4 Mar 2014

Hedge Funds

The term “hedge funds” is rather a misnomer, as it may give the impression that risks are hedged/offset. In reality, a hedge fund is an unconstrained, unregulated investment vehicle. However, as we shall see, the strategies employed by hedge funds do vary widely, so it is invidious to label them all as inherently very risky.

Key differences between mutual funds and hedge funds are:

  • Hedge funds focus on absolute returns rather than returns relative to a benchmark
  • Hedge funds use shorting (selling securities you do not own in the expectation of being able to purchase them later at a lower price). This is an advantage to investors in bear markets, as traditional fund managers are typically long of markets
  • Hedge funds use leverage, i.e. borrowing money to take more substantial market risk
  • Hedge funds use derivatives more frequently
  • Hedge funds do have a higher asset turnover and trading activity
  • Hedge fund managers often invest in the funds they are managing
  • The fees paid by investors to hedge funds usually have an element that is related to the performance of the fund
  • Hedge fund styles are many and various:
  • Macro: following trends linked to economic/political developments
  • Relative value: how assets perform relative to each other, often independent of the underlying market conditions. An example of this would be long Tesco shares and short Sainsbury shares
  • Event-driven strategies. Examples include M&A risk arbitrage and trading distressed securities
  • Opportunistic strategies. Traditional fund managers typically have relatively low asset turnover, operate a collegiate structure and are constrained by their benchmarks. The advantage of hedge funds is their ability to exploit pricing anomalies quickly and to take substantial risk
  • As higher volume traders, the hedge funds can have an influence on asset prices out of proportion to the value of their holdings

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