Hedge Funds: Everything You Need to Know

Good morning on this fine Monday!

Hedge funds are in the mailbag again, so I thought I’d do a quick Rude’s Guide to them.  It’s broken down from alternative investments to their operations, and then to their types.

I hope it’s easy for you to read and digest.

As always, write to asksean@paradigm.press with any questions, comments, or issues.

What are alternative investments?

Before we get into hedge funds, let’s do a complete schematic of the alternative investment universe.  It’s quite simple.  Alternative investments are, in alphabetical order, commodities, hedge funds, infrastructure, private equity, and real estate.

Only high net worth individuals (HNWIs), ultra-high net worth individuals (UHNWIs), and financial institutions such as pension funds, sovereign wealth funds, insurance companies, and endowment funds invest in this asset class.  (Except real estate, of course.)

Why do private bankers sell hedge funds to their clients?

Rich people have rich people problems.

Those problems are so much better than poor people’s problems.  But they are problems, nonetheless.

Those problems are portfolio management, tax liabilities, succession/estate planning, philanthropy, and asset protection.

From a portfolio management perspective, hedge funds make a lot of sense.  In theory, hedge funds enable investors to increase their returns without increasing their risk.

Credit: TheStreet.com

Does this always happen?  Of course not.

Of the 10,000 hedge funds in existence, only the upper quartile of hedge funds are worth investing in.  The rest are trash.

What are hedge funds?

From the July 8th edition of the Rude:

When Alfred Winslow Jones, an Australian who’d partied with Hemingway and Fitzgerald in Paris, finally moved to New York in 1949, he started his hedge fund.  

The Investment Company Act of 1940 stipulates that you must register it with the SEC if you have a fund with more than 100 investors.

He thought, “I’ll just get 99 or less wealthy people, so I don’t have to register.”

Was Jones’s hesitance to register for some nefarious reason?

No.  Registered funds are not allowed to short the market.

Jones thought shorting some stocks was an intelligent hedge against being long some stocks.

Hence, Jones wanted a “hedged fund.”

Of course, Americans love nothing more than murdering the Queen’s English, so they dropped the “d” and started calling those funds “hedge funds.”

Jones’s fund is the earliest example of an equity long-short hedge fund, still the largest class of hedge funds in existence.

In short, hedge funds are lightly regulated open-ended investment schemes that invest in the market using different methods than retail or long-only investors.  Hedge funds are allowed to short the market and leverage their fund by multiples, neither of which long-only funds can do.

Hedge funds may also use derivatives such as futures, options, and swaps to express their market views.

How do they operate?

Hedge funds require a large deposit from investors.  The well-known and most renowned may charge a $5 million initial investment.  Some may charge only $100,000.  Private banks also pool HWNI money together under the bank’s name to lower the entry investment.

Hedge funds then charge “2-20.”  That’s 2% on the year-end assets under management (AUM) and 20% on the fund’s performance.

For example, if a fund grew over one year from $80 million to $100 million, the fees would be as follows:

2% x $100 million = $2 million AUM fee

20% x $20 million = $4 million performance fee

That’s a total fee of $6 million.

This is a simple example.  Some funds charge less, and some charge more.

Also, keep in mind that a “high watermark” will be in effect.  So if our fund drops down to $80 million the following year, it can’t charge performance until it goes back over $100 million again.  This leads to some unethical fund managers closing down their funds and reopening the following year—dirtbags.

What are the different types of strategies?

Below is a schematic of hedge fund styles.  There are three big groups: high to low market exposure and nine classes below them.

Credit: Alpha Development

Opportunistic

These are directional strategies aiming to take a leveraged view on market trends, currencies, or other market-based opportunities.

Long/Short

Like Alfred Winslow Jones’s hedge fund, this one is long the stocks it likes (underpriced, in its view) and short the stocks it doesn’t like (overpriced, in its opinion).  Usually, they are net long.

Global Macro

These funds are funds based on interpreting significant macroeconomic events on a national, regional, and global scale.  Most notably, the famous hedge funds are built on this strategy, such as Bridgewater, Brevan Howard, and Tudor Fund Management.  The main strategies involve currencies, rates, and stock indexes.

CTAs

Sometimes files under global macro, commodity trading advisors (CTAs) use futures contracts to achieve their trading objectives.  Systematic and discretionary trading are two of the strategies CTAs use.

Systematic trading refers to putting all the fund manager’s knowledge into an algorithm and letting the computer take care of the trading.  Dunn Capital is notable for this style.

Discretionary trading refers to letting the fund manager decide what to trade after reviewing his research.  That is, trades are made at the manager’s discretion.

Relative Value

A relative value fund is an actively managed hedge fund that seeks to profit from temporary differences in the prices of related securities.

Market Neutral

Regardless of an upward or downward market environment, market-neutral funds aim to profit  through paired long and short positions or derivatives. These funds can mitigate market risk as they seek to generate positive returns in all market environments.  They aim to eliminate beta (or market risk) and profit from their excellent stock-picking skills (alpha).

Convertible Arbitrage

Convertible arbitrage essentially involves taking a long position in a convertible bond and a short position in its underlying stock simultaneously. The idea is to capture the pricing difference between the convertible bond (or preferred stock) and the underlying common stock.

Capital Structure Arbitrage

Capital structure arbitrage refers to strategies hedge funds use to take advantage of the relative mispricing across different security classes (both debt and equity) issued by the same company. 

Fixed Income Arbitrage

Fixed income arbitrage is an investment strategy that aims to profit from the minor differences in interest rates between fixed income securities.  When using a fixed-income arbitrage strategy, the investor assumes opposing positions (long-short) in the market while limiting interest rate risk.

Event-Driven

An event-driven strategy attempts to take advantage of temporary stock mispricing, which can occur before or after a corporate event takes place. Hedge funds use it because the method requires the expertise to analyze corporate events for successful execution.

Examples of corporate events include restructurings, mergers/acquisitions, bankruptcy, and  spinoffs.

Merger Arbitrage

Merger arbitrage involves exploiting market inefficiencies before or after a merger or acquisition.

Merger arbitrage traders focus on the probability of the deal being approved and how long it will take to finalize the deal. Since there is a probability the merger may not be approved, merger arbitrage carries some risk.

Distressed

Distressed debt trading involves purchasing bonds that are trading at a distressed level in anticipation of reselling them over a relatively short time period at a higher valuation, generating a profit.

Wrap Up

And there you have it—a 1,200-word introduction to hedge funds.  I hope you find it helpful to navigate through the investing world or the business newspapers.

Have a great day and a great week ahead!

All the best,

Sean

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