Hedge funds have been the talk of the town over the recent years. But the question is, what exactly are hedge funds and how exactly do they work? Are they similar to the process wherein an independent investor invests some money in some financial instrument? Or do they possess some unique features that set them apart from other investment activities.
Let us start from the basics. What is a hedge fund? A hedge fund in simple words is a pool of investments that trades in such a manner, that all the strategies which are being used are complex in nature. Hedge funds have the liberty to use risky strategies unlike mutual funds, which are more regulated by the government authorities. Hence, due to this reason, the riskiness aspect holds a lot of importance in every scenario. Therefore, generally hedge funds are open to only institutional investors, high net worth individuals (HNI’s) and those people who are considered to be sophisticated investors. Can a retail investor invest in hedge funds, even if he has a lot of funds? A strict no! The government authorities in different countries always make it a point that hedge funds are available to a restricted horizon of investors. But the important question here is, what makes hedge funds so restrictive? To answer this question, let me list down some of the risky strategies which hedge funds use in order to provide return for the people who have invested their share in the fund.
I. Global Macro:
In case of this strategy, the hedge fund manager would take considerable positions in instruments like share, bond, or even currency markets with the anticipation that some global macroeconomic events might be favourable for the investments and therefore there would be a risk adjusted return possibility. For example, let’s say a hedge fund manager anticipates that the political scenarios in a country might prove to change the price of dollar, therefore, he would initiate a strategy that might turn into a favourable outcome for the entire fund. As the name suggests, only macroeconomic factors will be considered in this case. Macroeconomic factors include exchange rates, interest rates, GDP, etc.
II. Directional:
This strategy works in such a manner that hedge fund managers use computer models or even pick up stocks on the basis of fundamental value, that is the value of a stock calculated by the fund manager on the basis of simplified assumptions. In this strategy, the hedge fund manager might also use hedging strategies backed by shorting of potential stocks. Directional Hedge Fund strategies also include quantitative and financial signalling processing techniques for equity trading, which is also considered to be an integral part of quantitative finance.
III. Relative Value:
The important term to be used in this strategy would be – “Arbitrage”. In this case, a hedge fund manager will identify potential stocks which have been a part of relative discrepancies and appropriately making an attempt to get risk free returns. Due to this mispricing of financial instruments, a hedge fund manager can surely make good returns for the entire fund as a whole. Different securities are a sub part of this particular strategy, some of which include fixed income arbitrage, statistical arbitrage (mathematical modelling) and value investing on the basis of fundamental analysis.
IV. Event Driven:
In this particular strategy, the hedge fund manager will have a micro approach. The hedge fund manager would be analysing the companies with the help of a certain set of criteria such as acquisitions, mergers, bankruptcies, recapitalisations, etc. In this entire process, the hedge fund manager analyses and understands the company’s recent major activity and therefore takes the investment decision accordingly. Different industries are to be analysed differently in this case. For example, if a hedge fund manager is analysing a particular company minutely after a certain activity had taken place in the company, he will also consider other factors that might have affected the company’s operations.
Apart from the above 4 categories of strategies, we can also consider a miscellaneous set of strategies wherein the concept of fund of hedge funds can be considered, wherein a hedge fund would invest in another hedge fund subject to certain terms and conditions. Another strategy would be to use artificial intelligence in analysis of big data and sophisticated machine learning models in order to predict prices.
Hence, we can say that hedge funds are an excellent pool of investments wherein risky strategies can be used to maximise returns, however, it should also be noted that the entire process of the strategies used in hedge fund operations are extremely risky, making it available to a restricted investment base.
Follow Us @
