Hedge Funds - How They Work For Investors

Hedge funds were originally created as a hedge against risk. Hedge fund managers combined bull market and bear market techniques for greater diversification. They used tried-and-true stock-picking strategies combined with hedging strategies such as shorting stocks or using put options. As investors began to see increased returns, many hedge funds began to use their arsenal of techniques in riskier ways.

In this article, we’ll explain the definition of "hedge fund," the most common types of hedge funds, key characteristics of hedge funds, the difference between "absolute return" and "relative return" and common techniques used by hedge fund managers.

Common Types of Hedge Funds

A hedge fund, like a mutual fund, is created to profit from a distinct market opportunity. Nine categories of hedge funds include the following:

• Long-short funds: Long-short funds combine flexible, balanced strategies where long and short positions are held at the same time.
• Event-driven funds: As the name implies, these funds speculate on how geopolitical events may impact market prices and attempt to generate outsized returns based on price inefficiencies.
• Macro funds: Macro funds are similar to event-driven funds except that they focus on macroeconomic events driven by research instead of geopolitical events, which are usually based more on speculation.
• Distressed securities funds: Distressed securities funds invest in troubled companies. It's important to note that if the company goes bankrupt, the shares become worthless.
• Emerging market funds: These funds invest in securities in developing countries, but the development process can be very volatile, increasing the risk.
• Long-only funds: These funds focus on stocks whose price is expected to increase. Similar to a mutual fund, in long bear markets, their focus on the positive absolute return can be risky. 
• Short-only funds: The opposite of long-only funds, these funds focus on stocks that are expected to decrease in price.
• Fixed-income arbitrage funds: Fixed-income arbitrage funds seek to profit from a price difference between fixed-income securities such as bonds, treasuries and credit default swaps.
• Merger arbitrage funds: Merger arbitrage funds buy and sell a stock of companies going through a merger. The theory is that in many cases, the stock price of the target company (moving up) and the acquiring company (moving down) will move in opposite directions.

Key Characteristics of Hedge Funds

Hedge funds are typically only open to qualified investors because of the risks associated with them. The Securities and Exchange Commission requires individuals to have an annual income or net worth sufficient to manage the risks. Hedge funds can invest in virtually anything, including real estate, currencies and futures. In contrast, mutual funds can only invest in stocks and bonds.

The third characteristic of hedge funds involves their use of leverage or borrowed money to generate higher returns. They also have a different fee structure which includes both an expense ratio and a performance fee, such as a 2% asset management fee and a 20% cut of any profit.

Hedge funds also focus on absolute return. It’s important to understand the concept of absolute return to understand how investing in a hedge fund is different from investing in a stock, bond or mutual fund. Absolute return is the dollar value an asset has gained or lost over a set period of time and is calculated independently of any competitive products or market benchmarks. 

For example, let’s say you invested $80,000 in a particular asset. In 12 months, the value of your investment was $88,000. Your absolute return would be $8,000. If the value of your investment fell to $72,000, your absolute return would equal -$8,000.

Many mutual fund advisors will talk about an absolute return in conjunction with an investment’s relative return. The relative return measures how a particular investment did in relation to a competitor or market benchmark such as the S&P 500.

Going back to our example above, if your $80,000 investment increased to $88,000, you might feel it performed well — unless you were to find out that the same investment would have increased to $90,000 if invested with the S&P 500 Index. In that case, your investment performed at 10% but the broader market performed at over 12%.

Relative return becomes more relevant to understanding hedge funds when an asset loses value. In our example, if your investment lost $8,000 but investing in the broader market would have shown a loss of $10,000, your investment advisor will be happy to let you know that he helped you “beat the market” because your loss was not as large compared to other benchmarks.

The difference between absolute and relative return is the primary difference between hedge funds and other forms of investments such as mutual funds. Hedge fund managers are interested in only a positive absolute return. Those involved want to see positive returns even in a bear market — a good relative return is just not good enough. Hedge fund managers work hard to avoid potential loss of principal, which gives hedge funds the prospect of spectacular returns (and the potential for enormous risk).

Common Hedge Fund Techniques

Hedge funds focus on achieving a positive absolute return regardless of market conditions in a given asset class. To do this, they employ a variety of techniques including short selling, futures, options, convertible arbitrage and leverage.

Short Selling 

Short selling takes advantage of a predicted decline in an asset. Investors reverse the traditional order of buying and then selling. They borrow stock from a broker and immediately sell it. If the price of the stock drops as anticipated, they can buy the new shares at the cheaper price, replace the borrowed shares and keep the profits. The risk of short selling is that the stock price might rise, which means that you must still repay the shares to your broker.

Here's an example: A hedge fund believes Company XYZ’s shares are currently valued too high at $75 per share. A hedge fund manager borrows 100 shares of stock from a broker and sells them immediately, “shorting” the stock 100 shares. If the stock drops as predicted to $65 per share, the fund can close the short position by buying the 100 shares at the new price to repay the shares borrowed. Because the shares went down, they would realize a profit of $35 times 100 shares, or $3,500.

Futures 

Futures are a common way investors trade commodities (gold, soybeans, oil) or financial instruments (Treasury bills or foreign currencies). When investors trade in the futures market, they make a legal agreement to buy or sell an amount of that commodity at a stipulated price during a specified time in the future. This time period could be in one month or as far away as nine months. During the time you hold the futures contract, the actual price of the investment may move closer or further away from the contract price. A good way to understand futures is to think about what we tend to do as consumers. When we “lock in” a great rate, we agree to pay for service for a fixed period of time at a specific rate. The same is true of a futures contract. If a trader believes the price of wheat will be significantly higher in three months, he can agree to buy it at its current price three months in the future. If the price of wheat rises in that time, he makes making money on his lower-priced shares.

Options 

An options contract is similar to a futures contract because it is an agreement between two parties that gives an investor the right to buy a security from or sell to another trader at a predetermined price within a certain time frame in the future. However, unlike a futures contract, the owner of the option does not have to make the transaction. The owner has the option to decline. Options can be expressed in terms of calls (when an investor predicts an asset will increase in value) or puts (when an investor predicts an asset will decrease in value).

Think of the contracts of professional athletes. Players may sign a three-year contract with a fourth-year option. If the option is a player option, that means the player can opt out of the contract without penalty. If it’s a team option, the team can opt out of the contract with no penalty. Because the salary for the option year is predetermined, the player or team can make a judgment of whether picking up the option is a smart decision.

If the stock price never gets to a level where exercising the option would be advantageous, the options buyer simply loses the money that they used to purchase the options.

Convertible Arbitrage

This technique is used when an investor believes that a company’s convertible bonds (bonds that can be converted to stock at a predetermined time and at a predetermined price) are priced inefficiently to that same company’s stock. By employing convertible arbitrage, a hedge fund will buy convertible bonds in a company and create a short position in the company’s stock. The idea is that as the price of the stock falls, the hedge fund will profit from its short position. If the stock price begins to rise, the fund can convert its bonds to stocks and profit from its long position, which theoretically will cover any losses in its short position.

The risk of convertible arbitrage is that convertible bonds must be held for a specific period of time before they can be converted to stock. This introduces an element of market timing that may make the potential reward not worth the risk.

Leverage

Leverage is the most common, riskiest technique used by hedge funds. Hedge funds use borrowed money to finance part of their investments with the hope of multiplying their gains. In simple terms, if an investor puts $100,000 of his own money into an investment that increases by $10,000, he earns a 10% return. If he only uses $50,000 of his own money by borrowing the other half, that same $10,000 return would be a 20% return (minus whatever interest was agreed upon for the loan). If the price of the security decreases in price, the negative return to the leveraged owner is greater.

The Bottom Line on Hedge Funds

Hedge funds play a role in the way markets work. They can provide diversification to a portfolio and create the potential for growth when markets lag. However, they are not without risk because investments are locked into a hedge fund for a specific period of time. This means you cannot pull your money out until the end of the lock-up period.

Depending on the type of hedge fund, this could mean that you would be at significantly more risk of losing your principal if the market shifts in a negative direction. Individual investors should pay attention to the particular objective of the hedge fund before diving in.

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