Hedge Fund Street

Hedge Funds: The Story

Interested in the hedge fund phenomenon but don’t know enough about it. Doesn’t matter. Here’s a simple and easy lowdown on what a hedge fund is about.

Just think of a hedge fund as a dolled-up, sexier version of your staid and dumpy mutual funds. They have that element of secrecy, a little danger and dallying with the authorities to make them even more enticing. Largely unregulated, hedge funds pursue investment strategies that are out of bounds to run-of-the-mill mutual funds.

And how do they make their money? Simple. They stick to their basic aim of trying to make money in all market conditions. For the supposedly great returns they provide, hedge fund managers do charge a hefty sum. The manager typically takes 20 percent of the profits, plus 2 percent for expenses.

It’s not all smooth sailing sans any rules whatsoever. You have to contend with the ‘lock-in’ period. Since your hedge fund manager has to follow complex strategies, he needs to be assured that you will not pull out your money and walk away anytime you wish. You have to lock in your money for a certain period – usually 12 months. Some funds ask for a two- or three-year lock in as well.

Know Your Hedge Funds

Knowing hedge fund strategies help you differentiate between various hedge funds. Investment returns, volatility, and risk vary largely among the different hedge fund strategies. There are some strategies, which are not correlated to equity markets and are yet capable of delivering consistent returns with extremely low risk of loss. And then, there are others that may be as or more volatile than mutual funds. If you want to have a successful run in the industry, you should be able to recognize these differences and blend various strategies and asset classes together to create a more stable long-term investment return.

Most hedge funds primarily aim to reduce volatility and risk while at the same time preserving capital. And irrespective of the market conditions, they want to consistently deliver positive returns. This is quite a tall order and hence it makes it doubly interesting to know how you can manage the volatile with the stable to ensure consistent returns.

Hybrid Mutual Fund -- For The Hedge Fund Experience

Want a hedge fund experience but don't have the budget to support your desires? Don't worry, hybrid mutual funds represent a practical way to get hedge-fund-like exposure. Fool.com reports:

Hybrid mutual funds, which strive for absolute returns in all kinds of markets, are similar to hedge funds, since both have the ultimate goal of making money even if markets tumble. Hybrid funds seek absolute returns; they're not focused on beating a particular benchmark. This emphasis on returns can make hybrid funds volatile, so they aren't for everyone.

Read more: Hedge Fund Wannabes

No More Roar, Only Purr

Title’s confusing? Well think of evolution. We all admire the lion, but we prefer to have cats as pets because they are not only beautiful but also manageable. It’s the same with hedge funds. Over the decades, they’ve been domesticated to suit the requirements of the investors. As the hedge fund industry has grown into a trillion-dollar industry in the past few years, it has become the focus of increased attention both from investors and regulators. Most investors believe that hedge funds are their ticket to high returns and this belief has led just about everyone to jump onto the hedge fund bandwagon.

Of course, everyone wants to invest in a hedge fund once they are convinced that the term is synonymous with 25 percent-plus annual returns. But they don’t want the risks associated with such high stakes – if you win big you also lose big. How many investors have actually asked themselves what makes hedge funds so special? Are the high returns on investment due to certain techniques, mode of investment or is it something else. I’m sure most investors are just too happy earning their high ROIs to bother about modes and methods. But to understand how the high returns come, it is important to understand hedge funds.

One of the biggest misconceptions about hedge funds is that it can provide high returns on the invested amount. Yes, the rate of return is quite good when you compare it with mutual funds. However the ability of hedge funds to generate high returns diminishes as with larger asset holdings get larger. Also, there is an increased need among investors to protect their holdings. So they still want the returns, but don’t want to play too dangerous. See how the lion slowly transmogrifies into a kitten!

Know Your Hedge Fund: Merger Arbitrage

Hedge funds by their inherent nature involve risks. If you are dealing in the market, you are expected to make a few profits and losses. However, there is one tool that is designed to ensure profits regardless of the direction the equity market takes. Sounds intriguing? Called merger arbitrage, this strategy takes advantage of the expected price movements or arbitrage opportunities that occur after the announcement of a merger or acquisition offer.

Now that you know what a merger arbitrage is, let’s examine how it works. Once a company makes an announcement of its intent to acquire another firm, the price of the target company's stock will go up. If you notice carefully, it does rise but usually not to the full offering price. And since there is a risk of the deal not closing on time or at all, the target company's stock may sell at a discount to its value at the merger's closing. This discount usually increases with the expected length of time until closing and the perceived risk of the deal. Now if you want to use the merger arbitrage strategy, you will try to lock in this spread. If the merger involves a cash offer, you will only have to buy the stock of the target company. But if the deal involves a trade of securities, you may also have to hedge against the possibility of the acquirer's stock falling. To do this, you can sell the acquirer's stock short.

You will notice that when compared to the uncertainty of playing the volatile equity markets, merger arbitrage investments can give you quite consistent returns. There is of course the risk of a merger or acquisition falling through. However, a good fund manager is expected to foresee such circumstances since they are quite predictable.

Defining hedge funds – the SEC way

I’ve written time and again about the SEC and regulation drama that’s been playing out for quite a few months now. So when I stumbled onto this article on what the SEC thinks a hedge fund exactly is, I pounced on it. Here you can know the SEC definition of a hedge fund. Hedgefundcenter.com reports:

They are not required to register because they generally only accept financially sophisticated investors and do not publicly offer their securities. In addition, some, but not all, types of hedge funds are limited to no more than 100 investors.

Read more: The SEC's Definition of a Hedge Fund

Fund of Hedge Funds! What Was That Again?

I recently wrote on how a fund of hedge funds was a good investment option. But I guess I haven’t explained a fund of hedge funds clearly enough so maybe we could have a tutorial on this aspect of hedge funds. So getting down to the definitions first, simply put, a fund of hedge funds is a diversified portfolio of hedge funds. These funds need not be correlated in any way.

The principle is similar to the ones used on the stock market. If you don’t think you can identify your stocks well enough, you tend to invest in a mutual fund that then invests in blue chip or whatever other types of stocks for you. While the returns are assured, they are not phenomenal. Now going one step further, a fund of hedge funds seeks to deliver consistent returns than even stock portfolios, mutual funds, unit trusts or individual hedge funds.

Since returns are assured, a fund of hedge funds is the preferred investment of choice for many pension funds, endowments, insurance companies, private banks and high-net-worth families and individuals. Yes, if you didn’t know, YOU too can invest in a fund of hedge funds. Only you have to be a high-net-worth individual or belong to such a family.

What are the benefits? Well, since you get access to a broad range of investment styles, strategies and hedge fund managers, your returns are more predictable than traditional investment funds. Another big time benefit is that it allows you access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements.

Hedge Funds: See Saw Industry

Back in 2003, this was a US $500 billion industry and in just three years, we are talking in trillions. Now, here are a few statistics I have managed to get off the web. They’ll show you how big hedge funds have become today.

• On an average day, between 18 and 22 percent of all trading on the New York Stock Exchange is hedge fund related.
• And between 30 to 35 percent of all trading on the London Stock Exchange is hedge fund related.

Something isn’t it? But that doesn’t mean there are no downfalls. This industry is famed for its enormous losses as much as it is for its legendary gains. Recently, the Ohio Bureau of Worker's Compensation lost $215 million in a hedge fund that only invested in U.S. Treasury securities! And the worst part: the Bureau of Worker's Compensation had only invested a total of $225 million in the fund in the first place, so their loss was to the tune of 95 percent of their total investment!

But such is life in the fast lane of the world's financial markets. You can always expect the unexpected. Things have occurred in the financial markets that nobody could have ever anticipated, but managed to happen anyway. Ultimately, the markets always have a way of showing even the best and the brightest that they are nowhere as smart as they sometimes think they are. However, the best thing about this industry is that you can never be bored with hedge funds. That’s because you are always anticipating something to occur and not knowing if it will happen or if things will take a turn for the unexpected.

Understanding hedge fund language

If you are an outsider trying to understand the hedge fund industry, the whole thing may seem very confusing and difficult. The language sounds alien and most of the time you are lost when hedge fund managers begin to speak. It isn't easy to keep track of what they are saying thanks to the professional jargon they use. So what's the best option available to you? You can either interrupt them every few minutes to ask them what a particular term means, or you can learn these terms so you can speak to them in their own language. Here’s a quick crash course for those who want to understand the market and the language of hedge funds. Since the subject is vast, we will go alphabetically:

• Abandon: To elect not to exercise or offset a long option position.
• Actuals: The physical or cash commodity, as distinguished from a futures contract.
• Agency Bond: A debt security issued by a government-sponsored enterprise such as Fannie Mae or Freddie Mac, designed to resemble a US Treasury bond.
• Aggregation: The principle under which all futures positions owned or controlled by one trader (or group of traders acting in concert) are combined to determine reporting status and compliance with speculative position limits.
• Arbitrage: A strategy involving the simultaneous purchase and sale of identical or equivalent commodity futures contracts or other instruments across two or more markets in order to benefit from a discrepancy in their price relationship. In a theoretical efficient market, there is a lack of opportunity for profitable arbitrage.
• Arbitration: A process for settling disputes between parties that is less structured than court proceedings. NFA ’s arbitration program provides a forum for resolving futures-related disputes between NFA members or between NFA members and customers. Other forums for customer complaints include the American Arbitration Association.
• Artificial Price: A futures price that has been affected by a manipulation and is thus higher or lower than it would have been if it reflected the forces of supply and demand.
• At-the-Market: An order to buy or sell a futures contract at whatever price is obtainable when the order reaches the trading facility.
• At-the-Money: When an option's strike price is the same as the current trading price of the underlying commodity, the option is at-the-money.
• Auction Rate Security: A debt security, typically issued by a municipality, in which the yield is reset on each payment date via a Dutch auction.

Knowing your hedge funds

Knowing hedge fund strategies help you differentiate between various hedge funds. Investment returns, volatility, and risk vary largely among the different hedge fund strategies. There are some strategies, which are not correlated to equity markets and are yet capable of delivering consistent returns with extremely low risk of loss. And then, there are others that may be as or more volatile than mutual funds. If you want to have a successful run in the industry, you should be able to recognize these differences and blend various strategies and asset classes together to create a more stable long-term investment return.

Most hedge funds primarily aim to reduce volatility and risk while at the same time preserving capital. And irrespective of the market conditions, they want to consistently deliver positive returns. This is quite a tall order and hence it makes it doubly interesting to know how you can manage the volatile with the stable to ensure consistent returns.

Hedge fund strategies

Today, I will continue on the topic of hedge fund strategies, their types and differences. Now there are some among you who are probably wondering why we need to know about hedge fund strategies. Well, one of the simplest and most basic reasons to study them is because it helps you know the difference between various hedge funds. Investment returns, volatility, and risk vary largely among the different hedge fund strategies. There are some strategies, which are not correlated to equity markets and are yet capable of delivering consistent returns with extremely low risk of loss. And then, there are others that may be as or more volatile than mutual funds. In case you want to have a successful run in the industry, you should be able to recognize these differences and blend various strategies and asset classes together to create a more stable long-term investment return.

Most hedge funds primarily aim to reduce volatility and risk while at the same time preserving capital. And irrespective of the market conditions, they want to consistently deliver positive returns. This is quite a tall order and hence it makes it doubly interesting to know how you can manage the volatile with the stable to ensure consistent returns.

And one final thing. There is a common belief or should I say misconception that hedge funds are volatile by nature. People who don’t know much about these funds believe that hedge funds use global macro strategies and use lots of leverage to place large directional bets on stocks, currencies, bonds, commodities or gold. Sadly, the reality is not so romantic. Less than 5 percent of hedge funds can claim to be global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all. And most importantly, many funds use no leverage.

Hedge fund strategies

This one’s for those who are interested in hedge funds but don’t know much about them. Let me give you a little tutorial about two hedge fund strategies.

There is a popular misconception that all hedge funds pursue an aggressive growth policy. Nothing could be further from the truth. Of course, there are those who do adopt this policy. A hedge fund that has an aggressive growth strategy, invests in equities that are expected to experience acceleration in growth of earnings per share. These equities usually Includes sector specialist funds such as technology, banking, or biotechnology. When using this kind of strategy, the hedge fund manager will hedge by shorting equities if the earnings are not up to mark or by shorting stock indexes.

Then there is the distressed securities strategy wherein the hedge fund buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Next time, we will discuss more strategies.

Understanding Hedge Funds

Those who are in the industry don’t need any introduction to hedge funds and their functioning. But if you are an outsider trying to understand the industry, the whole thing may seem very confusing and difficult. So, here’s a quick crash course for those who want to understand the market and hedge funds. You tend to hear a lot of talk about using hedge funds when the stock market is doing poorly. This makes people mistake hedge funds for mutual funds. This is a big mistake and must be remedied immediately. Firstly, let us examine the name. The word ‘hedge’ suggests defensive management or an insurance against bad times. But in reality, hedge funds come in hundreds of varieties and often use leverage.

So, how does one differentiate between hedge and mutual funds? You probably have a slight understanding of mutual funds. So, let understand hedge funds by examining the differences between these two types of funds. One of the first things you will notice is that while mutual funds are regulation SEC registered investment vehicles, hedge funds are not regulated and are private investment vehicles. Investments in mutual funds need not be very high – they can be reasonable. However, with hedge funds, large minimum investments of around $1 million are required.

Another thing is that hedge funds form exclusive clubs. In other words, while mutual funds are available to the public, to deal in hedge funds, you must be an accredited investor. To become an accredited investor, your net worth must exceed $1 million or your individual income must have been in excess of $200,000 in the past two years. You must also expect the same level of income in the current year.

In case you consider yourself a potential hedge fund investor, here’s a word of caution. Information on hedge funds is still not easy to come by, and there is quite a bit of misinformation floating around. So, it is important that you study the market first before taking the plunge.