Hedge funds look for opportunities to profit, regardless of the market.

Hedge funds look for opportunities to profit, regardless of the market

A hedge fund is a pooled investment vehicle, similar to a mutual fund (in which a group of investors pool their resources and entrust their money to a management), and hedge funds invest in publicly listed assets, much as mutual funds do. Hedge funds, on the other hand, differ significantly from mutual funds in a number of ways. In light of the hedge fund’s charter, it is easiest to understand where these come from and why they exist. Investors grant hedge funds the leeway to pursue absolute return strategies.

The Most Important Takeaways

  • In the world of pooled investments, mutual funds and hedge funds are both categories in which a portfolio manager executes an investment plan on behalf of the fund’s investors.
  • Mutual funds invest primarily in stocks and bonds, with the goal of achieving returns that are similar to or better than a benchmark index.
  • Hedge funds may employ one or more of various more complex methods, such as short-selling, the use of leverage, and the use of derivatives, in order to maximize their returns.

Mutual Funds Are Interested in Relative Returns

The majority of mutual funds invest in a set style, such as “small-cap value,” or in a certain area, such as the technology industry. The returns of a mutual fund are compared to the returns of an index or benchmark that is tailored to a particular style.

Consider the following scenario: If you invest in a small-cap value fund, the managers of that fund may attempt to outperform the S&P Small Cap 600 Index. A portfolio constructed by less active managers could be constructed by following the index and then utilizing stock-picking abilities to boost (overweigh) liked stocks and decrease (underweigh) less appealing stocks.

The purpose of a mutual fund is to outperform the index, even if only by a little margin. For example, if the index is down 10% and the mutual fund is down only 7%, the fund’s performance would be considered successful. When compared to the passive-active continuum, on which pure index investment represents the passive extreme, mutual funds fall somewhere in the center, as they strive to provide returns that are advantageous when compared to an index of their own creation.

Absolute returns are actively sought for by hedge funds.

Because they seek positive absolute returns, hedge funds are considered to be at the more active end of the investing spectrum. They seek positive absolute returns regardless of the performance of an index or sector benchmark. Instead of investing in traditional mutual funds, which are “long-only” (investing only in buy-sell decisions), hedge funds take on more aggressive strategies and positions, such as short selling, trading in derivative instruments such as options, and using leverage (borrowing) to improve the risk/reward profile of their bets.

This level of activity on the part of hedge funds explains why they are so popular during bad markets. Hedge funds may not outperform mutual funds in a bull market, but in a bad market, hedge funds should outperform mutual funds as a group or asset class because they have short positions and hedges against losses. In terms of absolute return, hedge funds have a variety of objectives. One such objective may be to generate a 6-9 percent yearly return, independent of market conditions.

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The fact that hedge funds pledge to seek absolute returns, however, implies that they are “liberated” in terms of registration, investment positions, liquidity, and fee structure. This is important for investors to grasp. First and foremost, hedge funds are not registered with the Securities and Exchange Commission (SEC). Because they limit the number of investors and require that their investors be accredited, which means that they reach a certain level of income or net worth, they have avoided registration. 1 Furthermore, hedge funds are barred from soliciting or promoting to a general audience, which contributes to the mystique surrounding their operations.

Investors in hedge funds are particularly concerned about liquidity. Although liquidity rules differ from one investment vehicle to the next, it may be difficult to remove funds “at will.” Several mutual funds, for example, have a lock-out period, which is the first period of time during which investors are unable to withdraw their cash.

Finally, hedge funds are more expensive, despite the fact that a portion of their fees are dependent on performance. Typically, they charge an annual fee equal to one percent of the assets under management (occasionally as high as two percent), in addition to receiving a part of the investment gains (typically 20 percent). 2 A large number of mutual funds, on the other hand, invest their own capital alongside their fellow shareholders, leading some to describe them as “eating their own cooking” (Eat Your Own Cooking).

There are three broad categories of hedge funds, as well as other strategies.
The majority of hedge funds are for-profit businesses that employ proprietary or closely guarded investment strategies. The following are the three basic kinds of hedge funds, which are based on the types of tactics they employ:

1. Arbitrage and Hedging Techniques (a.k.a., Relative Value)

In order to profit from observable pricing inefficiencies, arbitrage is regarded to be riskless in nature. Consider the following extremely straightforward illustration: Stock in Acme is currently trading at $10, while a single stock futures contract expiring in six months is currently being offered for $14. It is an agreement to buy or sell stock at a predetermined price that is the basis of a forward contract.

As a result, by purchasing the stock and concurrently selling the futures contract, you can lock in a $4 gain before transaction and borrowing expenses without taking any risks. If you look at it from the practical standpoint, arbitrage is more complicated, but three trends in investing practices have opened the door to all kinds of arbitrage strategies, including the use of derivative instruments, the use of trade software, and the use of various trading exchanges (for example, electronic communication networks and foreign exchanges make it possible to take advantage of “exchange arbitrage,” the arbitraging of prices among different exchanges).

Only a small number of hedge funds are pure arbitrageurs, but historical studies have consistently shown that when they are, they offer a reliable source of low-risk, consistently moderate returns. However, due to the tiny size of observable pricing inefficiencies, pure arbitrage necessitates significant, frequently leveraged investments and high turnover. Furthermore, arbitrage is perishable and self-defeating: if a method is too effective, it is imitated and eventually disappears from the marketplace.

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The majority of so-called arbitrage tactics would be better described as “relative value.” These techniques attempt to profit on pricing discrepancies, but they do not come without risks of their own. Convertible arbitrage, for example, comprises purchasing a corporate convertible bond that can be converted into common stock while concurrently selling short the common stock of the same business that issued the convertible bond.

This method attempts to take advantage of the differences in the values of the convertible bond and the stock: The arbitrageur employing this technique would believe that the bond is a little undervalued and the stock is a bit overvalued. The objective is to profit from the bond’s yield if the stock rises in value, but also to profit from the short sale if the stock falls in value, as in this case.

However, because the convertible bond and the stock might move independently of one another, the arbitrageur may lose money on both, indicating that the trade is fraught with danger. (See also Arbitrage Squeezes Profit From Market Inefficiency for more information.)

2. Strategies that are triggered by events

Strategies that take advantage of transaction notifications and other one-time occurrences are known as event-driven strategies. One example is merger arbitrage, which is employed in the event of a merger announcement and consists in purchasing the shares of the target firm while simultaneously selling short the stock of the acquiring company to hedge against the purchase of the target company.

Most of the time, when an acquisition is announced, the purchase price that the acquiring business will pay to acquire its target company exceeds the target company’s existing market price. Essentially, the merger arbitrageur is betting that the acquisition will take place and that the target firm’s price will converge (increase) to the purchase price paid by the acquiring company.

This is also not a case of pure arbitrage. The purchase may come crashing down if the market does not approve of it, sending the stock of the acquirer up (in relief) and the stock of the target firm down (wiping out the momentary bump), resulting in a loss for the investor who took the risk of investing.

An event-driven strategy can be classified into several categories. Another type of investment is “distressed securities,” which entails making investments in companies that are in the process of restructuring or that have been unfairly battered down in the stock market. Activist funds, which are predatory in character, are another sort of event-driven fund that is worth exploring more. This sort of investor buys substantial stakes in tiny, troubled businesses and then uses its ownership to compel management changes or a reorganization of the company’s financial sheet. (See also Why Hedge Funds Adore Distressed Debt for more more.)

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Strategies for a specific direction or tactic

The directional or tactical tactics employed by the largest group of hedge funds are the most common. One such example is the macro fund, which was made famous by George Soros and his Quantum Fund in the 1990s and which dominated the hedge fund universe and the front pages of the newspapers. Macro funds operate on a worldwide scale, placing “top-down” wagers on currencies, interest rates, commodities, and foreign economies, among other things. Because they are intended for “big picture” investors, macro funds are not required to conduct in-depth analyses of individual companies.

The following are some further examples of directed or tactical strategies:. Using long/short methods, you can make purchases (long positions) while also making short sales. In the case of the S&P 500 Index, a long/short manager can invest in a portfolio of core stocks that make up the index and hedge the portfolio by betting against (shorting) the S&P 500 index futures. The short position will offset the losses in the core portfolio if the S&P 500 falls, which will keep overall losses to a bare minimum.

In the financial markets, market neutral strategies are a sort of long/short strategy that aims to reduce the impact and risk of general market fluctuations by focusing on the pure returns of individual stocks. This type of strategy is a fantastic example of how hedge funds can strive for positive absolute returns even in a bear market by employing a long-term investment horizon. For example, a market neutral manager might invest in Lowe’s while simultaneously shorting Home Depot, betting that the former will outperform the latter over the long term. It is possible that the market will fall, and that both stocks will fall with the market, but as long as Lowe’s beats Home Depot, the short sale on Home Depot will generate a net return for the investor.

Dedicated short strategies are those that specialize in the short sale of securities that have been overvalued. Because the potential for losses on short-only positions is potentially limitless (because the stock can increase endlessly), these strategies are extremely dangerous to pursue. Short-term investment funds, such as some of these dedicated short funds, are sometimes among the first to predict corporate failures, as the managers of these funds are particularly adept at evaluating firm fundamentals and financial statements for signs of trouble.

What’s the bottom line?

Because hedge funds are typically reserved for high-net-worth people and accredited investors, most investors will opt to build their portfolios through the purchase of mutual funds or exchange-traded funds (ETFs). Mutual funds and exchange-traded funds (ETFs) are now available for a bigger variety of investing strategies than they were in the past, and they frequently offer greater transparency and lower risk than many hedge funds. Nonetheless, you should now have a clear understanding of the differences between mutual funds and hedge funds, as well as the numerous strategies that hedge funds employ in order to attempt to obtain absolute returns.

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