What is a hedge fund anyway?

In three words: leveraged absolute returns

A hedge fund is a specific type of investment fund, focused on generating absolute returns, often using various types of leverage and investing in publicly traded instruments. Absolute returns mean that  the funds focus on generating a specific return, regardless of what stock market is doing. Most investment funds’ results are compered to a relevant stock market index’s performance; however, hedge funds’ goal is to generate as large of a return above zero as possible, regardless of what happens in the markets. While there are many strategies which hedge funds use to generate these absolute returns, they generally have a common goal of generating absolute returns, and that is a key distinguishing characteristic.

Absolute return is typically expressed as a percentage gain of capital on the total amount of capital available for investment.  This is typically reported in annualized time frames, so that it is easy for investors to compare against other possible investments.  While often associated with hedge funds, you can also earn absolute returns in more “traditional” ways, such as a savings bank account. The difference lies in hedge fund’s goal to maximize the amount returned to investors regardless of market conditions, and also that they obtain these results by investing the money (as opposed to lending it like a bank).

Once hedge funds find an investment opportunity that generates a good absolute return, they use different kinds of financial leverage to increase or decrease the amount of risk they are taking. For example, an individual investor buys an apartment with a 5% down payment. Although he pays for only 5% of the value of the apartment, he is exposed to the risk of owning the whole apartment. If its value goes up, as he hopes, then he earns the full financial “effect” of owning the house using only 5% of the cost of the house. So the investment is “amplified” 20 times. This works both ways, unfortunately. If the house falls in value, the investor loses money at a rate 20 times as fast. A mortgage is a good example of financial leverage, in real estate of course. Hedge funds do similar things, but buying  stocks, bonds, and other instruments instead of apartments.  Once they have identified a good opportunity, typically of a lower risk, they use financial leverage, attempting to increase the returns to their benefit.

As a result, their overall return profile is quite different from other types of investments, making them a very attractive part of a balanced portfolio. Because they are leveraging investments that are typically not related to the standard indices, they are very good at “rounding out” a portfolio-in theory. In practice, there were significant concerns that many hedge funds performed badly during the instability of 2008-2009, when the stock market was crashing, so not all of them were successful in generating the absolute returns for their investors.

How shorting generates absolute returns

In the hedge fund sphere, absolute returns are typically the result of a combination of both long and short strategies.  A long strategy is a traditional buying cheap and sell dear approach. A long strategy is the typical approach anyone uses in investing, but also just when shopping. First you look for a good bargain, and then hope to sell it after the price goes up over time.

A short strategy is the exact opposite, where you sell dear and buy cheap. If dealing in a physical asset, this is like borrowing a specific valuable thing, selling it (despite not really owning it), expecting the price to fall, so that you can buy back the same thing in the future for a lower price. Once you have the same thing back again, you can return the valuable to its original owner. Here you make money based on how much the price of the valuable FALLS. At its core, a short strategy is any strategy where you make money when the price of something falls. There are multiple ways of entering into short positions, but most often this involves short selling of stock, one of the two currencies of a currency pair, or derivative instruments such as options or futures.

When entering into these various positions, hedge funds typically look at correlations among groups of instruments. By owning positions in two instruments, which are negatively correlated to each other, a hedge fund is able to generate absolute return. If a hedge fund owns two different but related instruments, with one expected to rise in value, and the other to fall in value, a hedge fund will often take a bet on this convergence. If the trade works out, the hedge fund makes money on both sides of the investment, once the prices converge.

comparing apples and oranges when shorting stockA good example is the pair trades strategy.  A trader believes two stocks in one industry are significantly out of line with the valuation for a particular industry, and he expects of them to converge to the industry average. Let’s take Apple (AAPL) and Microsoft (MSFT) as examples. The trader buys long the instrument which he believes is relatively inexpensive, for argument’s sake is Apple, and simultaneously shorts the instrument which he believes is too expensive, say Microsoft-simulatenously. The trader he creates a net position, which has completely different characteristics than just investing in either stock.  The net performance is independent  NASDAQ’s performance, probably the most relevant index to these two stocks.

The two instruments are effectively combined into one position, a pair. It is similar to a spread.  The trader expects the spread to narrow, and by taking equivalently sized positions of both instruments, he can earn an absolute return, if the two stocks converge as he expects. He can amplify the convergence effect with leverage. Let’s say the trader estimates the two stocks (Apple and Microsoft) will converge one percent. Using leverage, e.g. options, stock loans, or other instruments, the trader can multiply his exposure using the same amount of money. So using a fixed amount of money, he can create a position which has a risk profile which is the equivalent of e.g. five times the amount he could buy outright. In effect, this is the same as the apartment investor above, but instead the investment is in a spread between two stocks.

The above is only one example of an absolute return strategy, a simplest case to illustrate a point.  Typically, a hedge fund will employ a large number of strategies within their particular area of specialization or asset class.  The funds under management are allocated to the most lucrative expected opportunities, while managing the overall risk of the portfolio. For example, by actively looking at the proportions between net long and net short positions, hedge funds can choose how much they aim for pure absolute returns.

Absolute return strategies themselves typically have a low correlation with markets. For example, even though a specific hedge fund invests only in US stocks, it’s returns will typically not follow a stock market index like the S&P 500. Buying a hedge fund and buying an index fund would give very different results, assuming you are buying both using a long-term buy and hold strategy.  Correlation is a statistical measure of the strength of the relationship between two variables, and combining investments that have a low correlation tends to increase returns and/or lower overall portfolio risk.

Leverage, the two-edged sword

leverage as two edged swordAnother major innovation relative to other types of investments, is the use of leverage when investing.  Because hedge funds often use various types of loans or financing, and they frequently go after investment opportunities which generate absolute returns, they can multiply their earnings many times.

On one hand, a hedge fund aims to follow a series of strategies, which exceed the interest rate at which they need to pay financing costs.  This allows them to invest in more “boring” instruments or strategies – ones which give a very steady return-but amplify these strategies’ effects. This only works when the strategies’ returns exceed the funds’ borrowing costs.  On the other hand, if they are on the wrong side of the bet, this leverage amplifies their losses. Not only did they lose their own money, but they also lose borrowed money, which still must then be returned.

Leverage is strongly tied to the concept of position sizing when trading.  An important part of the trading process is determining how much money you are willing to risk on a particular idea. If you don’t put enough, you won’t get very much out of your analysis, regardless of how good it is.  If you put too much, you risk putting yourself out of business completely, or blowing up. Leverage helps a trader get the most out of an idea, while allowing him to fine tune the proportion of his portfolio’s exposure to a particular risk driver.

Largest funds, 2011

The table below lists the largest hedge fund, as ranked by Assets Under Management (AUM):

Rank Name Bln USD
1. Bridgewater Associates $58.9
2. JPMorgan Asset Mangagement $54.2
3. Man Investments $40.6
4. Paulson & Co $35.9
5. Brevan Howard $32.0
6. Soros Fund Management $27.9
7. Och-Ziff Capital Management $27.6
8. BlackRock $25.0
9. BlueCrest Capital Management $24.5
10. Angelo, Gordon, & Co $23.6

Source: Institutional Investor, http://dealbreaker.com

Sources of capital

Based on recent estimates of the Hennesee Group LLP, investors in hedge funds are classified into the following categories, in about the following proportions:


Historically, most of the capital provided to hedge funds came from wealthy individuals, but over time, more and more funds have come from institutional investors. Average consumers often unwittingly invest in hedge funds, via their pension fund’s activities.

Strategies

hedge fund historical dataThe table to the left, from Hedgefundresearch.net and Pertrac,  lists the highest performing strategies existing the hedge fund space. It is a good starting point for an analysis of strategies which hedge funds follow, and which worked. You can compare this against S&P 500 results during the same time period to get a sense of how effective these stragies are; however, these are the best performers, so they are not necessarily indicative of typical results obtained by hedge funds.

See the Hedge Fund Research classification for more detailed information, especially a definition of the strategies which hedge funds use. Also you can check out the latest Hedge Fund index results on HFR’s site. Also, there is a more specific breakdown of historical data up to 2008 at Hennessee Group. This information was once freely published on the web; however, today detailed index performance information is available only to paid subscribers.

Note that in 1997 and 1998, hedge funds as a whole underperformed the stock market. Because HFs focus on absolute return, investors get better returns by money directly into the stock market during a strong bull market. Conversely, notice that the returns generated in the highest return strategy type was consistently positive. For example, in Q1 2009, most equity markets have suffered negative performance across the globe; global macro hedge fund strategies, as well as a number of other strategies, have earned a positive return in these difficult times. Looking at the above, you will also see that slowly the returns of the sector as a whole are declining, as competition is increasing among hedge funds because the amount of money they manage and invest is increasing rapidly, thus making the sector as a whole less attractive.

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