Types of Hedge Funds
Alfred Winslow Jones’ organisation, A.W. Jones and Co., launched the idea of a hedge fund in 1949. He began investing with $100,000 in a combination of long-short positions to minimise his risk and made multiple folds thereafter.
The strategy he employed is today known as the classic Long/Short model. Over time, hedge fund managers have developed more innovative methodologies that aim to beat the market and produce market-uncorrelated absolute returns.
A hedge fund is a pool of money, mainly from accredited investors, which employs various trading strategies to deliver absolute returns, also known as alpha, to its investors in all market conditions.
Hedge fund managers will typically aim to optimize the risk-adjusted returns for its investors, i.e. employing various strategies to minimize the risk exposure to the markets while maximizing the potential gains.
In today’s article, we discuss the most popular hedge fund techniques.
Strategies employed in hedge funds
An Absolute-Return alternative investment vehicle’s primary objective is to ensure a steady return for the investors devoid of any impact from the changing market dynamics. These are for those who have a lower risk-taking ability and are happy getting a return, which is marginally higher than that of their savings account in a bank.
Absolute-Return funds are also popular with investors who already have a high proportion of allocation in their investment portfolio to investments with high volatility, as they seek diversification should a black swan event happen.
Directional funds are those that employ partial hedging instead of a complete one. The manager uses the technique when he is bullish of the market and incurs exposure to the swirls in the market.
It not only exposes the investors to a higher risk quotient but also allows them to earn a ‘stock-like’ return. These are apt for young investors who are not swayed by losses and are willing to go the extra mile for more returns.
Types of hedge funds
Here are the hedge fund strategies you are likely to come across.
1. Equity long/short
Hedge funds that employ long/short strategies in equity markets exploit positive earning opportunities by taking both purchase (long) and sale (short) positions in a cohort of stocks. The hedge fund manager buys those he deems underpriced and sells those that are overpriced in the current market scenario.
Should the trade not go as expected, the profit from the position favouring the other side will compensate the loss, ensuring a no profit-no loss situation (worst-case scenario) while still giving them the opportunity to capture gains. If the fund manager’s predictions go right, he will profit both outcomes.
2. Equity market neutral
The equity market neutral is another classic strategy which hedges the investor and ensures that his funds don’t move massively in either direction. Here, the fund manager goes long and short by the same exposure in similar stocks.
These may belong to the same sector, industry, or have similar characteristics to induce movement. The equity market neutral strategy can be effectively employed even if the manager is bearish. It gives the investors an opportunity to make gains while hedging them from the loss.
3. Event-driven investing
Event-driven investing aims to make alpha from corporate events such as company restructuring, mergers or takeovers, litigation or regulatory action etc, where there could be potential mis-pricing of the securities of the companies.
For example, a hedge fund could seek to buy the debt (mostly senior debt) of financially depleted companies. If these companies file for bankruptcy, there is a high chance of senior debt holders getting the entire amount back or after a slight haircut. If a company announces takeover or restructuring, the fund manager may short its equity, assuming that the price will fall soon.
Event-driven investing can take various forms such as capital structure arbitrage (taking long and short positions of the same issuer via equity and debt purchase/sale), distressed debt, holding company vs. subsidiary company arbitrage.
4. Global macro
A global macro fund manager analyses the effect of macroeconomic trends on several asset classes and invests in those that seem most sensitive to such events, i.e. take the requisite long/short position and wait for the trends to set in. This type of hedge fund prefers currency forwards and other highly liquid instruments as its subject of investment.
5. Fixed-income arbitrage
Fixed-income arbitrage exploits the inefficiencies in the pricing of bonds or interest rate instruments to create alpha. For example, arbitrageurs betting on the yield curve seek to profit from the gap between short- and long-term yields, taking long and short positions in the debt of various maturities and pricing in the yield curve to create profit potential.
6. Convertible bond arbitrage
A convertible bond allows users to convert it into equity after a fixed time. In this strategy, marketers aim for a delta-neutral (the ratio of conversion) position.
So, they will simultaneously go long on convertible bonds and short on the underlying shares into which they convert, and aim to profit from any market movements by having the hedge between the long and short positions.
7. Merger arbitrage
A subset of event-driven investing, merger arbitrage hopes to exploit the pricing inefficiencies before or after a merger or acquisition, where the fund manager will simultaneously purchase the stocks of the merging companies.
The strategy is subject to regulatory approvals, and the fund manager earns as the target company usually gets a higher acquisition price/share compared to its current market price. One key risk is that mergers often take months to close, and the advantage may erode over time.
A relatively newer entrant in the hedge fund world, the quantitative hedge looks beyond the manager’s experience and manual analysis. It employs statistics and more massive data sets to understand the reasons behind the patterns. It uses technology to accurately assess the upcoming changes and make investments based on the results.
How to choose a hedge fund
Here is what you must consider before investing in a hedge fund:
- Understand your objectives appropriately. Hedge funds are suitable for diversifying risk in your portfolio.
- Carefully analyse all the hedge funds that interest you and choose the one that replicates your needs the closest. It may seem like a tedious process but it will help you in making informed decisions.
- A thorough understanding of the fund manager is imperative before you make your move. If possible, it is ideal to meet the fund manager to have a clearer understanding of the fund’s investment objective.
- Keep the liquidity factor in mind and understand the redemption timeline. The minimum investment sumis usually quite substantial compared to mutual funds, making it crucial for investors to understand what they are getting themselves into.
- Investing in a hedge fund that has co-investment from the fund manager (‘skin in the game’) is a given. That way, you know that your aspirations are in line with that of the management team.
- Keep a tab on the risks involved. If you are comfortable with the volatility involved, the fund may be worth considering. One way to determine this is to ask yourself if the fund’s drawdown, or its historical maximum loss so far, is an amount you are willing to accept.
- Understand the costs involved and ensure that it is devoid of any hidden charges. Any hidden fees can trim the profits you expect from it.
Investing in the requisite hedge fund needs a lot of patience and due diligence. It is vital that you understand the intricacies involved before you commit to investing.
Choosing the right hedge fund is imperative for your financial goals. But given the intricacies involved, it may be difficult for a person without a sound knowledge to differentiate between two hedge funds.
We, at Salzworth, understand that each investor has a unique requirement and risk-taking appetite. So we have curated our services with that in mind. Our team of experts will take time in understanding your needs and suggest investments that are in sync with them.
More related articles:
- Types of Investment Funds in Singapore
- What is a Fund of Funds?
- What are Algo Funds?
- Shedding Light on Foreign Currency Denominated Funds
Co-Founder, Chief Executive Officer
Haruhito was the Executive Director of Marcuard Heritage Singapore Pte Ltd, a Swiss multi family office. He was instrumental in building up their European and Asian clientele base which comprised of a global network of asset managers, distribution partners, and legal & tax specialists. Prior to that, he held various positions for 10 years in Deutsche Bank where he gained extensive experience in various Asian markets.
Haruhito has been accredited as a Trust and Estate Practitioner (TEP) by STEP, and as a Financial Industry Certified Professional (FICP) by Singapore’s Institute of Banking and Finance. His vision for Salzworth is to steer it to establish multi-asset class portfolios and funds that seek to achieve steady returns for investors.