buying undervalued stocks (long positions) while simultaneously short selling overvalued stocks.

The strategy, sometimes referred to as pairs trading, aims to profit from the relative performance of the long and short positions while reducing overall market exposure.

Long/Short Case Study: If a hedge fund manager believes Microsoft (MSFT) is undervalued and Apple (AAPL) is overvalued, they might invest $100,000 long in Microsoft while simultaneously shorting $50,000 of Apple stock. The potential for profit (or losses) would be based on the relative performance of Microsoft and Apple stock, while overall market risk will be lower than if the fund had simply taken a $100,000 long position in MSFT.

These examples are simplified and for illustrative purposes only; actual liability depends on personal circumstances and local laws.

Global Macro Strategy

Global macro strategies involve taking positions based on broad economic and political trends across countries and asset classes.

These funds might simultaneously hold positions in currencies, commodities, bonds, and equities across multiple regions, building exposure to macroeconomic developments such as interest rate changes or political events.

Macro Case Study

A global macro fund anticipating higher UK inflation might short British government bonds because bond prices are typically inversely correlated to inflation, and also go long on commodities which are often regarded as being a hedge against price rises. It might also take currency positions that benefit from sterling weakness.

Statistical Arbitrage

Statistical arbitrage employs quantitative models and algorithms to identify pricing inefficiencies between related securities. These strategies can involve thousands of trades executed at high speed, exploiting tiny price discrepancies that may exist for fractions of a second.

Stat Arb Case Study: A stat arb strategy might analyse the short- and medium-term moving averages of a stock such as Shell. If the short-term moving average deviates from the longer-term moving average, trades could be placed based on the view that mean reversion will take place because the stock is overbought or oversold on a short-term time frame.

What Can Individual Investors Learn From Hedge Funds?

While most investors cannot directly access hedge funds or replicate their complex strategies, several valuable principles from hedge fund approaches can enhance individual portfolio management.

Understanding these concepts can help investors to think more strategically about risk, return, and the evaluation of market opportunities.

Risk Management

Hedge funds focus heavily on risk management, often employing stop-losses, position sizing rules, and hedging. Individual investors can adopt similar discipline by setting clear exit strategies, diversifying across uncorrelated assets, and considering hedging techniques during uncertain markets.

Absolute Returns

The hedge fund emphasis on absolute returns rather than relative performance offers another valuable perspective. Instead of simply trying to beat an index, consider measuring your risk-adjusted returns using more advanced metrics such as Jensen’s Alpha or the Sharpe Ratio.

This approach might lead you to combine growth assets with more defensive positions, using options for downside protection, or maintaining cash reserves for opportunistic investments.

Automated Trading

While individual investors might lack the technology for high-frequency trading, they can use different types of automated trade execution orders. Stop-losses, take-profit instruction and limit orders reduce the time needed to monitor live prices and bring discipline into an investment approach.

More Nuanced Strategies

The broad investment mandates of hedge funds mean that they might apply a range of niche strategies such as merger arbitrage, distressed securities, or fixed-income arbitrage. They might also invest in assets which are beyond the reach of many individual investors, such as insurance markets, fine art, and private equity.

Risks and Considerations for Hedge Fund Investing

Understanding the risks associated with hedge funds is essential, whether investing in hedge funds directly (for qualified investors) or applying hedge fund strategies to personal portfolios.

• Leverage: Leverage amplifies both gains and losses and even previously successful strategies can fail when market volatility exceeds expectations.
• Complexity: The opaque nature of some hedge fund strategies can obscure the risks and make it difficult for investors to understand true exposure.
• Liquidity: Lock-up periods and redemption restrictions can trap capital during market downturns presenting another challenge.
• Fee structures: These can significantly impact returns, with the traditional “2 and 20” model meaning investors need substantial gains just to break even after costs.

The argument for developing a more nuanced approach rather than investing in one single hedge-fund-style strategy is backed up by hedge funds themselves often taking that approach. Many hedge funds are termed multi-strategy funds, and these funds take the approach of allocating capital to multiple fund managers running diverse strategies – the intention being that overall returns are less volatile.

Final thoughts

The term “hedge” originally referred to the practice of hedging market risk through offsetting positions, but the hedge fund space has moved on a long way in recent years.

Anyone considering investing in hedge funds directly needs to make sure they understand the strategy it aims to apply and consider other risk factors such as restrictions on withdrawals. With the minimum investment amount a significant barrier to entry for many, an alternative approach is to adopt the techniques used by hedge funds and incorporate them into your own advanced investment strategies.

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FAQs

What is the minimum investment for hedge funds?

Most hedge funds require minimum investments of $100,000, but can stipulate minimums as high as $2 million. These high minimums reflect the regulatory requirements and the costs associated with vetting investors. It also reflects the risks involved and the need for investors to be able to afford losses, due to many hedge funds adopting a more aggressive approach to investing rather than basing their strategies on wealth preservation.

Can retail investors access hedge fund strategies?

While direct hedge fund investment remains restricted, retail investors can access hedge fund-like strategies through liquid alternative mutual funds, ETFs that replicate hedge fund indices, and by learning to implement simplified versions of strategies like long/short equity in their own portfolios.

How do hedge funds make money in down markets?

Hedge funds employ various techniques to profit during market declines, including short selling overvalued securities, using put options for downside bets, and trading volatility through derivatives. Some strategies, like global macro, can position entirely in cash or bonds when anticipating equity market weakness.

Are all hedge funds market-neutral?

No. While hedge funds originated out of a desire to provide absolute returns through market-neutral strategies, many modern-day hedge funds have abandoned that principle. That allows them to apply higher risk strategies focused on an area of expertise which can result in returns being exceptionally volatile.

What is a “fund of hedge funds” hedge fund?

A Fund of Hedge Funds (FoHF) is an investment fund that allocates capital to a portfolio of other hedge funds, rather than investing directly in individual securities itself. It aims to use industry knowledge to pick the funds most likely to generate a return and at the same time create a diversified portfolio of alternative investment strategies to promote to investors. FoHFs typically come with higher overall fees and potential for lower liquidity compared to investing directly in a single hedge fund.