Hedge FundInvestment & Trading

Trading Course: All About Hedge Funds The Easy Way to Get Started

All About Hedge Funds The Easy Way to Get Started

Introduction

Hedge funds represent a distinctive investment style. Their investment objectives, and their strategies, are very different from more traditional funds. They emphasize absolute return rather than relative return, and they use a very wide range of investment techniques— including leverage, short selling, and other hedging strategies—in the attempt to achieve their objectives.

Hedge funds also represent a distinctive investment culture. Hedge fund management firms tend to be small firms dominated by one or two key investment people. The hedge fund culture is part of the “smaller-is-better” culture. In addition, hedge funds give a new twist to the relationship between the money manager and the client. The client does not merely hire the manager. Instead, the client and the manager become partners, coinvesting in situations that the manager finds attractive.

Finally, hedge funds often use distinctive “delivery systems” to make their strategies available to investors. The hedge fund could take the form of a limited partnership, an offshore fund, a commodity pool, or a specialized kind of separate account. Hedge funds do not typically use the mutual fund structure since this structure does not give the hedge fund manager enough freedom.

To introduce the basic themes that separate the world of hedge funds from the world of traditional investment management, we will focus on hedge funds that are structured as limited partnerships and traditional money management strategies that are delivered in the form of a mutual fund.

As we mentioned in the preface, both of these categories are quite broad and include extremely diverse investment opportunities. Within the mutual fund universe, there is a world of difference between a money market mutual fund and an equity fund that specializes in small cap Latin American equities.

Within the hedge fund universe, there is a world of difference between a market-neutral equity hedge fund that specializes in U.S. utility stocks and a trend-following global asset allocator who takes highly leveraged positions, either long or short, in global financial markets as well as physical commodity markets. But there are nonetheless some basic differences that separate the two worlds. This chapter is a quick review of the basic contrasts.

Comparing Hedge Fund and Mutual Funds

 

INVESTMENT OBJECTIVES

Most equity mutual funds and most hedge funds are designed to deliver long-term growth of capital. The fundamental objective is to deliver a return that will exceed the inflation rate over the investment period, so that the real purchasing power of the investment will increase over time. Some funds are more aggressive than others, some are more tolerant of volatility than others, but the basic idea is to make the investors’ assets grow. Equity mutual funds do this by investing in the stock market, which has an upward bias over long time periods.

The investment management business is a very competitive business in which the objective is to beat some target rate of return. For an equity mutual fund, there are two targets: first, the rate of return achieved by competing money managers and second, the return of some relevant market index.

Thus the money manager first wants to do better than other managers, or, more specifically, he wants to do better than other managers who belong to his “style category” or “strategy category.” The large cap value manager wants to beat other large cap value managers but doesn’t mind lagging behind some small cap growth managers. Second, the money manager wants to beat some passive benchmark, such as the S&P 500 or the Wilshire 5000.

The passive benchmark represents the performance of the basic market that the fund is investing in. If the manager earns 10 percent when the passive benchmark earns 8 percent, he feels good. If the manager loses 8 percent when the index loses 10 percent, the manager also feels good, even though the investor has lost money. What this means is that the money manager is trying to deliver good relative performance: performance that is good relative to a passive benchmark that may, in fact, experience negative returns. But you can’t spend relative performance: If the index is down 10 percent and you, the investor, are down 8 percent, you have still lost money.

What defines the hedge fund business is that the hedge fund manager cares only about absolute return. The purpose of a hedge fund is to earn a positive return, which is totally different from beating a benchmark. Arisk-averse manager might be trying to earn 10 to 12 percent annually (after all fees), while a more aggressive manager might be trying to earn 15 to 20 percent. But in both cases the object of the game is to generate a positive number. Sometimes the hedge fund manager may say that he is trying to earn a premium over some short-term interest rate, such as the rate paid on Treasury bills or the London Interbank Offered Rate (LIBOR) or something similar. But these short-term interest rate benchmarks will always be positive numbers. The hedge fund manager who is trying to beat those benchmarks is automatically committed to delivering a positive rate of return.

The hedge fund manager wants to deliver a positive rate of return, while standard market benchmarks are sometimes positive and sometimes negative. So the hedge fund manager is looking for returns that do not depend on what the standard markets are doing. If a hedge fund manager is successful in delivering this objective, then that manager’s fund will be an “all-weather fund,” or “good for all  seasons.” Statisticians will say that the objective of the hedge fund manager is to deliver returns that have a low correlation with the standard stock and bond markets. (We will return to the concept of correlation in Chapter 7.) Needless to say, this is a tall order, and many hedge fund managers fail to deliver the goods. But at least everybody agrees from the start what the objective is: to earn an attractive positive return. If a hedge fund manager is down 12 percent, he cannot point to some benchmark and say, “Well, the index was down 15 percent, so I beat the index by 3 percent.” That excuse is removed from the start. The hedge fund manager walks the tightrope without a safety net.

 

INVESTMENT STRATEGIES

The basic business of the equity mutual fund manager is to buy good stocks, so that the fund will beat the passive benchmark and beat the competition. But mutual funds operate under specific rules defined by the Securities and Exchange Commission (typically referred to as the SEC), and these rules limit the manager’s freedom of movement. The most important limitations relate to leverage, short selling, and diversification.

Leverage is buying stocks on mar-gin—that is, using borrowed money to buy more stock than you can pay for with your own money. Short selling is a strategy designed to take advantage of falling prices: You borrow stock, sell it, then buy it back at a lower price and return the stock you borrowed.

Diversification is not putting all your eggs in one basket. Mutual funds must follow SEC rules of diversification, and they must observe limitations on leverage and short selling. In contrast, the hedge fund manager can do almost anything that she wants to do. (I say “almost” because the hedge fund manager is still subject to other rules, separate from the SEC’s mutual fund rules.) She can use leverage, she can sell short, she can use other hedging strategies, or she can take very concentrated positions in single stocks, or industries, or trading ideas.

Just as mutual fund managers set out their investment objectives and strategies in a prospectus, hedge fund managers set out their objectives and strategies in an offering memorandum. But mutual fund prospectuses tend to define the fund’s mission fairly narrowly. For example, a mutual fund objective might be to achieve long-term growth of capital by investing in growth stocks in the United States.

The offering memorandum for a hedge fund, in contrast, will define its mission very broadly: The mission is to make money by taking long or short positions in stocks, bonds, and related instruments. Since mutual funds are regulated by the SEC and hedge funds are not, it may seem that hedge funds are automatically more risky than mutual funds. This is not necessarily so. In the final analysis, the risk of a portfolio is determined by the skill and the risk tolerance of the person, or team of people, managing the portfolio. It is possible to build a very risky portfolio that conforms to all applicable SEC regulations, and it is possible to build a very risk-averse portfolio using the freedom afforded in the world of hedge funds. So the challenge for the hedge fund investor is to make sure that he invests with managers who know how to use the freedom that is available to them.

And, ultimately, even the best managers may misuse the freedom that is available to them. So diversification across multiple managers is an essential form of protection.

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