Hedge Funds: The “SHORT” brief

Our insight article provides an introductory guide to what hedge funds are and some of the common strategies. Written by:  Emeka Nwankwo

A hedge fund is an investment vehicle designed to maximise returns using funds pooled from investors. In truth, ‘hedge fund’ is a broad label that encompasses a variety of strategies and investment products. Understandably, hedge funds are guarded about their formulae for generating returns because some of them may involve the exploitation of systemic inefficiencies. The strategy may simply become less effective with more people using it. Investment in hedge funds is typically restricted to professional investors or high net worth individuals. The definition of a high net worth individual varies amongst different jurisdictions. For a sense of comparison, the UK defines a high net worth individual as an individual with an annual income of at least £100,000 or net assets exceeding £250,000. The U.S on the other hand, defines an accredited investor as an individual with annual income of at least $200,000 or a net worth of  $1,000,000 excluding the value of their main residence. The restrictions imposed on hedge funds in terms of participants, stem from their use of complex and sometimes high-risk strategies. The rationale being that any individual participating in such funds would be sophisticated enough to understand the nature of the risks entailed. Less sophisticated investors have the option of mutual funds. Mutual funds share some characteristics with hedge funds in the sense of the pooling and deployment of capital but there are some differences including stricter regulation, better transparency and cheaper fee structures.

 

In the financial world, the term ‘hedge’ is associated with the mitigation of overall risk. The concept of employing strategies that result in the overall reduction of risk or market exposure to a shock from any particular event shape the fundamental investment principles. These principles were established by the first hedge fund set up by Alfred Winslow Jones and he achieved this by using a combination of strategies. Most popularly, the classic long/short equities model. Alfred Winslow Jones set up A.W. Jones & Co. as a general partnership in 1949. Two years after it was began, the fund changed its structure to a limited liability partnership paving the way for future hedge funds to follow suit. Hedge funds nowadays tend to be established as offshore companies to circumvent the rigorous disclosure requirements, regulation would bring. Jones’ hedge fund had another characteristic that has become ubiquitous to hedge funds in general and that is the fund’s use of leverage. At its core, leverage is debt/borrowing and hedge funds take advantage of leverage to boost returns.

 

The allure of hedge funds emanates from the fund managers themselves. Hedge fund managers tend to start out on the trading desks at investment banks. These individuals build a reputation for producing good rates of return on Investment (RoI) and then venture out on their own. A fund manager will normally stake some of his own capital in the hedge fund. Some of the most notable fund managers include Ray Dalio, Steven Cohen, John Paulson & George Soros. The UK audience should be familiar with George Soros and his hedge fund the Quantum Group of Funds. Back in 1992, Mr Soros was able to make a profit of $1 billion short selling the Pound after correctly predicting that the Bank of England would be forced to devalue its currency (read about Black Wednesday). You only need to scan rich lists of financial publications to see just how profitable some of these Hedge fund managers are. Hedge Funds typically feature a 2%/20% fee structure; that is a management fee of 2% on the overall value of the fund along with a 20% charge on profits made. In comparison, mutual funds only charge an annual management fee (2% on average). As at the start of 2017, two of the biggest hedge funds in the world – Bridgewater Associates and Renaissance Technologies managed $122 billion and $45 billion respectively.

A reason for hedge funds charging such high fees is their promise of ‘absolute returns’. Absolute return concerns the performance of a specific asset over a certain period of time. In contrast, mutual funds offer relative returns i.e., returns compared to some sort of benchmark. To clarify, a hedge fund could offer a promise of 10% absolute return in a year, whereas a mutual fund promises to outperform a general benchmark such as the FTSE 100 in that same timeframe. In the case of a mutual fund, the promised return is always relative to the performance of something else. It is important to note that hedge funds are considered ‘illiquid’, that is to say that investors can only make withdrawals or inject funds at specific intervals without incurring penalties. Liquidity is a property of financial instruments that describes how quickly and easily that instrument can be converted into cash without acquiring a substantial loss. As hedge funds can invest in any type of financial instrument, the fund may hold some illiquid assets. Examples of illiquid assets include – classic cars, wine, antiques and paintings. These sorts of assets would be difficult to sell quickly as there aren’t many ready and willing buyers available at any specific time.

 

A variation of the long/short model strategy is the pair trade. The pair trade is a strategy that takes advantage of the established correlation in a pair of instruments. The shares of 2 companies operating in the same sector are an example of a correlated pair. The pair trade would see a fund take a contradictory view on both instruments (despite their correlation) by betting on prices for the shares in one company to appreciate and in the other to depreciate. For example, a fund speculating in the market for US automobiles, projects General Motors outperforming Ford in the next year. The fund could take advantage of this by simultaneously buying (going long) General Motors and selling (going short) Ford shares. The price for shares in both companies should increase in the event of the sector as a whole performing well. If the fund is right about General Motors doing better than Ford, then profit from its long position should outweigh the loss from its short position on Ford. The reverse holds true in the event of a market downturn (or bear market). In a bear market, both companies share price would decline but theoretically speaking, the decline in General Motors share price should be less than Ford’s. The idea behind the long/short strategy is for the result to be reliant on the fund manager’s ability to pick good companies rather than being at the mercy of the overall direction of the market. The traditional model would see the long/short exposure at the rates of 130%/30%. You may have noticed that the total allocation using this model exceeds 100%, this is made possible by fund’s use of leverage.

Another strategy employed by hedge funds is arbitraging. Hedge funds use different methods to exploit mispricing in financial instruments. Arbitraging is taking advantage of differentials in pricing of the same financial instrument as a means to generate a profit at low risk. For example, the GBP/USD foreign exchange rate could be trading at $1.1100 with Interactive Brokers and $1.1112 with CityIndex. A hedge fund would place a series of trades with the long-term view that prices will once again be equal on both brokerages.  These sorts of opportunities require nimbleness, swift action and sophisticated technological resources to be exploited. Other strategies include global macro – taking positions with the view to profit from global macroeconomic situations and event driven –  taking positions in an underlying instrument that is associated with a particular event.

 

The unregulated nature and consequently, opaqueness of hedge funds and their activities make them particularly susceptible to fraud or malpractice. There has been particular attention paid to the proximity of their relationship with analysts leading to concerns and allegations of insider trading. The infamous Galleon Fund managed by Raj Rajaratnam is one such example. Due in part to their alternative methods of investing, the performance of hedge funds tends to be uncorrelated to major markets and this feature makes them advantageous to forming a part of a diversified portfolio.

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