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What is a Hedge Fund?

The expression ?hedge funds? is commonly used to describe a non-conventional investment fund, that is, a fund whose strategy does not include long term investments in bonds, stocks and cash markets...

Article also available in : English EN | français FR

What is a Hedge Fund?

The expression ?hedge funds? is commonly used to describe a non-conventional investment fund, that is, a fund whose strategy or strategies are not long term investment in bonds, equities (equity-based mutual funds) and cash markets. Among these alternative strategies we can find: :

• Hedging by selling short - the sale of unowned securities by planning to buy them at a later date and at a lower price in the hope that their price will drop.

• Use of arbitration - attempt to exploit the prices mismatch between related securities.

• Derivative transactions - contracts whose value are based on the return of a financial asset, of an index or another investment.

• Use of leverage - borrowing to try to improve returns.

• Investing in underestimated securities which are not anymore on the spotlight or are unrecognized (debt or equity).

• Attempt to benefit from the difference between the current stock exchange price and the final purchase price in situations influenced by events such as mergers or hostile takeovers

How do hedge funds hedge their risk?

Some hedge funds do not really hedge their risks. As the term is used for a large range of alternative funds, it includes funds whose strategies present higher risks without protection against losses. A global macro-strategy for example, can speculate on economical or political changes of countries having an impact on the interest rate, which in turn has an impact on all financial instruments, all using a lot of leverage. The profits can be higher, and the losses too, as directional investments (which are not covered) with leverage tend to have the highest impact on returns.

Most hedge funds try to hedge their risks in one way or another through regularity and return stability, rather than by their size, whiich is their key priority. (In fact, less than 5 per cent of hedge funds are global macrofunds.) Strategies based on events such as investment in peculiar or special situations reduce the risks as they are not correlated to the market. These funds can buy interest-paying bonds or debts of a company that is subjected to a reorganization, to bankruptcy or to another form of restructuring, by relying on specific events in the company rather than on random global trends to influence their investment. Thus, they are generally capable of offering stable returns with lower risk of loss. Long/short investment funds, which depend on the direction of markets, cover a part of these risks thanks to short positions which generate profits during a market decline in an attempt to counterbalance the losses created by long positions. Market neutral funds which invest in equally between long and short equity portfolios (generally in the same market sectors), have no correlation with market movements.

A real hedge fund is therefore a vehicle of investment whose key priority is to minimize investment risks by attempting to offer profits in any circumstance.

Do hedge funds vary considerably according to their hedging strategies and the range of its risks / gains?

Absolutely! The types of hedge funds are as diverse as the members of the animal kingdom. Just as elephants, crocodiles and rabbits are very different, the same with global macrofunds, convertible bond arbitrage funds and long/short funds.

The different strategies of hedge funds vary greatly in terms of:

• Investment returns

• Volatility

• Risk

Some hedge funds which are not correlated to stock markets, are able to offer regular returns with extremely low risk of loss, while others can be as volatile as mutual funds

What is the difference between a hedge fund and a mutual fund?

There are five main distinctions:

1. Mutual funds are measured in terms of their performance relative to a benchmark. Their performances are compared to an index like the S&P 500 or to other mutual funds in the same sector. Hedge funds are supposed to offer absolute returns ; they attempt to make a profit in all circumstances, even when the relative indexes are at a low.

2. Mutual funds are highly regulated, which limits the use of short sales and derivatives. These regulations act as handcuffs, making it difficult for these funds to be more successful than the market or to protect their assets during a decline. Hedge funds on the other hand, are not regulated and therefore not limited; they allow short selling and other conceived strategies aimed at accelerating performance or reducing volatility. An unofficial limitation is generally imposed upon all hedge fund managers by professional investors who understand the different strategies and who typically invest in private funds due to their management expertise in a particular investment strategy. These investors require that the hedge fund remains within the limits of its specialization and skill domaine and they rely on this fact. One of the determining characteristics of the hedge fund is thus that they tend to be specialized, to operate in a niche, a speciality or an industry given which require a particular expertise.

3. Mutual funds generally remunerate their managers according to a percentage of the assets which they manage. As well as receiving a fixed fee, the remuneration of hedge fund managers is performance related. The investment for absolute returns is more difficult than the simple search for relative returns and requires more important abilities, knowledge and talents. It is not surprising that performance-related fees tend to attract the most talented investment managers in the hedge fund industry.

4. Mutual funds are not capable of effectively protecting portfolios against markets in decline if they are not moving towards liquid assets or selling short a limited amount by future shares. Hedge funds, on the other hand, are often capable of protecting themselves from markets in decline by using diverse cover strategies. The strategies used vary considerably according to the style and to the type of hedge fund investment. But, thanks to these cover strategies, certain types of hedge fund are capable of generating profits even with markets in decline.

5. The future performance of mutual funds depends on the direction of stock markets. One could compare it with a cork in the middle of the ocean: the cork will rise and fall with the waves. The future performance of numerous hedge fund strategies tends to be strongly predictable and does not depend on the direction of equity markets. One could compare this with a submarine sailing in a straight line under the surface thus shielded from the effect of waves. October 2006

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