Hedge Funds: Its Pros and Cons and Strategies

What are Hedge Funds?

Hedge funds are alternative investments using pooled funds that employ numerous different strategies to earn active return, or alpha. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets. Generally, hedge funds are only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles.

Each hedge fund aims to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and thus are often classified according to investment style. There is considerable diversity in risk attributes and investments among styles.

Legally, hedge funds often start as private investment limited partnerships for a limited number of accredited investors. Also, they require a large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.

History of the Hedge Fund

Former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co. launched the first hedge fund in 1949. It was while writing an article about current investment trends for Fortune in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000 and tried to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation now pertains to the classic long/short equities model. Jones also employed leverage to enhance returns.

In 1952, Jones changed the structure of his investment vehicle. He converted from a general partnership to a limited partnership. He also added a 20% incentive fee as compensation for the managing partner. Jones was the first money manager to combine short selling, the use of leverage, shared risk through a partnership with other investors and a compensation system based on investment performance. With that, Jones earned his place in investing history as the father of the hedge fund.

Hedge funds went on to dramatically outperform most mutual funds in the 1960s. They gained further popularity when a 1966 article in Fortune highlighted an obscure investment that outperformed every mutual fund on the market by double-digit figures over the past year and by high double-digits over the last five years.

Pros and Cons of Hedge Funds

When considering investing in hedge funds, remember that there will always pros and cons that will affect your overall portfolio.

Advantages

Aggressive Investment Strategies

One advantage to hedge funds is using aggressive strategies by investors in order to get a high return. Some aggressive investment strategies that can operate in local and international markets are called leverage, derivative, and long and short. Thus, as an example of a leverage strategy, investors will borrow and trade money on top of the capital they gain. This strategy can boost return, but the chance for big gains must be measured alongside the potential for huge loss. Those using this strategy must also employ complex risk management tools to reduce possible associated risk.

Huge Gains

Another advantage of hedge funds is the large amount of money that can be made by utilizing them within your investment portfolio. The aim of hedge funds is to acquire a high-return despite what market fluctuations are occurring at any given period. For example, one type of hedge fund strategy is called a “global macro” approach. This strategy tries to take a large position in commodities, stocks, bonds, etc. This happens through forecasting what investment opportunities one can take relating to what may happen in future global economic events. This is done in order to create the largest return with the least amount of risk.

Expert Advice

There is a very good reason why those working in hedge fund investing are paid generously. Aside from just the big gains that can be made on such investments, these individuals are extremely experienced and knowledgeable in matters of financial investment. Thus, when you invest in hedge funds you are getting expert advice not only to which hedge funds to use. This advice refers to when (anticipated market fluctuations) and where (domestic versus international), which can easily ensure you a greater chance of receiving a large return on your investment.

Good Performance

A hedge fund’s freedom of investment strategy generates potentially very high returns. Hedge funds can catch the upside of a rising market and offset the risk of a falling market. Fund manager payment is made on the basis of performance and provides and incentive to maintain investor profits.

Diversification

A diversification of investment strategy – long/short, tactical trading, event driven and emerging markets — by a hedge fund manager reduces the fund’s exposure to one specific style. The allocation of assets to a hedge fund from a traditional investment portfolio diversifies the traditional investor’s risks. The hedge fund allocation also stabilizes and improves returns for the traditional investor.

Disadvantages

Large Investment Fees

One major disadvantage of hedge funds is the often high fees one must pay to invest in hedge funds. For example, hedge fund investors typically charge both a performance fee on top of a management fee. A management fee is usually 2% of the net value of the fund, and is paid typically every month. Regarding performance fees, they are typically 20% of whatever the fund earns in any given year. Performance fees are mainly used to motivate managers to create as big of a profit as they can.

Standard Deviation

Another disadvantage to hedge funds is the use of the statistical tool known as the standard deviation. This is a very common tool that anticipates the risk in investing in a particular hedge fund. Therefore, the standard deviation measures the volatility of possible gains, expressed as a certain percentage per year.

The statistic can provide a good measure of potential variation in gains during the year. However, the downside is that the standard deviation cannot indicate the overall big picture of the risk of return.

Downside Capture

The downside capture is a risk management measure used to assess what level of correlation a hedge fund has to a specific market when that particular market is on the decline. The smaller the downside capture measure of a fund, the better equipped the hedge fund will handle a market decline.

However, the disadvantage is that all funds are compared to a unified benchmark for the market. So, if a hedge fund manager uses a different style of investing than the benchmark, the downside capture ratio may, for example, show that the fund is under-performing the benchmark, even if the market index generates high returns.

Draw-down

The draw-down is basically a statistic that provides estimation in the overall rate of return on an investment. The disadvantage to this measure is related to the disadvantage that the standard deviation has with a hedge fund. With that, hedge funds mainly don’t operate very consistently and predictably in order for the standard deviation, and thus the draw-down, to be very useful.

Leverage

Leverage is an investment measure that’s often overlooked as being the main factor in hedge funds acquiring large losses. Basically, when leverage rises, any downsides in investment returns are magnified. This often causes the hedge fund to sell off its assets at a cheap price. Leverage is usually a main reason why so many hedge funds go bankrupt.

Strategies Used in Hedge Funds

Hedge funds strategies cover a broad range of risk tolerance and investment philosophies within a wide display of investments, including debt and equity securities, commodities, currencies, derivatives, real estate and other investment vehicles.

Long/Short Equity

One of the most commonly used strategies for startup hedge funds is the long/short equity strategy. This strategy involves taking long and short positions in equity and equity derivative securities. Funds using a long/short strategy employ a wide range of fundamental and quantitative techniques to make investment decisions.

Credit Funds

Credit funds make debt investments based on lending inefficiencies. These funds tend to follow cyclical patterns, and are most active following economic downturns and restrictions in the credit market.

Credit funds include distressed debt strategies, which involves investment in corporate bonds; fixed-income strategies, which invest in long-term government, bank and corporate bonds and; direct lending and others.

Arbitage

Arbitrage strategies seek to play on visible price differences between closely-related investments by simultaneously purchasing and selling investments. When properly used, arbitrage strategies produce consistent returns with low risk. However, because price inefficiencies between investments are sometimes slight, arbitrage funds must rely heavily on leverage to obtain significant returns.

Event Driven

Event-driven strategies closely pertain to arbitrage strategies. It seeks to exploit pricing inflation and deflation that occurs in response to specific corporate events. That includes mergers and takeovers, reorganizations, restructuring, asset sales, spin-offs, liquidations, bankruptcy and other events creating inefficient stock pricing.

Event-driven strategies require knowledge in fundamental modeling and analysis of corporate events. Examples of event-driven strategies include: merger arbitrage, risk arbitrage, distressed debt, and event-based capital structure arbitrage.

Quantitative (Black Box)

Quantitative hedge fund strategies rely on quantitative analysis to make investment decisions. Such hedge fund strategies typically utilize technology-based algorithmic modeling to achieve desired investment objectives. Quantitative strategies are often referred to as “black box” funds, since investors usually have limited access to investment strategy specifics.

Global Macro

Global macro refers to the general investment strategy making investment decisions based on broad political and economic outlooks of countries. It involves both directional analysis as well as relative analysis. The former seeks to predict the rise or decline of a country’s economy while the latter evaluates economic trends relative to each other.

Global macro funds are not limited to any specific investment vehicle or asset class. Also, it can include investment in equity, debt, commodities, futures, currencies, real estate and other assets in various countries.

Multi-Strategy

Multi-strategy funds are not open to a single investment strategy or objective. It uses a variety of investment strategies instead to achieve positive returns regardless of overall market performance. Multi-strategy funds tend to have a low risk tolerance and maintain a high priority on capital preservation.

See Also: Things You Need to Know About Index Funds

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