Hedge funds have evolved significantly since 1949 when Alfred Winslow Jones set up what is generally viewed as the first hedge fund. His aim was to create a conservative fund that had the ability to sell US stocks that it did not own – ie go short – as well as buy stocks he felt would go up in value.
Since then, the term ‘hedge fund’ has grown to encompass all sorts of instruments, markets, risk profiles and investment styles. They range from global macro funds that can invest in just about anything and often use considerable amounts of leverage to Reg-D funds that only invest in hedged private placement investments into public companies.
How did hedge funds get their name? The term hedging refers to their ability to protect their returns from market crashes by selling assets they do not own, or going short. While most investors seek to profit from identifying an undervalued asset and buying it in the expectation that its price will go up, short sellers benefit from the share price of an asset going down.
The way this is achieved is surprisingly simple. Imagine you were convinced XYZ plc’s share price was much too high. If you could find a holder of XYZ plc who was willing to lend you the stock in exchange for a fee, you could then sell the stock, put the proceeds on deposit and buy it back at a later date after the share price had fallen. Your profit would be the difference between the price you initially sold it at and the price you bought it back – with some adjustments for dividends, interest rates and the cost of borrowing the stock.
Therefore, a fund that can short can hedge its assets against falls in asset prices.
In addition to the ability to short assets, hedge funds tend to have other characteristics:
o they are usually offshore vehicles;
o they can engage in considerable leverage;
o they usually charge performance related fees;
o they impose high minimum investments and they seek to generate high absolute returns.
Investors in hedge funds tend to be private banks (especially Swiss ones), high net worth individuals, family offices, fund of funds and charitable foundations. Increasingly, however, there has been considerable interest from pension funds and insurance companies. A number of US institutions have already made their first forays into hedge funds. In Europe, while the interest is there, institutions have been more cautious, perhaps because there is still some confusion about all the various different types of hedge funds and their suitability for institutional investors.
To help bridge the knowledge gap, IPE has compiled a list of the major types of hedge funds and their characteristics. The hedge fund strategies are ranked on a rather crude estimate of their volatility, with the most volatile first. However, it should be stressed that funds within a single hedge fund strategy can have very different risk profiles depending on the amount of leverage that they use.
Global macro
Although the global macro strategy is one of the most well known strategies, it actually makes up less than 5% of the total invested in hedge funds.
Global macro managers can invest anywhere in the world. They will generally formulate a view on various macroeconomic variables and estimate their impact on equities, bonds and currencies.
Often, the managers will use derivative markets to implement their positions because of the superior liquidity they offer. Until recently, global macro funds were seen as the last refuge for size.
Their global remit and willingness to use derivative instruments made it possible for large funds, often in the billions, to trade without moving the market unduly.
Recently, however, even global macro funds have been experiencing size problems as demonstrated by recent announcements from the two giants of the macro hedge fund world. After a period of dismal performance, Julian Robertson told his investors he would be winding up the largest fund in his Tiger group of hedge funds. Soon after, George Soros announced that he would be transforming his Quantum fund from a global macro hedge fund to a low-risk endownment fund.
Global macro funds are not for the meek and risk-averse. They tend to take large directional bets and they often leverage two to three times the value of their assets — sometimes even more. They perform best when markets are undergoing significant shifts in interest rates, currencies or economic policies. They tend to be absolute return targets although they will also measure themselves against the MSCI World index and the S&P 500.
Emerging markets
Although this is usually included as one of the hedge fund categories, the lack of liquid derivatives markets and the fact that short selling is banned in much of the region means that a lot of these Emerging Markets hedge funds are effectively long-only funds with significant equity, currency, and fixed income exposure. Some emerging market hedge funds will use index derivatives on the main markets to hedge part of their emerging market exposure.
They also tend to measure their performance against the relevant regional index.
Short selling
For years this hedge fund strategy was out of favour as markets seem to only be going one way: up. As a result, a lot of short-selling funds had to close down and today there is just a handful, most of which are short biased rather than dedicated short sellers. A prolonged bear market would go a long way to increasing their popularity.
Managed futures
Sometimes known as commodity trading advisors, or CTAs, managed futures managers use the futures and options to implement their views. Most CTAs tend to be systematic traders who rely on computerised algorithms to generate buy and sell orders. The others are known as discretionary traders who base their investment decisions on their own fundamental analysis. Both are generally very directional.
CTAs tend to have a short term horizon, ranging from just a few hours to a few weeks. Systematic traders tend to do best when markets are trending. They dislike choppy markets. Volatility can be considerable.
Long-short equity
The manager takes both long and short positions in equities, aiming to profit from both sides. The investment approach tends to be based on fundamental analysis rather than technical analysis. Some managers have a growth bias, others a value bias, some concentrate on small caps, others on large caps. Often the funds have a geographic specialisation, for instance US, Europe or Japan. Some even focus solely on a particular sector such as healthcare or technology.
Most long-short equity managers have a long bias although if market conditions warrant it, they may switch to a short bias.
A number of the more successful long-short equity funds are closed to new investments. Many say that past the $500m (E?m) level, it becomes more difficult to find liquid investments that can absorb the size of the trades.
The volatility of the long-short equity funds can vary a lot depending on their leverage and whether they are using shorts as a hedge or as a way of profiting from a collapse in a company’s share price. They perform best in markets that are not too volatile and where share prices are driven by fundamental factors. Although long-short equity funds tend to be absolute return funds, some of them may charge a performance fee on the outperformance above an equity index. The norm, however, is simply a performance fee on the absolute return.
Event-driven funds seek to identify and exploit pricing inefficiencies that result from various corporate events such as mergers, distressed situations or capital raising. For instance, a merger arbitrage fund will go long the stock of the company being acquired and short the stock of the company doing the acquiring. The principal risk is if the deal fails to close.
Another example is a Reg D fund that raises capital for companies that would find it difficult to raise capital through other means. The fund manager invests in a convertible security which has an exercise price that is at a discount to the listed price. This is in addition to the coupon receivable on the convertible. Some managers may even short the underlying stocks at the listed price as further protection.
A third example is ‘distressed securities investing’ where the fund manager buys corporate debt that is trading well below par that can be converted into equity at a future date. In some cases the manager may also hedge market risk by going short index futures.
Event-driven hedge funds are generally very specialised and reflect the manager’s individual expertise. Merger arbitrage strategies have been especially popular and successful in the recent past as corporate activity has been booming.
Convertible arbitrage
The strategy is to buy a convertible bond and simultaneously sell short the underlying stock. The fund profits from receiving the coupon and the differential between the price of the convertible and the short position.
This is generally viewed as a low risk strategy and fund managers will often pep up the returns by using substantial leverage. Convertible arbitrage funds will often perform well in falling markets because the profit on the short position will usually be bigger than the loss on the convertible.
Equity market neutral
Market neutral funds are funds that seek to exploit pricing discrepancies between related stocks or group of stocks. The objective is to create a portfolio that is not correlated to overall market movements. This is also known as a portfolio with no systematic risk.
The portfolios are carefully hedged to ensure there is no beta risk, industry bias, market capitalisation bias or geographic bias, among others. In most cases, the manager will utilise leverage to enhance returns.
Generally, the return objective of the fund is to generate return above that available on cash deposits. The volatility of a well constructed market neutral fund should be very low. In the past there have been a number of hedge funds that called themselves market neutral, but when conditions deteriorated it became quickly apparent that their longs and shorts were badly matched.
Fixed income arbitrage
The manager will seek to profit from the convergence in the price of related interest rate securities. For instance, the fund may be short a 10 year bond in France and long a 10 year bond in the UK.
Another strategy is to trade two bonds in the same market but in different positions on the yield curve. And a third strategy is called ‘capital structure arbitrage’ where the fund goes long and short different debt instruments of the same issuer.
The goal is to generate steady returns with minimal volatility. This has not always been the case, especially in the mortgage-backed market in the US.
Fund of funds
A fund of funds is a hedge fund that invests its assets in several other hedge funds. They can be as few as two or as many as thirty. The objective is to create a diversified portfolio that is made out of the best hedge funds in the industry and that has a lower volatility than its constituents.
Some fund of funds may specialise in a particular strategy such as convertible arbitrage or market neutral; some specialise on a single region such as Europe or the US; while others offer a global approach across all the various strategies.
Often a fund of funds will impose lower minimum investments that the underlying hedge fund, eg $200,000 against $1bn. In some cases, they offer access to hedge fund managers who are closed to further direct investment. The fees for the service of a fund of funds tend to be between 1% and 3%, in addition to the fees charged by the underlying funds. Sometimes, because the fund of funds is a big volume buyer, it is able to negotiate advantageous fees from the participating hedge funds. Many investors who don’t have the in-house expertise to conduct their own due diligence rely on fund of funds to gain access to hedge funds.
Michèle Harrison is a specialist freelance journalist