About Hedge Funds (Part 1)

What is a Hedge Fund?
A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously, many hedge against downturns in the markets especially important today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.

There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return. A macro hedge fund, for example, invests in stock and bond markets and other investment opportunities, such as currencies trading, in hopes of profiting on significant shifts in such things as global interest rates and countries’ economic policies. A macro hedge fund is more volatile but potentially faster growing than a distressed-securities hedge fund that buys the equity or debt of companies about to enter or exit financial distress. An equity hedge fund may be global or country specific, hedging against downturns in equity markets by shorting overvalued stocks or stock indexes. A relative value hedge fund takes advantage of price or spread inefficiencies.

Knowing and understanding the characteristics of the many different hedge fund strategies is essential to capitalizing on their variety of investment opportunities.

It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same -- investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. A successful fund of funds recognizes these differences and blends various strategies and asset classes together to create more stable long-term investment returns than any of the individual funds.

• Hedge fund strategies vary enormously – many, but not all, hedge against market downturns – especially important today with volatility and anticipation of corrections in overheated stock markets.
• The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive (absolute) returns under all market conditions.
• The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities or gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

Key Characteristics of Hedge Funds

• Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.).
• Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded.
• Many hedge funds have the ability to deliver non-market correlated returns.
• Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.
• Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent.
• Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns.
• Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage.
• Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund.

Facts About the Hedge Fund Industry

• Estimated to be a $1 trillion industry and growing at about 20% per year with approximately 8350 active hedge funds.
• Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or through the use of derivatives.
• Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.
• Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk.
• Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept.
• Hedge fund managers are generally highly professional, disciplined and diligent.
• Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.
• Beyond the averages, there are some truly outstanding performers.
• Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, that have lived through, and understand the consequences of, major stock market corrections.
• An increasing number of endowments and pension funds allocate assets to hedge funds.

Go to Part 2