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Tuesday August 03 2021
Taking the Mystery Out of Hedge Funds
  Articles by Dion Friedland
  Protection Against An Aging Bull
  Reducing Market Risk with Merger Arbitrage
  Interview with Dion Friedland
  Taking the Mystery Out of Hedge Funds
  About Special Situations Fixed Income
  The Kingdom of Hedge Funds
  Distressed Securities Investing
  The Case for Convertibles
  Private-to-Public Investing
  Global Macro Investing
  Market Neutral Long/Short Equity Trading

by Dion Friedland, Chairman, Magnum Funds

What is a hedge fund?

A hedge fund is a term commonly used to describe any fund that isn't a conventional investment fund - that is, any fund using a strategy or set of strategies other than investing long in bonds, equities (mutual funds), and money markets (money market funds). Among these alternative strategies are:

  • hedging by selling short -- selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop
  • using arbitrage - seeking to exploit pricing inefficiencies between related securities
  • trading options or derivatives - contracts whose values are based on the performance of any underlying financial asset, index or other investment
  • using leverage - borrowing to try to enhance returns
  • investing in out-of-favor or unrecognized undervalued securities (debt or equity)
  • attempting to take advantage of the spread between the current market price and the ultimate purchase price in event driven situations such as mergers or hostile takeovers.

How does a hedge fund "hedge" against risk?

Some funds that are called hedge funds don't actually hedge against risk. Because the term is applied to a wide range of alternative funds, it also encompasses funds that may use high-risk strategies without hedging against risk of loss. For example, a global macro strategy may speculate on changes in countries' economic policies that impact interest rates, which impact all financial instruments, while using lots of leverage. The returns can be high, but so can the losses, as the leveraged directional investments (which are not hedged) tend to make the largest impact on performance.

Most hedge funds, however, do seek to hedge against risk in one way or another, making consistency and stability of return, rather than magnitude, their key priority. (In fact, less than 5 percent of hedge funds are global macro funds). Event-driven strategies, for example, such as investing in distressed or special situations reduce risk by being uncorrelated to the markets. They may buy interest-paying bonds or trade claims of companies undergoing reorganization, bankruptcy, or some other corporate restructuring - counting on events specific to a company, rather than more random macro trends, to affect their investment. Thus, they are generally able to deliver consistent returns with lower risk of loss. Long/short equity funds, while dependent on the direction of markets, hedge out some of this market risk through short positions that provide profits in a market downturn to offset losses made by the long positions. Market neutral equity funds which invest equally in long and short equity portfolios generally in the same sectors of the market, are not correlated to market movements.

A true hedge fund then is an investment vehicle whose key priority is to minimize investment risk in an attempt to deliver profits under all circumstances.


So hedge funds vary greatly in their hedging strategies and range of risk/reward?

Absolutely. Different hedge fund styles are as different from one another as members of the animal kingdom. Just as elephants and crocodiles and rabbits are very different, so, too, are global macro funds and convertible bond arbitrage funds and long/short equity funds.

Different hedge fund strategies vary enormously in terms of:

  • Investment returns
  • Volatility
  • Risk

Some hedge funds 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 (unit trusts).


What is the difference between a hedge fund and a mutual fund?

There are five key distinctions:

1.      Mutual funds are measured on relative performance - that is, their performance is compared to a relevant index such as the S&P 500 Index or to other mutual funds in their sector. Hedge funds are expected to deliver absolute returns - they attempt to make profits under all circumstances, even when the relative indices are down.


2.      Mutual funds are highly regulated, restricting the use of short selling and derivatives. These regulations serve as handcuffs, making it more difficult to outperform the market or to protect the assets of the fund in a downturn. Hedge funds, on the other hand, are unregulated and therefore unrestricted - they allow for short selling and other strategies designed to accelerate performance or reduce volatility. However, an informal restriction is generally imposed on all hedge fund managers by professional investors who understand the different strategies and typically invest in a particular fund because of the manager's expertise in a particular investment strategy. These investors require and expect the hedge fund to stay within its area of specialization and competence. Hence, one of the defining characteristics of hedge funds is that they tend to be specialized, operating within a given niche, specialty or industry that requires a particular expertise.


3.      Mutual funds generally remunerate management based on a percent of assets under management. Hedge funds always remunerate managers with performance-related incentive fees as well as a fixed fee. Investing for absolute returns is more demanding than simply seeking relative returns and requires greater skill, knowledge, and talent. Not surprisingly, the incentive-based performance fees tend to attract the most talented investment managers to the hedge fund industry.


4.      Mutual funds are not able to effectively protect portfolios against declining markets other than by going into cash or by shorting a limited amount of stock index futures. Hedge funds, on the other hand, are often able to protect against declining markets by utilizing various hedging strategies. The strategies used, of course, vary tremendously depending on the investment style and type of hedge fund. But as a result of these hedging strategies, certain types of hedge funds are able to generate positive returns even in declining markets.


5.      The future performance of mutual funds is dependent on the direction of the equity markets. It can be compared to putting a cork on the surface of the ocean - the cork will go up and down with the waves. The future performance of many hedge fund strategies tends to be highly predictable and not dependent on the direction of the equity markets. It can be compared to a submarine traveling in an almost straight line below the surface, not impacted by the effect of the waves.

What is a fund of funds, and what is the advantage of investing in one versus a hedge fund?

A fund of funds is a fund that mixes and matches the most successful hedge funds and other pooled investment vehicles, spreading investments among many different funds or investment vehicles. As we've noted, hedge fund strategies are complex and varied in their ranges of risk/return Even within a particular style, no two managers are likely to be exactly the same. Each will apply different amounts of hedging or insurance to his/her portfolio and will employ different amounts of leverage. A fund of funds simplifies the process of choosing hedge funds, blending together funds to meet a range of investor risk/return objectives while generally spreading out the risks among a variety of funds. This blending of different strategies and asset classes aims to deliver a more consistent return (than any of the individual funds).

Among the advantages:

  • Returns, risk and volatility can be somewhat controlled by the mix of underlying funds.
  • Capital preservation is generally an important consideration.
  • Volatility depends on the mix and ratio of strategies employed.

Creating a fund of funds can be likened to baking a cake. Working from the same ingredients such as flour, butter, sugar, yeast, eggs, etc., a baker is capable of producing different cakes. For example:

  • a sponge cake may have more eggs
  • a fruit cake will include chopped fruit and nuts
  • a chocolate cake includes chocolate but the basic ingredients are still the butter, flour, eggs, etc.

So it is with a funds of funds. Understanding the characteristics and risk profiles of the different hedge fund strategies allows the fund of funds manager to blend funds together that often are able to produce fairly predictable returns.


So predictability of return is greater with a fund of funds?

Yes. In any investment strategy the predictability of future results is strongly correlated with the volatility of past returns of each strategy. Future performance of strategies with high volatility is far less predictable than future performance of strategies experiencing low or moderate volatility. Participants in the mutual fund industry, where the volatility of past results is high (because results are so dependant on the direction of the stock market), know how impossible it is to predict future performance. However, within the hedge fund industry many of the hedging strategies are able to produce consistent returns which are highly predictable.

As a result, focused funds of funds, utilizing some of these low-volatility strategies, are often able to produce predictable returns, not correlated to market direction.

What place should hedge funds or funds of funds have in investment portfolios given today's investment climate?

Equity markets, with the exception of Japan and emerging markets, have enjoyed an unprecedented boom for the last decade - in fact, the U.S. has enjoyed the longest bull market of this century. Given the vulnerability of the U.S. markets to a correction, which if it happened would undoubtedly trigger a downturn in global markets, it would be prudent for everyone in the investment industry, including private investors, to allocate at least a portion of their investment portfolios to hedge fund strategies that are not correlated to the direction of equity markets. Keeping in mind that not all hedge funds are the same, any investor can probably find a strategy within the hedge fund universe that best suits his risk profile and investment style.

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