Investment Features of Hedge Funds and Differences between Hedge Funds and Other Asset Classes

Hedge funds, as private investment entities, are distinguished by their distinctive investment strategy. They employ a blend of traditional debt and equity tools, leverage, derivatives, short selling, and various tactics to produce and amplify returns. The primary aim of a hedge fund is to generate substantial returns, whether in an absolute sense or concerning risk-adjusted performance relative to the volatility of its portfolio.

Benchmarking the performance of hedge funds against traditional index performance benchmarks can pose a challenge due to the unique strategies they utilize. Consequently, many hedge funds choose to assess their performance based on an absolute return standard rather than tracking a benchmark.

Hedge funds are appealing due to their diversification effects, showing a typically low correlation with traditional asset investments.

Comparing Hedge Funds and Mutual Funds

While hedge funds and mutual funds may seem similar, there are significant differences.

Mutual fund managers have fixed compensation and might not always invest in the funds they oversee. In contrast, hedge fund managers receive a performance-based fee, and many mandate that managers invest in the hedge fund. Certain hedge funds implement a high-water mark, where the manager receives a performance fee only if the returns surpass the fund’s previous highest value.

Hedge fund managers usually possess greater flexibility in making trading decisions and distributing client funds. Mutual funds are subject to extensive regulation as they are accessible to public investors, whereas hedge funds are exclusively available to institutional and accredited investors.

Hedge funds stand apart from various fund types like mutual funds, ETFs, bond funds, and REITs due to their private ownership and relatively minimal regulation. In contrast to private equity funds, hedge funds usually operate with a shorter time horizon and invest in more liquid asset classes.

Hedge Fund Strategies

Hedge funds frequently employ methods that appear to elevate portfolio risk, like borrowing funds for investment, employing leverage (derivatives), and engaging in short selling. However, rather than hedging risky positions against market movements, these strategies appear to magnify the risks instead.

Nonetheless, the hedge fund investment strategy divides the portfolio in a way where each part counterbalances the risks of the others. This approach allows for internal neutralization of market risks and, through careful management of the portfolio elements, enables the hedge fund manager to achieve improved risk-adjusted returns.

Hedge funds are investment vehicles that are typically classified based on their strategy. There are five broad categories of strategies that hedge funds employ. These include:

1. Equity hedge funds.
2. Event-driven hedge funds.
3. Relative value hedge funds.
4. Opportunistic hedge funds.
5. Multi-manager hedge funds.

Equity Hedge Fund Strategies

Equity hedge funds focus on investing in equities. Equity long-short funds concentrate on public equity markets and engage in both long and short positions involving equity and equity derivative securities. The fund manager would use their expertise to select stocks that they believe will outperform the market.  The strategies used by these funds can be broadly categorized into two approaches: “bottom-up” and “top-down.” The bottom-up Approach starts with a company-level analysis, followed by an overall industry analysis, and finally, an overall market analysis. The top-down approach approach involves a global macro analysis, followed by sector/regional analysis, and finally, an individual company analysis or any market-timing approach.

Types of Equity Hedge Strategies

• Fundamental Long/Short: This approach includes purchasing undervalued stocks relative to their potential intrinsic value while selling short those moving in the opposite direction. The objective is to execute this trade reversal to achieve alpha. For example, a fund might go long on Amazon due to its strong growth prospects and short on a company like GameStop due to its struggling business model.
• Fundamental Growth: These tactics utilize fundamental analysis to pinpoint companies anticipated to display substantial growth and value appreciation. The fund then takes a long position in these stocks. On the other hand, the fund will take short positions on companies facing downward pressure in their business models, expected to demonstrate low or negative growth, and encounter capital devaluation.
• Fundamental Value: These strategies leverage fundamental analysis to detect undervalued companies with potential for corporate turnarounds, leading to anticipated future revenue and cash flow growth and, subsequently, higher valuations. The hedge fund acquires long positions in these companies to benefit from projected future stock price increases.
• Short Biased: This involves utilizing quantitative, technical, and fundamental analysis; these strategies involve shorting overvalued equity securities with minimal or no long-side exposures. The anticipation is for the company’s share price to decline, consequently enhancing the profitability of the fund’s portfolio.
• Market Neutral: These strategies use quantitative, fundamental, and technical analysis to identify under and overvalued equity securities. The hedge fund takes long positions in undervalued securities and short positions in overvalued securities while seeking to maintain a market-neutral net position. The intent is to profit from the movements of individual securities, undervalued ones rising and overvalued ones falling. For example, a fund might go long on an undervalued company like IBM and short on an overvalued company like Netflix to maintain a market-neutral position.

Event-driven Strategies

Event-driven strategies involve detailed bottom-up approaches that seek to generate profits from anticipated events that are predicted to alter valuations. These events generally revolve around changes in corporate structure, such as acquisitions or restructurings. For example, a significant event like Microsoft’s acquisition of LinkedIn presents an opportunity for potential gains. These strategies might encompass long and short positions in common and preferred stocks, debt securities, and options.

Event-driven strategies include:

• Merger Arbitrage: This strategy involves going long on the stock of the target company, purchasing at a price below the publicly announced takeover value, and shorting the acquiring company’s stock at the merger or acquisition announcement. For example, if Company A announces its intention to acquire Company B, a hedge fund may buy shares of Company B, expecting a price rise while simultaneously shorting shares of Company A, expecting a price fall. While leverage can amplify potential returns, it also increases losses if the strategy doesn’t succeed.
• Distressed/Restructuring: These strategies focus on securities of companies in distress or nearing bankruptcy. Hedge funds may buy discounted fixed-income securities senior enough to be backed by ample corporate assets. Alternatively, a fund might invest in a debt instrument expected to convert into new equity during restructuring or bankruptcy, known as a fulcrum security. The fund can then decide to hold onto the equity or sell its position.
• Special Situations: These strategies focus on opportunities to acquire shares of companies engaged in specific activities, such as security issuance, repurchase, specialized capital distributions, rescue finance, asset sales, spin-offs, or other catalyst-driven scenarios. For instance, a hedge fund might invest in a company like HP during its split into two separate entities, aiming to profit from the restructuring.
• Activist: Managers in these strategies acquire sufficient equity stakes to secure a board position within the company, enabling them to influence corporate policies or direction. The goal is to initiate business changes that guide the investment toward a desired outcome. For example, an activist hedge fund like Pershing Square might advocate for divestitures, restructuring, or capital distributions to shareholders. These hedge funds differ from private equity as they primarily operate within the public equity market.

Relative Value Strategies

Relative value hedge funds aim to exploit price discrepancies between related financial instruments. For instance, if the price of gold is high in the US but low in the UK, a relative value hedge fund might buy gold in the UK and sell it in the US to profit from the price difference.

• Convertible Bond Arbitrage: This investment strategy aims to remain neutral in the market and capitalize on an identified mispricing between a convertible bond and its components; the underlying bond and the included call option.
• Fixed Income (general): These strategies center on assessing relative value within fixed-income markets, emphasizing sovereign debt and occasionally the comparative pricing of investment-grade corporate debt (known as relative value credit). Tactics may involve long-short trades between distinct issuers, corporate and government issuers, various sections within an issuer’s capital structure, or different segments of an issuer’s yield curve.
• Fixed Income (Asset Backed, mortgage-backed, and High Yield): These strategies emphasize the comparative value among diverse higher-yielding securities. They aim to secure an appealing and well-protected coupon return and capitalize on relative mispricing concerning security and quality. For example, if a mortgage-backed security is trading at a discount to its underlying mortgages, an investor could buy the security and short the individual mortgages, profiting if the security’s price rises or if the mortgages’ prices fall.
• Multi-strategy: These strategies engage in trading based on relative value, both within and among different asset classes or instruments. A multi-strategy manager’s objective is to efficiently and promptly allocate capital across various strategy areas as market conditions evolve. For example, a multi-strategy hedge fund might have one team trading convertible bond arbitrage, another trading relative value in fixed income, and another trading relative value in asset-backed securities, all with the goal of maximizing returns while minimizing risk.

Opportunistic Strategies

Opportunistic hedge funds are flexible and can shift their investment strategies based on market conditions. For example, during a market downturn, an opportunistic hedge fund might shift its strategy to invest in distressed assets, anticipating that these assets will increase in value when the market recovers. The strategies used include:

• Macro Strategies: Using a top-down approach, macro strategies identify economic trends and execute trades based on anticipated shifts in economic indicators. For example, if a macro strategy fund identifies a trend of rising inflation in the United States, it might take a long position in gold, a common hedge against inflation.
• Managed Futures Funds: Managed futures funds are actively managed funds making diversified directional investments primarily in the futures markets on the basis of technical and fundamental strategies. These funds are also known as commodity trading advisers (CTAs) because they historically focused on commodity futures. However, CTAs may include investments in a variety of futures, including commodities, equities, fixed income, and foreign exchange.

Multi-Manager Hedge Funds

Multi-manager hedge funds employ multiple fund managers, each with their own strategy. Many hedge funds trade in a variety of financial instruments, including sovereign and corporate debt, commodities, futures contracts, options, derivatives, and even real estate investments. However, it’s important to note that not all hedge funds maintain short positions or use leverage. Some hedge funds exploit niche areas of expertise in a sophisticated manner, and hedging and leverage may or may not be involved.

There are also funds of hedge funds, which create a diversified portfolio of hedge funds. These are particularly attractive to smaller investors who lack the resources to select individual hedge funds and build a portfolio of them.

Unique Characteristics of Hedge Fund Investments

Hedge funds, unlike traditional investments such as mutual funds or ETFs, possess several unique characteristics that set them apart.

1. Less Legal and Regulatory Flexibility

Hedge funds are subject to fewer legal and regulatory constraints, which allows them more flexibility in their investment strategies. This includes the use of shorting and derivatives, as well as the ability to focus on a larger investment universe.

2. Aggressive Investment Styles

Hedge funds often adopt aggressive investment styles, taking concentrated positions in securities that offer exposure to credit, volatility, and liquidity risk premiums. They also make relatively liberal use of leverage, which can increase the potential for higher returns but also increase risk.

3. Liquidity Constraints

Hedge funds often impose liquidity constraints, such as lockups and liquidity gates, which can limit investors’ ability to withdraw their funds. For instance, a hedge fund might have a one-year lockup period during which investors cannot withdraw their funds, whereas a mutual fund investor can typically redeem their shares on any business day.

4. Higher Fee Structures

Hedge funds typically have higher fee structures involving both management and incentive fees. The incentive fees are designed to align the interests of the fund managers with those of the investors, as they are based on the fund’s performance. For example, a hedge fund might charge a 2% management fee and a 20% performance fee, often referred to as “two and twenty.”

5. Flexible Mandates Permitting the Use of Derivatives

This flexibility allows for more varied investment strategies and the use of specialized tools, like derivatives, shorting, or access to hedge funds, to manage and potentially enhance investment returns.

6. Large Investment Universe

Hedge funds often have the flexibility to invest in various financial markets, assets, and strategies that might not be accessible to other types of investment funds, such as mutual funds. This expansive investment scope allows hedge funds to explore diverse opportunities across different markets, asset classes, and investment instruments.

7. Relative Liberal Use of Leverage

Hedge funds often have fewer regulatory constraints compared to other types of investment funds. They can use borrowed money or derivatives to magnify their positions, enabling them to potentially generate higher returns, but it also comes with increased risk due to the amplified exposure.

Considerations for Choosing a Hedge Fund

Investors should consider several factors when choosing a hedge fund:

• Assess the operational framework, risk management practices, and portfolio performance monitoring of the limited partner capabilities. For instance, a limited partner with a robust operational framework and strong risk management practices would be better equipped to handle market volatility and protect investor capital.
• Evaluate the General Partner (GP) performance, considering their fiduciary management guidelines, manager experience, and alignment of interests towards the fund’s strategies. For example, a GP with a long track record of successful investments and a clear alignment of interests (such as investing their own money in the fund) would be a positive sign.
• Be aware of the potential for fraud, such as Ponzi schemes and false performance data reporting. This is particularly important given the reduced regulatory oversight of hedge funds compared to other investment vehicles.
• Consider the fund’s strategy, transparency, liquidity, and reporting practices. For example, a fund that uses a complex, opaque strategy and has poor liquidity (i.e., it is difficult to withdraw your investment) may be riskier than a fund with a clear strategy and good liquidity.
• Evaluate the fund manager’s past performance and understand how the fund compensates the managers and calculates the fees charged to investors. For instance, a common fee structure is “2 and 20”, where the fund charges 2% of total asset value as a management fee and 20% of profits as a performance fee.

Risks of Hedge Funds

Despite their potential benefits, hedge funds also come with risks. Some of these include:

• Complex strategies that may fail during market turmoil. For example, a hedge fund using a high-leverage strategy could suffer significant losses if the market moves against them.
• Reduced regulatory oversight can open the door for unscrupulous fund managers to exploit investors. This is why due diligence is crucial when selecting a hedge fund.
• Large investments are typically required to participate in a hedge fund. This can make hedge funds inaccessible to smaller investors and can also tie up a significant portion of an investor’s capital, potentially limiting their ability to take advantage of other investment opportunities.

Question #1

A hedge fund manager is considering implementing a long-short equity hedge fund strategy. Which of the following is most likely the primary purpose of this strategy in the context of hedge fund management?

1. To ensure that the hedge fund always has a balanced portfolio of long and short positions.
2. To take advantage of price movements in both directions, potentially generating profits regardless of market conditions.
3. To reduce the risk of the hedge fund’s portfolio by always having an equal number of long and short positions.

The correct answer is B.

The primary purpose of a long-short equity strategy in the context of hedge fund management is to take advantage of price movements in both directions, potentially generating profits regardless of market conditions. This strategy involves buying stocks that are expected to increase in value (long positions) and selling short stocks that are expected to decrease in value (short positions).

The goal is to profit from both rising and falling markets. This strategy is not dependent on the overall direction of the market, making it a potentially effective approach in both bull and bear markets. The long-short equity strategy is a type of absolute return strategy, which seeks to produce positive returns irrespective of the overall market conditions. It is a common strategy used by hedge funds to generate returns and manage risk.

A is incorrect. While a long-short equity strategy does involve maintaining both long and short positions, the primary purpose is not to ensure a balanced portfolio. The balance between long and short positions can vary depending on the fund manager’s outlook on the market and individual stocks. The strategy is more about exploiting opportunities for profit in both rising and falling markets than maintaining a specific balance of long and short positions.

C is incorrect. While a long-short equity strategy can help to reduce risk by providing a hedge against market downturns, the primary purpose is not to reduce risk by always having an equal number of long and short positions. The number of long and short positions can vary, and the strategy is more focused on generating profits from price movements in both directions than on risk reduction.

Question #2

An investor is reviewing the performance of a General Partner (GP) of a hedge fund. The GP has a long track record of successful investments and has shown a clear alignment of interests by investing their own money in the fund. What does this indicate about the GP’s performance and commitment to the fund?

1. The GP is likely to be less committed to the fund’s success because they have their own money at risk.
2. The GP’s successful track record and personal investment in the fund are positive signs of their commitment and potential for continued success.
3. The GP’s past performance does not necessarily indicate future success, and their personal investment does not affect their commitment to the fund.

The correct answer is C.

The GP’s successful track record and personal investment in the fund are indeed positive signs of their commitment and potential for continued success. A General Partner (GP) who invests their own money in the fund they manage is demonstrating a strong alignment of interests with the other investors in the fund. This is often seen as a positive sign by investors, as it indicates that the GP has a personal stake in the fund’s success and is therefore likely to be highly motivated to ensure its performance.

Furthermore, a GP with a long track record of successful investments is likely to have developed a strong set of investment skills and strategies, which could potentially contribute to the continued success of the fund. However, it’s important to note that past performance is not a guarantee of future results, and all investments carry some level of risk.

A is incorrect. The assertion that the GP is likely to be less committed to the fund’s success because they have their own money at risk is counterintuitive. In fact, the opposite is generally true: a GP who has invested their own money in the fund is likely to be more committed to its success, as they have a personal financial stake in the outcome.

C is incorrect. While it’s true that a GP’s past performance does not necessarily indicate future success, their personal investment in the fund can indeed affect their commitment to the fund. As mentioned above, a GP who invests their own money in the fund is demonstrating a strong alignment of interests with the other investors, which is generally seen as a positive sign of their commitment to the fund’s success.