The name hedge fund, as far as I am concerned, is a bit of a misnomer. In the financial world, the word ‘hedge’ is a term to describe an investment strategy where there is a removal of exposure to certain factor(s) in the market (e.g. by taking an investment in 1 security, and counteracting it with another, you could remove foreign currency exposure). Hedging your bets is an expression to avoid losses, to avoid risk.
The term ‘hedge fund’ may or may not have anything to do with the term ‘hedging’. It is the wild west of finance, where portfolio managers have the freedom to choose ANY investment strategy on ANY security, and can change their strategy at ANY time. A cynic would describe a hedge fund as an extremely high stakes trip to the casino, where the manager gets to gamble other people’s money in any way he/she chooses. While an optimist would describe a hedge fund as a blank canvas for the elite investors, where there are no boundaries to what strategy can be imagined.
The reason why hedge fund is a misnomer is most strategies have extreme levels of risk and leverage. Some examples of strategies include:
- Long / Short Funds: These common strategies normally involve taking the long position on an underpriced security, while also shorting an overpriced security. The objective is not to be neutral with the market, but to exploit the mispricings / movements / trends of the market.
- Statistical Arbitrage Funds (Stat Arb): These pure number crunching strategies involve heavy computer power and a lot of geeks. They often hunt the markets for minute mispricings where the expected values of the trades are in one side’s favour. By the law of large numbers, when these strategies are repeated thousands of time, they often lead to incredible profits. These strategies function much like a casino winning slightly more blackjack hands than the gamblers on a percentage basis, but from repetition, this slight edge leads to huge casino profits.
- Event Driven Funds: These strategies involve an exploitation of some current / predicted event in the world that effects the market. One famous fund manager shorted collateralized mortgage obligations (CMOs) just before the American housing market crashed. As well, one gas trader took on an extremely risky long position on natural gas just before Hurricane Katrina hit (hurricanes in the Gulf are heavily related to gas reserves). This funds are essentially high stakes gambling on an event.
- Market Neutral Funds / Commodity Neutral Funds: These are true ‘hedging’ strategies. Where a fund architect will combine a basket of securities with sensitivities that exactly match some sort of index in the market. This could be the S&P 500, TSX, FTSE, Bond Indexes, Brent Oil, or anything really. These are often associated with ETFs. If the Captial Asset Pricing Model (CAPM) was in fact true, every investor in the world would invest in this basket of securities. When combined with high alpha securities, market neutral funds contribute to a very robust portfolio.
- Global Macro Funds: Much like Event Driven Funds, and Long / Short Funds, these make bet(s) on some economic variable(s) in the world (e.g. inflation, interest rates, GDP, or anything).
Another important feature about hedge funds is they seek to achieve absolute returns, rather than relative to some benchmark or treasury rate. The implication of this is they try to capitalize upon advantages in every market (bull or bear).
Why You Should Love Hedge Funds:
- They are extremely customizable
- Because of the ability to change strategy and use incredible leverage, hedge funds can exploit any opportunity to the maximum
- Many of the best investment strategies over the past couple decades have been hedge funds (some have achieved annualized returns ~40% consistently, trumping even the great Warren Buffett)
- The lack of transparency involved in hedge funds means if you think of a winning strategy, you don’t have to reveal it and you can keep exploiting the market.
- Many hedge fund strategies have a low correlation with the S&P 500, meaning huge diversification potential.
Why You Should Fear Hedge Funds:
- There is no effective way to measure performance of hedge funds, especially because of style drift and a lack of transparency / regulation.
- The top performers of the past give the false impression of superior investing with hedge funds; however, so many of them have failed, and these failures tend to not make the newspapers.
- Huge fees can be charged by fund managers, especially in the top performing funds.
- Survivorship Bias leads to artificially low standard deviations of returns in the past.
- Because of the lack of transparency, there is potential for fraud from the fund managers.
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