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The Kingdom of Hedge Funds

by Dion Friedland, Chairman, Magnum Funds

        In the animal kingdom, few creatures are as terrifying – and as awe-inspiring -- as the grizzly bear. Mammoth and quick, keen and powerful, these carnivores take no prisoners – not even human ones – when feeling threatened or hungry. They are sudden and aggressive; they go for the kill; they want it all, not content with only a mere morsel of their prey.

        In the hedge-fund kingdom, global macro funds can be compared to grizzlies. Aiming to profit from changes in global economies, and using leverage and derivatives to accentuate the impact of market moves, such funds are not for the faint of heart. They can be enormously profitable, but are volatile, not terribly predictable, and can also produce occasional sudden falls. For example, during the first quarter of 1994 hedge-fund superstar Michael Steinhardt (whose funds produced an average annual return of 24 percent over several decades) bet European interest rates would decline, causing bonds to rise. Instead, his funds lost 29 percent when the Fed raised interest rates in the U.S., causing European interest rates to kick up. I compare macro funds to grizzlies not only to highlight these common aggressive characteristics but to point out that like grizzlies, macro hedge funds are only one species in a wide universe – and that they differ from other hedge funds as much as grizzlies differ from other animals.

        This point is especially important to hammer home given the popular misconceptions about hedge funds that were fueled by 1994’s declines in hedge funds run by Steinhardt, George Soros (Quantum Group), and Julian Robertson (Tiger Management). For while it is true these managers’ strategies of placing large directional investments in stocks, currencies, bonds, commodities, and gold while using lots of leverage can create huge returns with very high volatility, in reality less than 5 percent of hedge funds use strategies such as these. The vast majority of hedge funds make consistency of return, rather than magnitude, their primary goal. Most use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

        Some hedge fund strategies, in fact, are not correlated to equity markets and are thus able to deliver consistent returns with extremely low risk of loss. Take event-driven funds, funds investing in special situations, or distressed securities, for example. Buying interest-paying bonds or trade claims of companies undergoing reorganization, bankruptcy, or some other corporate restructuring, such funds may avoid the vicissitudes of the equity markets. If macro funds are grizzlies, special situations funds can be compared to tortoises – slow but steady, often able to hide from danger beneath their tough protective shells.

        Like special situations funds, market-neutral funds are able to provide steady returns with low volatility. They might be thought of as any kind of amphibian – one foot in the water, one foot out. In the case of market-neutral arbitrage funds, they attempt to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. In the case of funds using market neutral securities hedging, they invest equally in long and short equity portfolios generally in the same sectors of the market.

        There are dozens of different kinds of hedge funds, varying by strategies, asset classes, use of derivatives and leverage, sectors, and regions. Emerging markets funds, for example, invest in equity or debt of less mature markets which tend to have higher inflation and volatile growth. Call them panthers due to the speed and aggressiveness with which they function. Short selling is not permitted in many emerging markets, and therefore effective hedging is often not available.

        Funds of funds are combinations of the many different strategies – call them the biogenetic hybrids of the hedge fund universe. Mixing and matching hedge funds and other pooled investment vehicles, they blend different strategies and assets classes aiming to provide a more stable long-term investment return than any of the individual funds. Returns and risk can be controlled by the mix of underlying strategies and funds, which also impacts the amount of volatility the fund of funds will have. Generally, the bigger the mix of non-correlated asset classes, the less volatility the fund of funds will have.

        The list goes on. It is critical that investors understand the wide range of strategies found in the hedge fund universe and their differing degrees of risks and returns – or consult with experts who do. That way they won’t overlook opportunities that may well match their investment objectives. For all hedge funds are not the same: Investment returns, volatility, and risk vary enormously among them – not unlike the different levels of pace and aggressiveness in the animal kingdom.

 

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