RISK AND RETURN OF HEDGE FUND INVESTMENT

 

 

We can define hedge fund as a private investment partnership and funds pool that uses varied and complex proprietary strategies and invests in complex products, including listed and unlisted derivatives. 

Simply explained, hedge fund is a pool of money that takes both short and long investments, buys and sells equities, initiates arbitrage, and trades bonds, currencies, convertible securities, commodities and derivative products, to generate returns at lower risk. As the name suggests, the hedge fund manager tries to hedge risks to investor’s capital against market volatility by employing alternative investment approaches. 

Going back, the first hedge fund made its debut in 1949, when sociologist Alfred Winslow Jones started a general partnership, later changed to a limited partnership, to trade equities. In his stock trades, Jones invest for both long term and short term. Jones’s ability to profit both ways was extraordinary, which led other hedge funds followed. 

In 1956, Warren Buffett established a partnership which resembled a hedge fund in most ways; the difference was that Buffett did not sell short, which resulted to high income. For instance, from 1956 to 1969, his returns were 29.5 percent compounded. Buffett was a contrarian, and specialized in finding and buying stocks that he thought were undervalued. 

When the market soared in the late 1960s, he couldn’t find enough undervalued stocks to practice his traditional approach and he dissolved the partnership instead of changing his approach. 

George Soros, another renowned hedge fund investor, may be even greater at it than Buffett. His compound annual return from 1969 to 2001, after deducting fees, was 31.6 percent. During the first decade of that period, the 1970s, only a few other, mostly small, hedge funds were in the market. 

A handful of prominent money managers set up funds during the 1980s, but hedge funds proliferated in the 1990s, as money managers left big financial institutions and set up shop on their own. Not only did hedge funds multiply during this period, but a wide range of investment approaches appeared. 

What Are The Disadvantages In The Hedge Fund Industry 

In 2021, hedge funds, collectively, probably manage between 500 billion USD and 600 billion USD in assets. This is minuscule compared to the 15.9 trillion USD 1999 asset base of pension funds. European hedge funds account for about 11 percent of total managed assets for the industry. 

Hedge funds achieved an important landmark in 1999 when the California Public Employees’ Retirement System (CalPERS) announced that it would invest in hedge funds. Also, other investors, such as funds of funds, corporations, pension funds and individuals started to invest in hedge funds as well. 

The success of hedge funds in attracting new investors is rather surprising given their generally negative press. Hedge funds are open to some justified criticism on several counts: 

• Magnitude — Once hedge funds grow big, they have trouble delivering superior, or even positive, returns. 
• Leverage — Highly leveraged hedge funds have sometimes threatened the stability of the entire financial system. The most notable example was Long Term Capital Management (LTCM). 
• Transparency — Transparency allows third parties to monitor risk, but hedge funds are quite secretive and it is difficult to know exactly what they are doing. 
• Stability of funding — A run on the bank scenario can cause serious market disruption. Hedge funds need stable fund sources. Many Long Term Capital Management LTCM trades were actually good trades and might have scored if investors had not rushed to pull out their capital. 
• Pride — Hedge fund managers need a great deal of self-confidence, because they receive rich compensation when they are right. Such confidence can easily evolve into arrogance and lead to disastrous missteps.

The top three hedge fund investment styles, measured by their outcomes in the third quarter of 2001, were: 

1. Equity Long/Short — 228 billion USD in assets, roughly 46 percent of total hedge fund assets. 
   1. Event — 108 billion USD, roughly 22 percent of total hedge fund assets. 

• Macro, global — 40 billion USD, 8 percent of total.

The average age of hedge funds has declined as more new hedge funds have emerged. This means, of course, that evaluating and selecting good managers is getting more difficult. The field is so crowded that you may easily confuse luck with skill. Even so, several myths about hedge funds should be debunked, including: 

1. Hedge funds are high-risk investments — In fact, any investment may be high-risk when it is not diversified. Hedge funds are inherently no riskier than technology or transportation stocks. Diversification is important in every case. 
2. Hedge funds are gambles — Although hedge funds speculate, they are not necessarily speculative. Every investment is a speculation, but hedge funds may be more protective of principal than other types of funds, precisely because they often hedge. 
3. Hedge funds do great regardless of market moves — In fact, like other investments, hedge funds have good years and bad years. 
4. Hedge funds always hedge — Hedge fund managers choose when to hedge and when not to, and take risks when they judge the risks to be good investments. 
5. Short and long are opposites — In fact, in an investing context, short and long are not the mirror image of each other. Short positions have a different risk profile than long positions and need to be handled with greater caution. 

However, most long and short investors consider a pure long strategy to be quite speculative compared to a strategy that balances long and short positions. 

Hedge funds usually, but not always, outperform mutual funds — in the aggregate. This makes sense since most mutual funds cannot exploit a down market or defend against one effectively. Hedge funds do not aim at a benchmark; by and large, the only measure of hedge fund success is cash won in the markets. A good benchmark of hedge fund performance is unlikely to be developed because such a metric would have to be: 

1. Reflective of the range of hedge fund styles and approaches. 
2. Clear and subject to measurement. 
3. Capable of being replicated passively. 

Hedge fund styles are too diverse and idiosyncratic to fit a benchmark. The best funds do well because they are run by superlative risk managers. Investing in hedge funds has disadvantages, most notably the relative absence of transparency. But fees seem to be money well spent — hedge funds are no costlier than other investments when the costs are viewed in the context of performance. To some extent, hedge fund success flies in the face of efficient market theory, but efficient market theory itself often flies in the face of plainly observable facts. 

What Are the Best Hedge Funds Styles

Some of the main hedge fund styles include: 

1. Convertible arbitrage — Most managers in this area buy bonds, warrants or convertible bonds and hedge away the market exposure. A formula allows them to calculate a fair value relationship between the stock and the convertible. When the convertible is underpriced relative to the stock, they buy. 
2. Fixed income arbitrage — This school applies a similar arbitrage approach to bonds and other fixed income investments. 
3. Market-neutral equity — These funds aim to exploit inefficiencies in the equity market by holding roughly equivalent long and short positions. Managers take a statistical approach to historical price analysis to discern good potential trades. 
4. Risk arbitrage — Risk arbitrageurs essentially bet on a merger, acquisition or spin-off, usually buying the stock of the target and shorting the acquirer to capture the spread. 
5. Distress — Managers in the distressed securities business take positions in bankrupt or otherwise troubled companies. These securities often trade at a discount off of their fundamental value because so many investors avoid them. This leads to opportunities since the various classes of securities that these companies issue generally don’t follow rational pricing relationships. 
6. Equity long/short — This approach has many variations but, in general, managers take a directional view on securities, buying the ones they expect will appreciate and selling short the ones they expect will depreciate. This is not quite the same thing as market neutral. Market neutral players do not take a general market view; in fact, they seek to eliminate any suggestion of such a view from their portfolios. 
7. Sector specialization — Managers apply a long/short approach to a particular sub- class of securities, for example, technology stocks, health care stocks and so on. 
8. Macro — These funds are utterly unrestrained and completely flexible. 
9. Short — Short managers aim to find overvalued securities, borrow them, sell them for what the market thinks they’re worth, buy them back when the market recognizes what they’re really worth and generate money doing it. 
10. Emerging markets — Emerging market managers trade the securities of less developed countries or markets, for instance, Latin America, Africa, Southeast Asia and Eastern Europe. 
11. Fund of funds — This is not precisely an investment style but rather is a way of investing in hedge funds. A fund of funds invests in funds managed by a number of managers, mixing and matching to achieve a certain overall balance of risk and return. 
12. Some say hedge funds represent a paradigm shift in investing. Others suggest that hedge funds are a bubble waiting to pop. The truth is probably somewhere between these extremes. Hedge funds are neither extremely risky nor sure investments. The most important advice to prospective investors is to know what risk you are taking before you invest, and if you aren’t sure, don’t invest.                                                          To learn more about the fund  and other investments, you can purchase THE FIRST INVESTOR book and receive a discount by clicking on The First Investor