Hedge Funds: Exploring Their Investment Strategies And Secrets

Hedge funds are pooled investment funds that aim to maximise returns and protect against market losses by investing in a wide range of assets. They are considered alternative investments, employing complex trading and risk management techniques to improve performance and insulate returns from market risk.

Hedge funds are often structured as limited partnerships, with investors acting as limited partners and the fund acting as a general partner. They are managed by professional fund managers, who employ a range of strategies, including leverage and the trading of non-traditional assets, to earn above-average investment returns.

Hedge funds are considered high-risk and are typically only available to accredited investors with a high net worth or annual income. They charge higher fees than conventional investment funds, including a management fee and a performance fee.

Hedge funds use a variety of investment strategies, including equity hedge, long/short credit, event-driven, relative value, and global macro strategies. They can invest in various asset classes, such as stocks, bonds, derivatives, and real estate.

While hedge funds offer the potential for greater returns and portfolio diversification, they also carry significant risks, including their speculative nature, high fees, lack of liquidity, and complex tax reporting.

Derivatives

Hedge funds use derivatives to gain exposure to various asset classes and markets, such as equities, fixed income, commodities, and currencies. They can also use derivatives to hedge their positions and protect themselves from market risk. For example, a hedge fund might use derivatives to short an asset, which involves taking a position that will profit from a decline in the asset's price. This can be used to offset potential losses in other positions or to speculate on a decline in the underlying asset's price.

The use of derivatives by hedge funds can be complex and opaque, making it difficult for regulators and counterparties to fully understand and monitor risk exposures. This complexity, along with the use of leverage and aggressive investment strategies, contributes to the perception of hedge funds as risky investment vehicles.

The guidance has been created to support investors in including derivatives within their net-zero commitments, targets, and strategies. It also provides guidelines for hedge fund managers on reporting the real economy impact of their holdings to better align with net-zero investment strategies. However, there is disagreement among investors and hedge fund managers on how to best account for derivatives in net-zero investment strategies.

Leverage

The use of leverage, however, is a double-edged sword. While it can amplify returns, it can also magnify losses and increase the risk of failure if the investment bets go wrong. Hedge funds may face margin calls and increased credit risk if their leveraged bets turn sour.

There are two types of leverage: explicit leverage and implicit leverage. Explicit leverage is money or assets borrowed contractually for a fee. It includes shorting, prime broker financing, and repurchase agreements. Shorting involves selling borrowed securities and using the cash to buy more securities. Prime broker financing involves a broker extending credit to a fund manager in exchange for cash and securities as collateral. Repurchase agreements allow funds to sell a security they own, receive cash, and promise to repurchase the security at a fixed price in the future.

Implicit leverage, on the other hand, does not appear on a hedge fund's balance sheet. It includes options, futures, forwards, and swaps. These instruments allow investors to gain exposure to a security without putting up the full purchase amount. Options provide leverage with limited downside risk, while futures, forwards, and swaps have costs embedded in the contract.

The extent of leverage used by hedge funds can be assessed by investors through audited financial statements and footnotes, which provide details on the fund's use of explicit and implicit leverage.

Shorting

• Work with a brokerage to locate shares available for borrowing, usually for an interest fee. The lender is often another client with a margin account containing the shares.
• The borrowed shares are immediately sold at the current market price to an outside buyer. This cash from the sale goes into the short seller’s account.
• The investor monitors the market, hoping the share price falls substantially below the initial selling point.
• If the price drops as desired, the short seller uses the funds in their account to repurchase the same number of shares in the open market to return to the lender.
• The originally borrowed shares are returned to the lender to close out the loan.
• The short seller pockets the difference between the initial selling price and the lower repurchase price as profit after interest, hedge fund fees and commissions.

Short selling is a controversial strategy that has received increased attention in recent years. Critics argue that short sellers deliberately drive down prices and spread negative information about companies. However, proponents of short selling argue that it is crucial for price discovery and market efficiency.

Hedge funds frequently use short selling as part of their investment strategy. They use forensic accounting and valuation analysis to identify overvalued securities or companies with declining fundamentals. Hedge funds also use short selling to hedge against losses in their long positions. By taking a short position in a security, they can offset the risk of their long positions losing money in a market downturn.

There are three types of hedge funds where shorts play a major role:

• Short-only hedge funds: These funds focus exclusively on short positions and aim to profit from declines in the market.
• Short-bias hedge funds: These funds primarily take short positions but may also have some long positions to hedge against market risk.
• Long-short hedge funds: These funds balance long and short positions to generate returns regardless of the overall market direction.

Short selling provides hedge funds with the potential for tremendous gains but also carries the risk of significant losses. It requires careful risk management and is only suitable for sophisticated investors. The risks of short selling include unlimited losses, high costs, regulatory interventions, and short squeezes, which can cause rapid price increases and devastating losses.

High-risk assets

Hedge funds are considered high-risk investments due to their aggressive and complex investment strategies. These funds often invest in high-risk assets, including non-traditional and illiquid securities, and employ speculative investment techniques.

One common strategy is short-selling, where investors sell shares and buy them back later at a lower price to profit from falling markets. Hedge funds also use leverage, which involves borrowing money or trading on margin to increase their purchasing power and amplify potential returns. However, this also increases the potential for losses.

Additionally, hedge funds may take concentrated positions, where a single type of security represents a large percentage of an investor's overall portfolio. This strategy can lead to significant gains or losses, depending on the performance of that particular security.

Another strategy is investing in derivatives, such as options and futures contracts. Derivatives are financial instruments whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies. They allow investors to speculate on the future price movements of these assets without actually owning them. Derivatives can provide hedge funds with additional opportunities for profit but also come with higher risks.

Hedge funds may also invest in distressed debt, which involves purchasing the bonds or loans of companies facing bankruptcy or financial distress at a discounted price. While this strategy can lead to significant gains if the company recovers, it also carries the risk of complete loss if the company fails.

Overall, hedge funds' investment strategies, which often involve high-risk assets and aggressive techniques, contribute to their reputation as high-risk alternative investments.

Global events

These funds have a broad investment mandate and can invest in a diverse range of asset classes, markets, and investment types. The fund managers focus on analysing the global economic landscape to identify profitable opportunities arising from macroeconomic and geopolitical events. They invest in various markets and asset classes, including currency trading, futures, options contracts, public equities, and fixed-income products.

Global macro funds are considered risky due to their use of leverage and the potential impact of market timing on their performance. The success of these funds relies on the accurate identification and timely implementation of investment strategies.

Directional strategies are also influenced by global events, as they involve investing based on market trends and the potential continuation or reversal of those trends. Event-driven strategies, on the other hand, focus on corporate transactional events such as acquisitions, consolidations, and bankruptcies, which can be influenced by global economic and political factors.

Overall, global events play a crucial role in shaping the investment strategies of hedge funds, particularly those with a global macro or directional focus. These funds aim to capitalise on market shifts and events to generate attractive returns while managing the associated risks.

Frequently asked questions