Introduction To Hedge Funds - Part Two

In Part One of this series, we explain that hedge fund managers actively manage investment portfolios with a goal of absolute returns regardless of overall market or index movements. Hedge funds, however, conduct their trading strategies with more freedom than a mutual fund, typically avoiding registration with the Securities & Exchange Commission (SEC). In this part of the series, we qualify hedge funds' potential for higher returns, examine their volatility patterns, and take a look at funds of hedge funds, identifying their advantages and disadvantages.

There are two basic reasons for investing in a hedge fund: to seek higher net returns (net of management and performance fees) and/or to seek diversification.

Potential for Higher Returns, Especially in a Bear Market
Higher returns are hardly guaranteed. As discussed in Part I, most hedge funds invest in the same securities available to mutual funds and individual investors. You can therefore only reasonably expect higher returns if you select a superior manager or pick a timely strategy. Many experts argue that selecting a talented manager is the only thing that really matters. This helps to explain why hedge fund strategies are not scalable, meaning bigger is not better. With mutual funds, an investment process can be replicated and taught to new managers, but many hedge funds are built around individual "stars", and genius is difficult to clone. For this reason, some of the better funds are likely to be small.

A timely strategy is also critical. The often cited statistics from CSFB/Tremont in regard to hedge fund performance during the 1990s are revealing. From January 1994 to September 2000 - a raging bull market by any definition - the passive S&P 500 index outperformed every major hedge fund strategy by a whopping 6% in annualized return. But particular strategies performed very differently. For example, dedicated short strategies suffered badly, but market neutral strategies outperformed the S&P 500 index in risk-adjusted terms (i.e. underperformed in annualized return but incurred less than one-fourth the risk). If your market outlook is bullish, you will need a specific reason to expect a hedge fund to beat the index. Conversely, if your outlook is bearish, hedge funds should be an attractive asset class compared to buy-and-hold or long-only mutual funds.

Diversification Benefits
Many institutions invest in hedge funds for the diversification benefits. If you have a portfolio of investments, adding uncorrelated (and positive-returning) assets will reduce total portfolio risk. Hedge funds - because they employ derivatives, short sales or non-equity investments - tend to be uncorrelated with broad stock market indices. But again, correlation varies by strategy. Historical correlation data (e.g. over the 1990s) remains somewhat consistent, and here is a reasonable hierarchy:










Fat Tails Are the Problem
Hedge fund investors are exposed to multiple risks, and each strategy has its own unique risks. For example, long/short funds are exposed to the short-squeeze.

The traditional measure of risk is volatility, that is, the annualized standard deviation of returns. Surprisingly, most academic studies demonstrate that hedge funds, on average, are less volatile than the market. For example, over the bull market period we referred to earlier, volatility of the S&P 500 was about 14% while volatility of the aggregated hedge funds was only about 10%. That is, about two-thirds of the time, we might have expected returns to be within 10% of the average return. In risk-adjusted terms, as measured by the Sharpe ratio (unit of excess return per unit of risk), some strategies outperformed the S&P 500 index over the bull market period mentioned earlier.

The problem is that hedge fund returns do not follow the symmetrical return paths implied by traditional volatility. Instead, hedge fund returns tend to be skewed. Specifically, they tend to be negatively skewed, which means they bear the dreaded "fat tails", which are mostly characterized by positive returns but a few cases of extreme losses. For this reason, measures of downside risk can be more useful than volatility or Sharpe ratio. Downside risk measures, such as value at risk (VaR), focus only on the left side of the return distribution curve where losses occur. They answer questions such as, "What are the odds that I lose 15% of the principal in one year?"

















Funds of Hedge Funds
Because investing in a single hedge fund requires time-consuming due diligence and concentrates risk, funds of hedge funds have become popular. These are pooled funds that allocate their capital among several hedge funds, usually in the neighborhood of 15 to 25 different hedge funds. Unlike the underlying hedge funds, these vehicles are often registered with the SEC and promoted to individual investors. Sometimes called a "retail" fund of funds, the net worth and income tests may be lower than usual.














The advantages of funds of hedge funds include automatic diversification, monitoring efficiency and selection expertise. Because these funds are invested in a minimum of around eight funds, the failure or underperformance of one hedge fund will not ruin the whole. As the funds of funds are supposed to monitor and conduct due diligence on their holdings, their investors should in theory be exposed only to reputable hedge funds. Finally, these funds of hedge funds are often good at sourcing talented or undiscovered managers who may be "under the radar" of the broader investment community. In fact, the business model of the fund of funds hinges on identifying talented managers and pruning the portfolio of underperforming managers.

The biggest disadvantage is cost, because these funds create a double-fee structure. Typically, you pay a management fee (and maybe even a performance fee) to the fund manager in addition to fees normally paid to the underlying hedge funds. Arrangements vary, but you might pay a 1% management fee to both the fund of funds and the underlying hedge funds. In regards to performance fees, the underlying hedge funds may charge 20% of their profits, and it is not unusual for the fund of funds to charge an additional 10%. Under this typical arrangement, you would pay 2% annually plus 30% of the gains. This makes cost a serious issue, even though the 2% management fee by itself is only about 50 basis points higher than the average small cap mutual fund (i.e. about 1.5%).

Another important and underestimated risk is the potential for over-diversification. A fund of hedge funds needs to coordinate its holdings or it will not add value: if it is not careful, it may inadvertently collect a group of hedge funds that duplicates its various holdings or - even worse - ends up constituting a representative sample of the entire market. Too many single hedge fund holdings (with the aim of diversification) are likely to erode the benefits of active management, while incurring the double-fee structure in the meantime! Various studies have been conducted, but the "sweet spot" seems to be around eight to 15 hedge funds.

Conclusion - Questions to Ask
After reading this introductory series to hedge funds, you are no doubt aware that there are important questions to ask before investing in a hedge fund or a fund of hedge funds. Look before you leap and make sure you do your research.

Here is a list of questions to consider as you get started:

* Who are the founders and the principals? What are their backgrounds and credentials? How long before the founders/principals expect to retire?
* How long has the fund been in business? What is the ownership structure? (e.g. Is it a limited liability company? Who are the managing members? Are classes of shares issued?)
* What is the fee structure and how are principals/employees compensated?
* What is the basic investment strategy (must be more specific than proprietary)?
* How often is valuation performed and how often are reports produced for investors (or limited partners)?
* What are the liquidity provisions? (e.g. What is the lock-out period?)
* How does the fund measure and assess risk (e.g. VaR)? What is the track record in regard to risk?
* Who are the references?


by David Harper
In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder of The Bionic Turtle, a site that trains professionals in advanced and career-related finance, including financial certification. David was a founding co-editor of the Investopedia Advisor, where his original portfolios (core, growth and technology value) led to superior outperformance (+35% in the first year) with minimal risk and helped to successfully launch Advisor.

He is the principal of Investor Alternatives, a firm that conducts quantitative research, consulting (derivatives valuation), litigation support and financial education.

READ MORE - Introduction To Hedge Funds - Part Two

Introduction To Hedge Funds - Part One

Hedge funds are like mutual funds in two respects: (1) they are pooled investment vehicles (i.e. several investors entrust their money to a manager) and (2) they invest in publicly traded securities. But there are important differences between a hedge fund and a mutual fund. These stem from and are best understood in light of the hedge fund's charter: investors give hedge funds the freedom to pursue absolute return strategies.

Mutual Funds Seek Relative Returns
Most mutual funds invest in a predefined style, such as "small cap value", or into a particular sector, such as the Internet sector. To measure performance, the mutual fund's returns are compared to a style-specific index or benchmark. For example, if you buy into a "small cap value" fund, the managers of that fund may try to outperform the S&P Small Cap 600 Index. Less active managers might construct the portfolio by following the index and then applying stock-picking skills to increase (over-weigh) favored stocks and decrease (under-weigh) less appealing stocks.

A mutual fund's goal is to beat the index or "beat the bogey", even if only modestly. If the index is down 10% while the mutual fund is down only 7%, the fund's performance would be called a success. On the passive-active spectrum, on which pure index investing is the passive extreme, mutual funds lie somewhere in the middle as they semi-actively aim to generate returns that are favorable compared to a benchmark.

Hedge Funds Actively Seek Absolute Returns
Hedge funds lie at the active end of the investing spectrum as they seek positive absolute returns, regardless of the performance of an index or sector benchmark. Unlike mutual funds, which are "long-only" (make only buy-sell decisions), a hedge fund engages in more aggressive strategies and positions, such as short selling, trading in derivative instruments like options and using leverage (borrowing) to enhance the risk/reward profile of their bets.

This activeness of hedge funds explains their popularity in bear markets. In a bull market, hedge funds may not perform as well as mutual funds, but in a bear market - taken as a group or asset class - they should do better than mutual funds because they hold short positions and hedges. The absolute return goals of hedge funds vary, but a goal might be stated as something like "6 to 9% annualized return regardless of the market conditions".

Investors, however, need to understand that the hedge-fund promise of pursuing absolute returns means hedge funds are "liberated" with respect to registration, investment positions, liquidity and fee structure. First, hedge funds in general are not registered with the SEC. They have been able to avoid registration by limiting the number of investors and requiring that their investors be accredited, which means they meet an income or net worth standard. Furthermore, hedge funds are prohibited from soliciting or advertising to a general audience, a prohibition that lends to their mystique.

In hedge funds, liquidity is a key concern for investors. Liquidity provisions vary, but invested funds may be difficult to withdraw "at will". For example, many funds have a lock-out period, which is an initial period of time during which investors cannot remove their money.

Lastly, hedge funds are more expensive even though a portion of the fees are performance-based. Typically, they charge an annual fee equal to 1% of assets managed (sometimes up to 2%), plus they receive a share - usually 20% - of the investment gains. The managers of many funds, however, invest their own money along with the other investors of the fund and, as such, may be said to "eat their own cooking".

Three Broad Categories and Many Strategies
Most hedge funds are entrepreneurial organizations that employ proprietary or well-guarded strategies. The three broad hedge fund categories are based on the types of strategies they use:
1. Arbitrage Strategies (A.K.A., Relative Value)
Arbitrage is the exploitation of an observable price inefficiency and, as such, pure arbitrage is considered riskless. Consider a very simple example. Say Acme stock currently trades at $10 and a single stock futures contract due in six months is priced at $14. The futures contract is a promise to buy or sell the stock at a predetermined price. So by purchasing the stock and simultaneously selling the futures contract, you can, without taking on any risk, lock in a $4 gain before transaction and borrowing costs.

In practice, arbitrage is more complicated, but three trends in investing practices have opened up the possibility of all sorts of arbitrage strategies: the use of (1) derivative instruments, (2) trading software, and (3) various trading exchanges (for example, electronic communication networks and foreign exchanges make it possible to take advantage of "exchange arbitrage", the arbitraging of prices among different exchanges).

Only a few hedge funds are pure arbitrageurs, but when they are, historical studies often prove they are a good source of low-risk reliably-moderate returns. But, because observable price inefficiencies tend to be quite small, pure arbitrage requires large, usually leveraged investments and high turnover. Further, arbitrage is perishable and self-defeating: if a strategy is too successful, it gets duplicated and gradually disappears.

Most so-called arbitrage strategies are better labeled "relative value". These strategies do try to capitalize on price differences, but they are not risk free. For example, convertible arbitrage entails buying a corporate convertible bond, which can be converted into common shares, while simultaneously selling short the common stock of the same company that issued the bond. This strategy tries to exploit the relative prices of the convertible bond and the stock: the arbitrageur of this strategy would think the bond is a little cheap and the stock is a little expensive. The idea is to make money from the bond's yield if the stock goes up but also make money from the short sale if the stock goes down. However, as the convertible bond and the stock can move independently, the arbitrageur can lose on both the bond and the stock, which means the position carries risk.

2. Event-Driven Strategies
Event-driven strategies take advantage of transaction announcements and other one-time events. One example is merger arbitrage, which is used in the event of an acquisition announcement and involves buying the stock of the target company and hedging the purchase by selling short the stock of the acquiring company. Usually at announcement, the purchase price that the acquiring company will pay to buy its target exceeds the current trading price of the target company. The merger arbitrageur bets the acquisition will happen and cause the target company's price to converge (rise) to the purchase price that the acquiring company pays. This also is not pure arbitrage. If the market happens to frown on the deal, the acquisition may unravel and send the stock of the acquirer up (in relief) and the target company's stock down (wiping out the temporary bump) which would cause a loss for the position.

There are various types of event-driven strategies. One other example is "distressed securities", which involves investing in companies that are re-organizing or have been unfairly beaten down. Another interesting type of event-driven fund is the activist fund, which is predatory in nature. This type takes sizeable positions in small, flawed companies and then uses its ownership to force management changes or a restructuring of the balance sheet.

3. Directional or Tactical Strategies
The largest group of hedge funds uses directional or tactical strategies. One example is the macro fund, made famous by George Soros and his Quantum Fund, which dominated the hedge fund universe and newspaper headlines in the 1990s. Macro funds are global, making "top-down" bets on currencies, interest rates, commodities or foreign economies. Because they are for "big picture" investors, macro funds often do not analyze individual companies.

Here are some other examples of directional or tactical strategies:
• Long/short strategies combine purchases (long positions) with short sales. For example, a long/short manager might purchase a portfolio of core stocks that occupy the S&P 500 and hedge by selling (shorting) S&P 500 Index futures. If the S&P 500 goes down, the short position will offset the losses in the core portfolio, limiting overall losses.

• Market neutral strategies are a specific type of long/short whose goal is to negate the impact and risk of general market movements, trying to isolate the pure returns of individual stocks. This type of strategy is a good example of how hedge funds can aim for positive, absolute returns even in a bear market. For example, a market neutral manager might purchase Lowe's and simultaneously short Home Depot, betting that the former will outperform the latter. The market could go down and both stocks could go down along with the market, but as long as Lowe's outperforms Home Depot, the short sale on Home Depot will produce a net profit for the position.

• Dedicated short strategies specialize in the short sale of over-valued securities. Because losses on short-only positions are theoretically unlimited (because the stock can rise indefinitely), these strategies are particularly risky. Some of these dedicated short funds are among the first to foresee corporate collapses - the managers of these funds can be particularly skilled at scrutinizing company fundamentals and financial statements in search of red flags.
Conclusion
You should now have a firm grasp of the differences between mutual and hedge funds and understand the various strategies hedge funds implement to try to achieve absolute returns. Next (in Part Two of this series), we will review the "fund of hedge funds vehicle", highlight the risk/reward features of hedge fund investing, and propose key questions to ask when considering a hedge fund investment.

by David Harper
In addition to writing for Investopedia, David Harper, CFA, FRM, is the founder of The Bionic Turtle, a site that trains professionals in advanced and career-related finance, including financial certification. David was a founding co-editor of the Investopedia Advisor, where his original portfolios (core, growth and technology value) led to superior outperformance (+35% in the first year) with minimal risk and helped to successfully launch Advisor.

He is the principal of Investor Alternatives, a firm that conducts quantitative research, consulting (derivatives valuation), litigation support and financial education.

READ MORE - Introduction To Hedge Funds - Part One

A Beginner's Guide To Hedging

Although it sounds like it might be the hobby of your neighbor obsessed with his topiary garden full of tall bushes shaped like giraffes and dinosaurs, hedging is a practice every investor should know about - there is no arguing that portfolio protection is often just as important as portfolio appreciation. Like your neighbor's obsession, however, hedging is talked about more than it is explained, making it seem as though it belongs only to the most esoteric financial realms. Well, even if you are a beginner, you can learn what hedging is, how it works and what hedging techniques investors and companies use to protect themselves.

What Is Hedging?
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.

Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.

Technically, to hedge you would invest in two securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another.

Although some of us may fantasize about a world where profit potentials are limitless but also risk free, hedging can't help us escape the hard reality of the risk-return tradeoff. A reduction in risk will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you will have typically reduced the profit that you could have made, and if the investment loses money, your hedge, if successful, will reduce that loss.

How Do Investors Hedge?
Hedging techniques generally involve the use of complicated financial instruments known as derivatives, the two most common of which are options and futures. We're not going to get into the nitty-gritty of describing how these instruments work, but for now just keep in mind that with these instruments you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Let's see how this works with an example. Say you own shares of Cory's Tequila Corporation (Ticker: CTC). Although you believe in this company for the long run, you are a little worried about some short-term losses in the Tequila industry. To protect yourself from a fall in CTC you can buy a put option (a derivative) on the company, which gives you the right to sell CTC at a specific price (strike price). This strategy is known as a married put. If your stock price tumbles below the strike price, these losses will be offset by gains in the put option. (For more information, see this article on married puts or this options basics tutorial.)

The other classic hedging example involves a company that depends on a certain commodity. Let's say Cory's Tequila Corporation is worried about the volatility in the price of agave, the plant used to make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which would eat into profit margins severely. To protect (hedge) against the uncertainty of agave prices, CTC can enter into a futures contract (or its less regulated cousin, the foreward contract), which allows the company to buy the agave at a specific price at a set date in the future. Now CTC can budget without worrying about the fluctuating commodity.

If the agave skyrockets above that price specified by the futures contract, the hedge will have paid off because CTC will save money by paying the lower price. However, if the price goes down, CTC is still obligated to pay the price in the contract and actually would have been better off not hedging.

Keep in mind that because there are so many different types of options and futures contracts an investor can hedge against nearly anything, whether a stock, commodity price, interest rate and currency - investors can even hedge against the weather.

The Downside
Every hedge has a cost, so before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of hedging isn't to make money but to protect from losses. The cost of the hedge - whether it is the cost of an option or lost profits from being on the wrong side of a futures contract - cannot be avoided. This is the price you have to pay to avoid uncertainty.

We've been comparing hedging versus insurance, but we should emphasize that insurance is far more precise than hedging. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn't a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice.

What Hedging Means to You
The majority of investors will never trade a derivative contract in their life. In fact most buy-and-hold investors ignore short-term fluctuation altogether. For these investors there is little point in engaging in hedging because they let their investments grow with the overall market.

So why learn about hedging?

Even if you never hedge for your own portfolio you should understand how it works because many big companies and investment funds will hedge in some form. Oil companies, for example, might hedge against the price of oil while an international mutual fund might hedge against fluctuations in foreign exchange rates. An understanding of hedging will help you to comprehend and analyze these investments.

Conclusion
Risk is an essential yet precarious element of investing. Regardless of what kind of investor one aims to be, having a basic knowledge of hedging strategies will lead to better awareness of how investors and companies work to protect themselves. Whether or not you decide to start practicing the intricate uses of derivatives, learning about how hedging works will help advance your understanding the market, which will always help you be a better investor.

by Investopedia Staff,
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including more than 1,200 original and objective articles and tutorials on a wide variety of financial topics.

READ MORE - A Beginner's Guide To Hedging