What are Hedge Funds?

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An interest in studying investment vehicles always lead to a fascination with hedge funds, which is almost inevitable.

In the world of investments, where dismal performance is widely noticeable, hedge funds still manage to outperform traditional investment vehicles by huge margins even in economic downturns.

So, what are Hedge Funds?

Hedge Funds are a lot like Mutual Funds: Like Mutual funds, Hedge Funds are also pools of capital.

However, mutual funds, unlike Hedge Funds, are highly regulated entities. The problem with this regulation is that mutual fund managers do not enjoy competitive remuneration based on the performance of funds as much as their counterparts at hedge funds do, which does not incentivize the performance of the mutual fund managers.

Hedge funds are also different from mutual funds in the strategy they apply to find alpha in the markets (The excess return of an investment relative to the return of a benchmark index is the investment’s alpha..)

Rivalry among hedge funds using similar processes and strategies presents challenges. To survive, funds employ dynamic strategies, move nimbly from market to market, and develop unique strengths. Being an effective market and strategy timer is critical because funds using the right strategy at the right time are more likely to survive.

So, can I also invest in Hedge Funds? Well, only investors who meet certain criteria of having a minimum annual income, have an accredited investor status and have enough risk appetite can invest in hedge funds.

So, are Hedge Funds and Private Equity Funds same?

Hedge funds, private equity funds and venture capital funds all fall into the same category in many aspects. They are minimally regulated, private sources of pooled capital that invest in securities and the manager’s remuneration also consists of a share of the fund’s profits.

Hedge funds typically invest in very liquid assets and allow investors to exit easily.

Private equity funds on the other hand, usually invest in very illiquid assets such as early-stage start-ups and the lock-in period is for the entire term of the fund (typically 5 years). Hedge funds also look to invest in private equity companies’ acquisition funds, to gain exposure to startup investments.

How do Hedge Funds Do Things Differently?

To name a few:

i. Invest in Various Assets across different markets.
ii. Combine different investment strategies for the same asset class.
iii. Cross-over investment strategies very quickly.
iv. Use leverage to magnify returns.

Alfred Winslow Jones started the first hedge fund way back in 1949. He was a financial magazine editor, a sociologist who decided to try his hand at investing.

His strategy was to buy stocks with half his investors’ money, and sell short with the other half.

Short selling a stock is betting that the value of a stock will go down rather than up. Buying some stocks and shorting others at the same time was the strategy he had adopted, by doing this Jones was in effect hedging his bets (hence the name.) If the entire market experiences a downturn, Jones could at least recoup some of his losses or ideally turn a profit.

The skill and luck of the manager in a hedge fund became the only determining factor in how much money could be made.

Hedge Fund Strategies:

i. Equity Market Neutral: Using statistical techniques and valuation models to capture fundamental inefficiency and drive alpha in equity markets.

ii. Macro: Massive changes in government policies which could impact interest rates or bring about major economic upheaval, in turn affecting currency, stock, and bond markets help in driving stock prices.

iii. Distressed Securities: Buying equity, debt, or trade claims (invoices) at deep discounts of companies which are facing bankruptcy or restructuring, to capture returns from pricing inefficiencies due to improved cash flow or value post restructuring.

iv. Hedge equities: Global or country-specific, Long or short investments in equity and their derivatives, hedging against downturns in equity markets by shorting overvalued stocks.

v. Income: Focusing on investments in ‘yield or current income’, for eg. Interest or Dividends, rather than only on ‘capital gains’(Gain from rise in price of the asset). It may or may not take on leverage to buy bonds and sometimes fixed income derivatives to profit from principal appreciation and interest income.

vi. Multi-strategy: As the name suggests, various hedge fund strategies are employed simultaneously to realize short- and long-term gains.

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