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Synopsis of Hedge Fund Strategies
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.
Key Characteristics of Hedge Funds
- Many, but not all, hedge fund strategies tend to hedge against downturns
in the markets being traded.
- Hedge funds are flexible in their investment options (can use short
selling, leverage, derivatives such as puts, calls, options, futures, etc.).
- Hedge funds benefit by heavily weighting hedge fund managers’
remuneration towards performance incentives, thus attracting the best brains
in the investment business.
Facts About the Hedge Fund Industry
- Estimated to be a trillion dollar industry, with about 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 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, who have lived
through, and understand the consequences of, major stock market corrections.
Many endowments and pension funds allocate assets to hedge funds.
Popular Misconception
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, and gold, while using lots of leverage. In
reality, less than 5% of hedge funds are global macro funds like Quantum, Tiger,
and Strome. Most hedge funds use derivatives only for hedging or don’t use
derivatives at all, and many use no leverage.
Hedge Fund Strategies
The predictability of future results show a strong correlation with the
volatility of each strategy. Future performance of strategies with high
volatility is far less predictable than future performance from strategies
experiencing low or moderate volatility.
- Aggressive Growth: Invests in equities expected to
experience acceleration in growth of earnings per share. Generally high P/E
ratios, low or no dividends; often smaller and micro cap stocks which are
expected to experience rapid growth. Includes sector specialist funds such
as technology, banking, or biotechnology. Hedges by shorting equities where
earnings disappointment is expected or by shorting stock indexes. Tends to
be "long-biased." Expected Volatility: High
- Distressed Securities: Buys equity, debt, or trade claims at
deep discounts of companies in or facing bankruptcy or reorganization.
Profits from the market’s lack of understanding of the true value of the
deeply discounted securities and because the majority of institutional
investors cannot own below investment grade securities. (This selling
pressure creates the deep discount.) Results generally not dependent on the
direction of the markets. Expected Volatility: Low - Moderate
- Emerging Markets: Invests in equity or debt of emerging
(less mature) markets which tend to have higher inflation and volatile
growth. Short selling is not permitted in many emerging markets, and,
therefore, effective hedging is often not available, although Brady debt can
be partially hedged via U.S. Treasury futures and currency markets. Expected
Volatility: Very High
- Fund of Funds: Mixes and matches hedge funds and other
pooled investment vehicles. This blending of different strategies and asset
classes aims to provide a more stable long-term investment return than any
of the individual funds. Returns, risk, and volatility can be controlled by
the mix of underlying strategies and funds. Capital preservation is
generally an important consideration. Volatility depends on the mix and
ratio of strategies employed. Expected Volatility: Low - Moderate
- Income: Invests with primary focus on yield or current
income rather than solely on capital gains. May utilize leverage to buy
bonds and sometimes fixed income derivatives in order to profit from
principal appreciation and interest income. Expected Volatility: Low
- Macro: Aims to profit from changes in global economies,
typically brought about by shifts in government policy which impact interest
rates, in turn affecting currency, stock, and bond markets. Participates in
all major markets -- equities, bonds, currencies and commodities -- though
not always at the same time. Uses leverage and derivatives to accentuate the
impact of market moves. Utilizes hedging, but leveraged directional bets
tend to make the largest impact on performance. Expected Volatility: Very
High
- Market Neutral - Arbitrage: Attempts to hedge out most
market risk by taking offsetting positions, often in different securities of
the same issuer. For example, can be long convertible bonds and short the
underlying issuers equity. May also use futures to hedge out interest rate
risk. Focuses on obtaining returns with low or no correlation to both the
equity and bond markets. These relative value strategies include fixed
income arbitrage, mortgage backed securities, capital structure arbitrage,
and closed-end fund arbitrage. Expected Volatility: Low
- Market Neutral - Securities Hedging: Invests equally in long
and short equity portfolios generally in the same sectors of the market.
Market risk is greatly reduced, but effective stock analysis and stock
picking is essential to obtaining meaningful results. Leverage may be used
to enhance returns. Usually low or no correlation to the market. Sometimes
uses market index futures to hedge out systematic (market) risk. Relative
benchmark index usually T-bills. Expected Volatility: Low
- Market Timing: Allocates assets among different asset
classes depending on the manager’s view of the economic or market outlook.
Portfolio emphasis may swing widely between asset classes. Unpredictability
of market movements and the difficulty of timing entry and exit from markets
adds to the volatility of this strategy. Expected Volatility: High
- Opportunistic: Investment theme changes from strategy to
strategy as opportunities arise to profit from events such as IPOs, sudden
price changes often caused by an interim earnings disappointment, hostile
bids, and other event-driven opportunities. May utilize several of these
investing styles at a given time and is not restricted to any particular
investment approach or asset class. Expected Volatility: Variable
- Multi Strategy: Investment approach is diversified by
employing various strategies simultaneously to realize short- and long-term
gains. Other strategies may include systems trading such as trend following
and various diversified technical strategies. This style of investing allows
the manager to overweight or underweight different strategies to best
capitalize on current investment opportunities. Expected Volatility: Variable
- Short Selling: Sells securities short in anticipation of
being able to rebuy them at a future date at a lower price due to the
manager’s assessment of the overvaluation of the securities, or the
market, or in anticipation of earnings disappointments often due to
accounting irregularities, new competition, change of management, etc. Often
used as a hedge to offset long-only portfolios and by those who feel the
market is approaching a bearish cycle. High risk. Expected Volatility:
Very High
- Special Situations: Invests in event-driven situations such
as mergers, hostile takeovers, reorganizations, or leveraged buy outs. May
involve simultaneous purchase of stock in companies being acquired, and the
sale of stock in its acquirer, hoping to profit from the spread between the
current market price and the ultimate purchase price of the company. May
also utilize derivatives to leverage returns and to hedge out interest rate
and/or market risk. Results generally not dependent on direction of market. Expected
Volatility: Moderate
- Value: Invests in securities perceived to be selling at deep
discounts to their intrinsic or potential worth. Such securities may be out
of favour or underfollowed by analysts. Long-term holding, patience, and
strong discipline are often required until the ultimate value is recognized
by the market. Expected Volatility: Low - Moderate
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