2/17/2015

AboutHedgeFundsWhatisaHedgeFund?

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AboutHedgeFunds

WhatisaHedgeFund?

WhatIsaHedgeFund?
HedgingStrategies
HedgeFundStyles
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Ahedgefundisafundthatcantakebothlongandshortpositions,usearbitrage,buyandsell
undervaluedsecurities,tradeoptionsorbonds,andinvestinalmostanyopportunityinanymarket
whereitforeseesimpressivegainsatreducedrisk.Hedgefundstrategiesvaryenormouslymany
hedgeagainstdownturnsinthemarketsespeciallyimportanttodaywithvolatilityandanticipationof
correctionsinoverheatedstockmarkets.Theprimaryaimofmosthedgefundsistoreducevolatilityand
riskwhileattemptingtopreservecapitalanddeliverpositivereturnsunderallmarketconditions.
Thereareapproximately14distinctinvestmentstrategiesusedbyhedgefunds,eachofferingdifferent
degreesofriskandreturn.Amacrohedgefund,forexample,investsinstockandbondmarketsandother
investmentopportunities,suchascurrencies,inhopesofprofitingonsignificantshiftsinsuchthingsas
globalinterestratesandcountrieseconomicpolicies.Amacrohedgefundismorevolatilebutpotentially
fastergrowingthanadistressedsecuritieshedgefundthatbuystheequityordebtofcompaniesaboutto
enterorexitfinancialdistress.Anequityhedgefundmaybeglobalorcountryspecific,hedgingagainst
downturnsinequitymarketsbyshortingovervaluedstocksorstockindexes.Arelativevaluehedgefund
takesadvantageofpriceorspreadinefficiencies.Knowingandunderstandingthecharacteristicsofthe
manydifferenthedgefundstrategiesisessentialtocapitalizingontheirvarietyofinvestment
opportunities.
Itisimportanttounderstandthedifferencesbetweenthevarioushedgefundstrategiesbecauseall
hedgefundsarenotthesameinvestmentreturns,volatility,andriskvaryenormouslyamongthe
differenthedgefundstrategies.Somestrategieswhicharenotcorrelatedtoequitymarketsareableto
deliverconsistentreturnswithextremelylowriskofloss,whileothersmaybeasormorevolatilethan
mutualfunds.Asuccessfulfundoffundsrecognizesthesedifferencesandblendsvariousstrategiesand
assetclassestogethertocreatemorestablelongterminvestmentreturnsthananyoftheindividualfunds.
Hedgefundstrategiesvaryenormouslymany,butnotall,hedgeagainstmarketdownturns
especiallyimportanttodaywithvolatilityandanticipationofcorrectionsinoverheatedstockmarkets.
Theprimaryaimofmosthedgefundsistoreducevolatilityandriskwhileattemptingtopreserve
capitalanddeliverpositive(absolute)returnsunderallmarketconditions.
Thepopularmisconceptionisthatallhedgefundsarevolatilethattheyalluseglobalmacro
strategiesandplacelargedirectionalbetsonstocks,currencies,bonds,commoditiesorgold,while
usinglotsofleverage.Inreality,lessthan5%ofhedgefundsareglobalmacrofunds.Mosthedge
fundsusederivativesonlyforhedgingordontusederivativesatall,andmanyusenoleverage.
KeyCharacteristicsofHedgeFunds
Hedgefundsutilizeavarietyoffinancialinstrumentstoreducerisk,enhancereturnsandminimize
thecorrelationwithequityandbondmarkets.Manyhedgefundsareflexibleintheirinvestment
options(canuseshortselling,leverage,derivativessuchasputs,calls,options,futures,etc.).
Hedgefundsvaryenormouslyintermsofinvestmentreturns,volatilityandrisk.Many,butnotall,
hedgefundstrategiestendtohedgeagainstdownturnsinthemarketsbeingtraded.
Manyhedgefundshavetheabilitytodelivernonmarketcorrelatedreturns.
Manyhedgefundshaveasanobjectiveconsistencyofreturnsandcapitalpreservationratherthan
magnitudeofreturns.
Mosthedgefundsaremanagedbyexperiencedinvestmentprofessionalswhoaregenerally
disciplinedanddiligent.
Pensionfunds,endowments,insurancecompanies,privatebanksandhighnetworthindividuals
andfamiliesinvestinhedgefundstominimizeoverallportfoliovolatilityandenhancereturns.
Mosthedgefundmanagersarehighlyspecializedandtradeonlywithintheirareaofexpertiseand
competitiveadvantage.
Hedgefundsbenefitbyheavilyweightinghedgefundmanagersremunerationtowards
performanceincentives,thusattractingthebestbrainsintheinvestmentbusiness.Inaddition,

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hedgefundmanagersusuallyhavetheirownmoneyinvestedintheirfund.
FactsAbouttheHedgeFundIndustry
Estimatedtobea$1trillionindustryandgrowingatabout20%peryearwithapproximately8350
activehedgefunds.
Includesavarietyofinvestmentstrategies,someofwhichuseleverageandderivativeswhileothers
aremoreconservativeandemploylittleornoleverage.Manyhedgefundstrategiesseektoreduce
marketriskspecificallybyshortingequitiesorthroughtheuseofderivatives.
Mosthedgefundsarehighlyspecialized,relyingonthespecificexpertiseofthemanageror
managementteam.
Performanceofmanyhedgefundstrategies,particularlyrelativevaluestrategies,isnotdependent
onthedirectionofthebondorequitymarketsunlikeconventionalequityormutualfunds(unit
trusts),whicharegenerally100%exposedtomarketrisk.
Manyhedgefundstrategies,particularlyarbitragestrategies,arelimitedastohowmuchcapital
theycansuccessfullyemploybeforereturnsdiminish.Asaresult,manysuccessfulhedgefund
managerslimittheamountofcapitaltheywillaccept.
Hedgefundmanagersaregenerallyhighlyprofessional,disciplinedanddiligent.
Theirreturnsoverasustainedperiodoftimehaveoutperformedstandardequityandbondindexes
withlessvolatilityandlessriskoflossthanequities.
Beyondtheaverages,therearesometrulyoutstandingperformers.
Investinginhedgefundstendstobefavoredbymoresophisticatedinvestors,includingmanySwiss
andotherprivatebanks,thathavelivedthrough,andunderstandtheconsequencesof,majorstock
marketcorrections.
Anincreasingnumberofendowmentsandpensionfundsallocateassetstohedgefunds.
HedgingStrategies
Awiderangeofhedgingstrategiesareavailabletohedgefunds.Forexample:
sellingshortsellingshareswithoutowningthem,hopingtobuythembackatafuturedateata
lowerpriceintheexpectationthattheirpricewilldrop.
usingarbitrageseekingtoexploitpricinginefficienciesbetweenrelatedsecuritiesforexample,
canbelongconvertiblebondsandshorttheunderlyingissuersequity.
tradingoptionsorderivativescontractswhosevaluesarebasedontheperformanceofany
underlyingfinancialasset,indexorotherinvestment.
investinginanticipationofaspecificeventmergertransaction,hostiletakeover,spinoff,exitingof
bankruptcyproceedings,etc.
investingindeeplydiscountedsecuritiesofcompaniesabouttoenterorexitfinancialdistressor
bankruptcy,oftenbelowliquidationvalue.
Manyofthestrategiesusedbyhedgefundsbenefitfrombeingnoncorrelatedtothedirectionof
equitymarkets
PopularMisconception
Thepopularmisconceptionisthatallhedgefundsarevolatilethattheyalluseglobalmacrostrategies
andplacelargedirectionalbetsonstocks,currencies,bonds,commodities,andgold,whileusinglotsof
leverage.Inreality,lessthan5%ofhedgefundsareglobalmacrofunds.Mosthedgefundsusederivatives
onlyforhedgingordon'tusederivativesatall,andmanyusenoleverage.
BenefitsofHedgeFunds
Manyhedgefundstrategieshavetheabilitytogeneratepositivereturnsinbothrisingandfalling
equityandbondmarkets.
Inclusionofhedgefundsinabalancedportfolioreducesoverallportfolioriskandvolatilityand
increasesreturns.
Hugevarietyofhedgefundinvestmentstylesmanyuncorrelatedwitheachotherprovides
investorswithawidechoiceofhedgefundstrategiestomeettheirinvestmentobjectives.
Academicresearchproveshedgefundshavehigherreturnsandloweroverallriskthantraditional
investmentfunds.
Hedgefundsprovideanideallongterminvestmentsolution,eliminatingtheneedtocorrectlytime
entryandexitfrommarkets.
Addinghedgefundstoaninvestmentportfolioprovidesdiversificationnototherwiseavailablein
traditionalinvesting.
HedgeFundStyles
Thepredictabilityoffutureresultsshowsastrongcorrelationwiththevolatilityofeach
strategy.Futureperformanceofstrategieswithhighvolatilityisfarlesspredictablethanfuture
performancefromstrategiesexperiencinglowormoderatevolatility.
AggressiveGrowth:Investsinequitiesexpectedtoexperienceaccelerationingrowthofearnings
pershare.GenerallyhighP/Eratios,lowornodividendsoftensmallerandmicrocapstockswhich
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areexpectedtoexperiencerapidgrowth.Includessectorspecialistfundssuchastechnology,
banking,orbiotechnology.Hedgesbyshortingequitieswhereearningsdisappointmentisexpected
orbyshortingstockindexes.Tendstobe"longbiased."ExpectedVolatility:High
DistressedSecurities:Buysequity,debt,ortradeclaimsatdeepdiscountsofcompaniesinor
facingbankruptcyorreorganization.Profitsfromthemarket'slackofunderstandingofthetruevalue
ofthedeeplydiscountedsecuritiesandbecausethemajorityofinstitutionalinvestorscannotown
belowinvestmentgradesecurities.(Thissellingpressurecreatesthedeepdiscount.)Results
generallynotdependentonthedirectionofthemarkets.ExpectedVolatility:LowModerate

EmergingMarkets:Investsinequityordebtofemerging(lessmature)marketsthattendtohave
higherinflationandvolatilegrowth.Shortsellingisnotpermittedinmanyemergingmarkets,and,
therefore,effectivehedgingisoftennotavailable,althoughBradydebtcanbepartiallyhedgedvia
U.S.Treasuryfuturesandcurrencymarkets.ExpectedVolatility:VeryHigh
FundsofHedgeFunds:Mixandmatchhedgefundsandotherpooledinvestmentvehicles.This
blendingofdifferentstrategiesandassetclassesaimstoprovideamorestablelongterm
investmentreturnthananyoftheindividualfunds.Returns,risk,andvolatilitycanbecontrolledby
themixofunderlyingstrategiesandfunds.Capitalpreservationisgenerallyanimportant
consideration.Volatilitydependsonthemixandratioofstrategiesemployed.ExpectedVolatility:
LowModerateHigh
Income:Investswithprimaryfocusonyieldorcurrentincomeratherthansolelyoncapitalgains.
Mayutilizeleveragetobuybondsandsometimesfixedincomederivativesinordertoprofitfrom
principalappreciationandinterestincome.ExpectedVolatility:Low
Macro:Aimstoprofitfromchangesinglobaleconomies,typicallybroughtaboutbyshiftsin
governmentpolicythatimpactinterestrates,inturnaffectingcurrency,stock,andbondmarkets.
Participatesinallmajormarketsequities,bonds,currenciesandcommoditiesthoughnot
alwaysatthesametime.Usesleverageandderivativestoaccentuatetheimpactofmarketmoves.
Utilizeshedging,buttheleverageddirectionalinvestmentstendtomakethelargestimpacton
performance.ExpectedVolatility:VeryHigh
MarketNeutralArbitrage:Attemptstohedgeoutmostmarketriskbytakingoffsettingpositions,
oftenindifferentsecuritiesofthesameissuer.Forexample,canbelongconvertiblebondsand
shorttheunderlyingissuersequity.Mayalsousefuturestohedgeoutinterestraterisk.Focuseson
obtainingreturnswithlowornocorrelationtoboththeequityandbondmarkets.Theserelative
valuestrategiesincludefixedincomearbitrage,mortgagebackedsecurities,capitalstructure
arbitrage,andclosedendfundarbitrage.ExpectedVolatility:Low
MarketNeutralSecuritiesHedging:Investsequallyinlongandshortequityportfoliosgenerally
inthesamesectorsofthemarket.Marketriskisgreatlyreduced,buteffectivestockanalysisand
stockpickingisessentialtoobtainingmeaningfulresults.Leveragemaybeusedtoenhance
returns.Usuallylowornocorrelationtothemarket.Sometimesusesmarketindexfuturestohedge
outsystematic(market)risk.RelativebenchmarkindexusuallyTbills.ExpectedVolatility:Low
MarketTiming:Allocatesassetsamongdifferentassetclassesdependingonthemanager'sview
oftheeconomicormarketoutlook.Portfolioemphasismayswingwidelybetweenassetclasses.
Unpredictabilityofmarketmovementsandthedifficultyoftimingentryandexitfrommarketsaddto
thevolatilityofthisstrategy.ExpectedVolatility:High
Opportunistic:Investmentthemechangesfromstrategytostrategyasopportunitiesarisetoprofit
fromeventssuchasIPOs,suddenpricechangesoftencausedbyaninterimearnings
disappointment,hostilebids,andothereventdrivenopportunities.Mayutilizeseveralofthese
investingstylesatagiventimeandisnotrestrictedtoanyparticularinvestmentapproachorasset
class.ExpectedVolatility:Variable
MultiStrategy:Investmentapproachisdiversifiedbyemployingvariousstrategiessimultaneously
torealizeshortandlongtermgains.Otherstrategiesmayincludesystemstradingsuchastrend
followingandvariousdiversifiedtechnicalstrategies.Thisstyleofinvestingallowsthemanagerto
overweightorunderweightdifferentstrategiestobestcapitalizeoncurrentinvestmentopportunities.
ExpectedVolatility:Variable
ShortSelling:Sellssecuritiesshortinanticipationofbeingabletorebuythematafuturedateata
lowerpriceduetothemanager'sassessmentoftheovervaluationofthesecurities,orthemarket,or
inanticipationofearningsdisappointmentsoftenduetoaccountingirregularities,newcompetition,
changeofmanagement,etc.Oftenusedasahedgetooffsetlongonlyportfoliosandbythosewho
feelthemarketisapproachingabearishcycle.Highrisk.ExpectedVolatility:VeryHigh
SpecialSituations:Investsineventdrivensituationssuchasmergers,hostiletakeovers,
reorganizations,orleveragedbuyouts.Mayinvolvesimultaneouspurchaseofstockincompanies
beingacquired,andthesaleofstockinitsacquirer,hopingtoprofitfromthespreadbetweenthe
currentmarketpriceandtheultimatepurchasepriceofthecompany.Mayalsoutilizederivativesto

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leveragereturnsandtohedgeoutinterestrateand/ormarketrisk.Resultsgenerallynotdependent
ondirectionofmarket.ExpectedVolatility:Moderate
Value:Investsinsecuritiesperceivedtobesellingatdeepdiscountstotheirintrinsicorpotential
worth.Suchsecuritiesmaybeoutoffavororunderfollowedbyanalysts.Longtermholding,
patience,andstrongdisciplineareoftenrequireduntiltheultimatevalueisrecognizedbythe
market.ExpectedVolatility:LowModerate
WhatisaFundofHedgeFunds?
Adiversifiedportfolioofgenerallyuncorrelatedhedgefunds.
Maybewidelydiversified,orsectororgeographicallyfocused.
Seekstodelivermoreconsistentreturnsthanstockportfolios,mutualfunds,unittrustsor
individualhedgefunds.
Preferredinvestmentofchoiceformanypensionfunds,endowments,insurancecompanies,
privatebanksandhighnetworthfamiliesandindividuals.
Providesaccesstoabroadrangeofinvestmentstyles,strategiesandhedgefundmanagers
foroneeasytoadministerinvestment.
Providesmorepredictablereturnsthantraditionalinvestmentfunds.
Provideseffectivediversificationforinvestmentportfolios.
BenefitsofaHedgeFundofFunds
Providesaninvestmentportfoliowithlowerlevelsofriskandcandeliverreturns
uncorrelatedwiththeperformanceofthestockmarket.
Deliversmorestablereturnsundermostmarketconditionsduetothefundoffund
managersabilityandunderstandingofthevarioushedgestrategies.
Significantlyreducesindividualfundandmanagerrisk.
Eliminatestheneedfortimeconsumingduediligenceotherwiserequiredformakinghedge
fundinvestmentdecisions.
Allowsforeasieradministrationofwidelydiversifiedinvestmentsacrossalargevarietyof
hedgefunds.
Allowsaccesstoabroaderspectrumofleadinghedgefundsthatmayotherwisebe
unavailableduetohighminimuminvestmentrequirements.
Isanidealwaytogainaccesstoawidevarietyofhedgefundstrategies,managedbymany
oftheworldspremierinvestmentprofessionals,forarelativelymodestinvestment.

LearnMoreAboutHedgeFunds
WhatIsaHedgeFund?
WhatAretheDifferentHedgeFundStrategies?
HedgeFundStyles
AdvantagesofHedgeFundsOverMutualFunds
BenefitsofHedgeFunds
WhatIsaFundofHedgeFunds?
BenefitsofaFundofHedgeFunds
HedgeFundArticles
TakingtheMysteryOutofHedgeFunds
ByDionFriedland,Chairman,MagnumFunds
Viewthisarticleinanyofthefollowinglanguages:

OtherArticlesByDionFriedland,Chairman,MagnumFunds:
HedgeFunds:ProtectionAgainstanAgingBull
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TheCaseforConvertibles
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ReducingMarketRiskWithMergerArbitrage
DistressedSecuritiesInvesting
PrivatetoPublicInvesting
GlobalMacroInvesting
MarketNeutralLong/ShortEquityTrading

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