The World of Hedge Funds

Hedge Funds are arguably one of the most prestigious investment firms in the field of financial institutions. Since their inception in the 1950’s, hedge funds have gained immense popularity among wealthy investors, but also pension funds and other institutional investors. Using less traditional investment strategies, hedge funds promise to produce alpha with low correlation to market movements. This article explores the world of hedge funds, which strategies they apply, how to evaluate them and how your investment group can profit from their insights.

What are Hedge Funds?

It is hard to give one definition for hedge funds. Whereas many people see hedge funds as an asset class, they are certainly not. The main characteristics that differentiate hedge funds from other investment vehicles are their strategies, performance measure, clients and fee structure. With regards to investment strategies, hedge funds have the most unconstrained mandate. They are allowed to virtually trade any security available on the market and they can take short positions, something that many other funds are not allowed to do. In the next section, the most common strategies will be explained in slightly more detail. Moreover, hedge funds have the possibility to take their money off the table. Whereas, many mutual funds have requirements to have at least 80 or 90 per cent of their capital invested at any time, hedge funds can invest their capital as they see fit.

Furthermore, hedge funds are assessed on their absolute return. As they have a broader mandate and versatile toolkit, investors expect them to produce positive returns. Opposed to many other funds, that are mainly compared to indices, losing 5 percent while the market is down 25 percent, means that the hedge fund did a terrible job.

Moreover, the type of clients distinguishes hedge funds from other players in the field. Hedge funds are only accessible for wealthy individuals and institutions. Their main fee structure that they maintain is the two-and-twenty model. This means that investors pay a yearly two percent management fee, plus a twenty percent performance fee that is paid when the hedge fund makes a positive return.

Which strategies do Hedge Funds apply?

Hedge funds apply a wide variety of strategies. The most clear or common known strategies highlighted in this article are event driven, long/short, global macro and relative value strategies. Event driven strategies look at certain influential events such as elections, but also natural disasters or mergers and acquisitions. Hedge funds try to look for discrepancies in the value of securities influenced by these events and exploit these to gain a profit.

Another strategy is the long/short equity approach. Through taking long and short positions, a hedge fund can decrease or completely eliminate the systematic risk involved in trading securities, creating a portfolio that is market neutral.

Global macro strategies involve all kind of trades that deal with macro trends. It can either be in equity, credit or commodity markets and looks at markets from a top down approach.

Lastly, hedge funds can apply relative value strategies, where they exploit changes in the spread between certain securities that are highly correlated with each other. By going long in one and short in another security that are positively correlated, when the spread between the two securities becomes mispriced, a hedge fund can earn a profit without facing the general market risk.

All these strategies allow for different ways of approach. Hedge funds can for example apply fundamental or quantitative approaches to create trading strategies and the way of approach depends on the values of the hedge fund or its manager.

How Hedge Funds’ performances are assessed

As was mentioned previously, a hedge fund is mainly reviewed on the basis of absolute return. However, this way of performance measuring does not consider the degree of risk involved in the applied strategies. There are different statistical ways to incorporate this amount of risk, using the so called Value at Risk methods (VaR’s). The common difficulty that many of them face is that they are backward looking. The degree of risk is based on data of the past, and logically this can never perfectly predict the future. One of the consequences of this is that many performance measures underestimate the degree of tail risk, meaning that the probability of encountering an extremely negative performance is underestimated. This may cause performance measures to sketch a view on a certain strategy that is too positive, as it underestimates the risk involved.

A simple example can be obtained by considering the Sharpe ratio (a performance measure that looks at excess returns, scaled by their standard deviation) of the following strategy: selling put options on the S&P 500 in a relatively calm and steady period, like the period of November 2017 until the end of January 2018. As the S&P 500 kept rising steadily, this strategy resulted in high returns by collecting the premium on these puts, also relative to their volatility, resulting in a great Sharpe ratio. However, when the market tumbles by a large percentage, like in February 2018, the strategy results in huge losses, as the leveraging characteristics of options magnify this loss of value. This example shows that these performance measures can greatly miss specify the degree of risk that some strategies face.

Another reason why risk might be underestimated is the lack of liquidity of some securities that are traded by hedge funds. As many hedge funds apply less traditional strategies and trade complex products, there might be low liquidity for some of these securities. Especially in the event of a downturn, the funds may end up in a vicious circle as the loss of value of these securities lowers liquidity, potentially causing the value to drop even further.

Even though these difficulties can sound alarming, many hedge funds manage to stay highly uncorrelated to markets, also during crises and market crashes. This makes hedge funds an ideal opportunity to diversify your investment portfolio. In spite of the fact that hedge funds are highly inaccessible for small investors like the investment groups at B&R Beurs, there are ways to benefit from these characteristics.

With the rise of big data analysis and artificial intelligence, there are many firms that offer alternative or smart beta products, that offer similar characteristics at a fraction of the price of hedge funds. Moreover there are alternative UCITS that also provide low correlation to stocks and bonds, providing excellent diversification opportunities. Whether these products can replace hedge funds is a difficult question and remains to be seen. Many hedge funds see them as a complement to their services and do not fear their competition too much. It remains to be seen whether this view is justified.

This article has only provided a glimpse of the highly complex world of hedge funds. Things like transparency, fraud and scandals are a darker side about hedge funds that have not been highlighted in this article, but do chase the industry. In short, the hedge fund industry is an extremely competitive and interesting world, managing billions of dollars. And who knows, maybe you will be part of one in the future.