Hedge Funds 101: Introduction to Hedge Fund Investing
The $1 Trillion hedge fund industry is one of the fastest growing in the financial markets with its 20% yearly growth rate. As of today, there are more or less 8,400 hedge funds in the market with more and more pension funds, private funds, insurance companies, and endowments investing in them.
A hedge fund is usually an unregistered fund sold through private offerings. Its aim, just like other investment companies, is to pool investors' money into one large fund, invest this fund into various instruments, and provide returns that are way above or contrary to negative index performance.
Hedge funds aim for a positive rate of return, regardless of the trends in the equity and bond markets. From this perspective, hedge funds are less exposed to market risk than conventional investment vehicles like mutual funds or index funds.
The recent stock market volatility, however, has exposed some of the vulnerabilities of some hedge funds like the Long Term Capital Management, which had to grab the lifeline thrown by the government and Wall Street. This prompted securities regulators to investigate possible fraudulent activities in hedge funds that could lead to investors losing a substantial amount of money.
Hedge Funds: An Overview
Hedge funds usually employ unconventional investment means like trading bonds and options, shorting derivatives through leveraging, investing in global markets, using arbitrage, trading undervalued securities, and taking short and long options to name a few. As such, hedge funds can and do invest in almost any market where it can take advantage of high probability returns and gains and/or lower risks.
Contrary to popular belief, hedge funds are not volatile investments. Most of the hedge funds available in the market hedge against possible downturns in the market with the key aim of capital preservation, risk reduction, minimizing investment volatility, and delivery of consistent positive gains. This is even truer in today's volatile economic climate. As such, most conservative hedge funds use little or no leveraging.
Because hedge funds are a lot more complicated financial investment vehicles than traditional ones like mutual funds and index funds, sophisticated and wealthy market investors are their primary investors. Hedge funds are oftentimes managed by a general partner who owns a substantial portion of the fund and is responsible for supervising the fund's portfolio as well as making investment decisions.
Hedge funds are highly specialized in both focus and strategies. In other words, a hedge fund's focus and investment strategy is highly dependent on the specific expertise of the general manager. Hedge funds are therefore some of the most actively managed funds. As such, they are also some of the most expensive investment vehicles in terms of administrative and performance fees. In fact, performance fees of 20% of profits and fixed annual fees of 1-2% are not uncommon.
Some hedge funds like those employing arbitrage strategies experience diminishing returns above a certain capital level. Because of this, some hedge fund managers place a limit on how many investors they accept.
Hedge Funds Investment Strategies
Different hedge funds mean different investment strategies and market focus. This means that the innate volatility, capacity for returns and risks vary widely from hedge fund to hedge fund. While most of the hedge funds hedge against market downturns and present little risk to investors, some hedge funds are more volatile than mutual funds.
Investing successfully on the hedge fund market requires that an investor should understand the basic differences and blends of the different hedge fund strategies presented below:
Short selling is the practice of selling shares that you do not own or have borrowed from a broker in the hope that you can buy them back at a lower price at a certain date in the future.
This pertains to synchronized buying and selling of the same securities in different markets. This strategy is used to take advantage of price differences in different markets. Arbitrage investing can also mean investing in related securities and using a combination of short and long positions on these securities.
Investing in International Markets
Hedge funds also often invest in international markets, where potential returns may be much higher due to a limited number of investors. Macro hedge funds, or the funds that usually uses this strategy, takes advantage of financial shifts in foreign markets due to changes in government policies as well as changes in currency rates, stocks and bond markets.
Investing in Distressed, Bankruptcy-Imminent Companies or Deeply Discounted Securities
Some hedge funds invest in distressed companies (say, companies that have filed Chapter 11 bankruptcy) to take advantage of share prices lower than their real market value.
Event Driven Investing
This is investing in a particular company or asset (or selling shares of a company or asset) in the anticipation of an event that are expected to boost share prices or cause their decline. Examples of such events are a spin-off, a hostile takeover, a merger, etc.
This is borrowing money to finance an investment in the hopes that the gains will be greater than the interest payments due on the loan.
Investing in Equities Experiencing Aggressive Growth
This type of strategy consists of hedging in overheated markets or equities that are experiencing rapid growth like biotechnology, banking, etc. Short selling is a common strategy in securities or sectors where a crash or market adjustment is imminent.
Investing in Sophisticated Investment Vehicles
Sophisticated investment vehicles include futures contracts, options or derivatives. These are contracts that base their values based on the performance of the underlying investments.
This refers to the purchase of particular assets to "hedge on" or offset a potential loss in another investment.
This refers to switching portfolio composition among different asset classes depending on sector specific outlook. This strategy is highly volatile as it is difficult to forecast market movements and time market entry and exit.
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