Hedge Fund is a generic term used to describe a fund that does not fit into any of the categories of 'traditional' investment strategy.
Despite the reputation that some Hedge funds may have of being high-risk investments, most of them in fact seek to hedge against risk in one way or another, making consistency and stability of return their key priority. Hedge funds are expected to deliver 'absolute returns' i.e. they offer profit potential in both rising and falling markets.
By contrast, traditional equity and bond funds are measured on their ability to outperform their relevant benchmark indices. When these market benchmarks fall, traditional investments normally fall with them.
The performance of Hedge funds does not necessarily depend on the direction taken by the stock markets. Whereas the most that a traditional fund manager can hope to do is reduce his holdings in a falling market and move (within strict limits) into cash, the Hedge fund manager can employ alternative strategies to make returns even when markets are falling.
However, Hedge funds are generally less highly regulated than traditional funds. Whilst this allows the managers to employ a variety of different investment and trading strategies that are not open to the mutual fund, it also means that they are not as transparent in their dealings. Access to money may be more difficult as many funds deal on a quarterly basis.
Hedge fund managers tend to be remunerated on a performance-driven basis through incentive fees rather than on a simple percentage take of assets under management. If their clients make money then they make money too. This philosophy has tended to attract some highly successful and skilled managers into the Hedge fund arena.
Before investing in this type of fund it is important to have at least a basic understanding of the characteristics of the different Hedge fund strategies.
There are perhaps in the region of ten or more separate alternative investment strategies, each of which offers different degrees of risk and return. Essentially, these can be broken down in to four broad categories which are introduced below.
Probably the largest category of Hedge funds in terms of numbers, Long/Short Equity Strategies combine long (a 'long' position in a portfolio is when the manager has ownership of the security.)and short (a 'short' position in a portfolio occurs when the manager has sold shares it does not own. To make a profit, the stock must go down in order for the manager to buy it back more cheaply.) positions, primarily in equities and bonds to exploit under and overvalued securities. The volatility of returns can vary significantly between managers. This is largely due to the level of direct market exposure held in the fund.
Relative Value strategy managers seek returns by trying to identify price discrepancies and inefficiencies in the market between related investment instruments or combination of instruments. This is called 'arbitraging'. These funds are often regarded as 'market neutral' because there is little or no market-related element to their returns.
However, they are not without risk and can be adversely affected during periods of low market liquidity. Arbitrage* instruments can include Convertible Bonds, Fixed Income, Mortgage-Backed Securities and equities.
This type of strategy seeks to anticipate and profit from price movements that arise from specific corporate events, such as takeovers or mergers. Although these strategies show lower correlation with equity and bond market movements they tend to do better in strong market conditions where there is greater liquidity in the market. Events may include;
Merger Arbitrage. The normal strategy is to go short on the acquiring company and long on the target as there will usually be a margin in pricing to to reflect the risk of the deal falling through.
Distressed Securities. The stock of companies facing bankruptcy or major reorganisation may trade at a substantial discount to the underlying assets and often represents a good opportunity for profit.
Arguably, tactical strategies are the highest risk of all Hedge funds as a sector and sometimes make headline news as anyone familiar with George Soros will know. They tend to be more volatile because in many cases the manager uses leveraging to enhance the returns from directional trading strategies employed. The different styles include;
Global Macro. The fund manager uses his judgement of global macro-economic factors in taking positions across asset classes. Global Macro funds may also gear heavily, which adds to the volatility.
Systematic Traders. The fund manager uses quantitative models to identify pricing anomalies. The focus tends to be on trading shorter term with the use of stop losses to limit capital risk.
It is generally believed that the two safest types of Hedge funds with less volatile returns are Relative Value (Market Neutral) and Event Driven funds. Long/Short strategies tend to move in the same direction as the market as a whole because they tend to go long more often than they go short. They do still tend to outperform traditional funds when markets fall since traditional funds can only go long. Tactical Trading strategies tend to be the most volatile of all Hedge funds, because they heavily on the predictive and intuitive skills of the manager.
The range of investment returns between individual Hedge funds can be very wide. This is even true within strategies as well as between different strategies. One of the main reasons is the enormous range of techniques employed by Hedge funds to generate profits. At the individual fund level, the investment profile is typically dominated by the use of relatively small number of 'alpha generation'** strategies. often resulting from the expertise and ideas of only one or two people.
However,, when pooled, the volatility or risk profile of a portfolio of Hedge funds tends to fall dramatically, reflecting the extraordinarily low correlation between the returns of individual Hedge fund strategies. Furthermore, Hedge funds can be used as part of an overall portfolio to offer diversification and reduced risk.
In summary, a Hedge 'fund of funds"
* Arbitrage - The nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies or, the purchase of a stock of a takeover target especially with a view to selling it profitably to the raider.
**Alpha is a measure of how the fund is performing under the assumption that the market return is zero. For example, a fund with an alpha of 1, based on the S&P index would have returned 1% if the market had returned zero.