Hedge Funds Explained

Introduction

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Hedge funds have grown significantly in popularity over the past decade. Total hedge fund industry capital has reached a record level of $2.41 trillion as of Q2 2013. (1) Originally, hedge funds offered little transparency and were limited to sophisticated institutions and ultra-high net worth individuals. Today, hedge funds have become widely accepted among qualified investors. Hedge fund transparency has increased while hedge funds have become a top performing asset class with a low correlation to traditional markets. Hedge funds vary enormously in terms of investment strategy, return profile, volatility and risk. Understanding these characteristics is essential to capitalizing on the various investment opportunities that exist. This analysis highlights some of the fundamentals of hedge fund investing. Contact us for assistance with your hedge fund portfolio needs.

What are hedge funds and how do they differ from traditional investments?

resources---Hedge-Funds-Explained-6A hedge fund is a private pool of capital managed by an investment advisor. Hedge funds are similar to mutual funds in that they are pooled and professionally managed, but differ in that the funds cater to sophisticated investors and have far more flexibility in their investment strategies.

Hedge funds vary enormously in terms of investment strategies, returns, volatility and risk. Hedge fund managers typically are highly specialized and trade within their areas of expertise and competitive advantage.

One of the main differences between traditional and hedge fund investments is that the skill of the manager (alpha) rather than the performance of the market or asset class (beta) drives hedge fund returns.

Hedge funds invest in a broad range of assets including stocks, bonds, options, currencies and commodities and may utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets.

Hedge funds have the ability to deliver non-correlated returns due to their use of flexible investment options and methods such as short selling and derivatives (e.g., puts, calls, options, futures, etc.) that may reduce risk or even achieve positive returns when markets are falling.

Hedge fund managers often invest a significant amount of their own money in their fund giving them “skin in the game”. There is an incentive for managers to deliver returns as the managers compensation is typically heavily weighted towards performance incentives. However there is a business incentive to seek to preserve capital during riskier times.

How Investing in Hedge Funds May Enhance a Traditional Investment Portfolio (2)

resources---Hedge-Funds-Explained-5Adding hedge funds to an investment portfolio can provide diversification not otherwise available in traditional investing. There is a wide variety of hedge fund investment styles – many uncorrelated with each other – providing investors with a choice of distinct strategies to meet their investment objectives.

  • Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets.
  • Inclusion of hedge funds in a balanced portfolio may reduce overall portfolio risk and volatility and increase returns.
  • Hedge funds are a long-term investment solution, minimizing the need to correctly time entry and exit from markets.

Misconceptions about Hedge Funds

Misconception: Managers are unregulated

The majority of the larger hedge fund managers are registered with the SEC, CFTC, FSA and/or other regulatory organizations. CrystalResearchTM tracks these registrations and provides relevant information to our users.

Misconception: Hedge funds are volatile and take large directional bets

While strategies vary significantly, hedge funds typically offer more diversification and downside protection to long-only investments. CrystalAnalyticsTM allows users to easily analyze manager performance against certain benchmarks.

Misconception: They are highly leveraged

While hedge funds typically have the ability to leverage, many banks’ trading desks use significantly more leverage. It is important to understand the nature of the strategy, as some strategies (e.g., arbitrage) will use leverage, while others may not.

Misconception: They charge excessive fees

Compensation is often heavily weighted on performance so that a manager only gets paid well if investors do well. Managers’ performance should always be monitored on a net basis. CrystalAnalyticsTM allows users to easily analyze fund performance against other investments, net of fees.

Misconception: Hedge funds are illiquid and have long lock up periods

While some managers do have long lock up periods, many investments can be liquidated quarterly. It is important to understand that liquidity typically goes hand-in-hand with a strategy’s investment horizon. CrystalResearchTM details the manager strategy, liquidity and terms. CrystalPortfoliosTM allows users to build portfolios specific to their liquidity needs.

Hedge Fund Strategies

Hedge funds use one or more of the following investment strategies: (5)

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Activist: Activist strategies may obtain or attempt to obtain representation of the company’s board of directors in an eort to impact the rm’s policies or strategic direction and in some cases may advocate activities such as division or asset sales, partial or complete corporate divestiture, dividend or share buybacks, and changes in management. Strategies employ an investment process primarily focused on opportunities in equity and equity related instruments of companies which are currently or prospectively engaged in a corporate transaction, security issuance/ repurchase, asset sales, division spin-o or other catalyst oriented situation. These involve both announced transactions as well as situations which pre-, post-date or situations in which no formal announcement is expected to occur. Activist strategies are distinguished from other Event Driven strategies in that, over a given market cycle, Activist strategies would expect to have greater than 50% of the portfolio in activist positions, as described.

Credit Arbitrage: Credit Arbitrage strategies employ an investment process designed to isolate attractive opportunities in corporate xed income securities; these include both senior and subordinated claims as well as bank debt and other outstanding obligations, structuring positions with little or no broad credit market exposure. These may also contain a limited exposure to government, sovereign, equity, convertible or other obligations but the focus of the strategy is primarily on xed corporate obligations and other securities are held as component of positions within these structures. Managers typically employ fundamental credit analysis to evaluate the likelihood of an improvement in the issuer’s creditworthiness, in most cases securities trade in liquid markets and managers are only infrequently or indirectly involved with company management. Fixed Income – Corporate strategies differ from Event Driven: Credit Arbitrage in that the former more typically involve more general market hedges which may vary in the degree to which they limit fixed income market exposure, while the latter typically involve arbitrage positions with little or no net credit market exposure, but are predicated on specific, anticipated idiosyncratic developments.

Distressed Securities: Distressed/Restructuring strategies employ an investment process focused on corporate xed income instruments, primarily on corporate credit instruments of companies trading at signicant discounts to their value at issuance or obliged (par value) at maturity as a result of either formal bankruptcy proceeding or nancial market perception of near term proceedings. Managers are typically actively involved with the management of these companies, frequently involved on creditors’ committees in negotiating the exchange of securities for alternative obligations, either swaps of debt, equity or hybrid securities. Managers employ fundamental credit processes focused on valuation and asset coverage of securities of distressed rms; in most cases portfolio exposures are concentrated in instruments which are publicly traded, in some cases actively and in others under reduced liquidity but in general for which a reasonable public market exists. In contrast to special situations, distressed strategies employ primarily debt (greater than 60%) but also may maintain related equity exposure.

Emerging Markets: An emerging market hedge fund specializes its investments in the securities of emerging market countries. Although there is no exact denition of “emerging market countries,” these countries are in the process of developing. They typically have per-capita incomes on the lower to middle end of the world range, and are in the process of moving from a closed market to an open market. Examples of emerging markets include China, India, Latin America, much of Southeast Asia, parts of Eastern Europe, and parts of Africa.

Equity Market Neutral: Equity Market Neutral strategies employ sophisticated quantitative techniques of analyzing price data to ascertain information about future price movement and relationships between securities, select securities for purchase and sale. These can include both Factor-based and Statistical Arbitrage/Trading strategies. Factor-based investment strategies include strategies in which the investment thesis is predicated on the systematic analysis of common relationships between securities. In many but not all cases, portfolios are constructed to be neutral to one or multiple variables, such as broader equity markets in dollar or beta terms, and leverage is frequently employed to enhance the return prole of the positions identied. Statistical Arbitrage/Trading strategies consist of strategies in which the investment thesis is predicated on exploiting pricing anomalies which may occur as a function of expected mean reversion inherent in security prices; high frequency techniques may be employed and trading strategies may also be employed on the basis on technical analysis or opportunistically to exploit new information the investment manager believes has not been fully, completely or accurately discounted into current security prices. Equity Market Neutral Strategies typically maintain characteristic net equity market exposure no greater than 10% long or short.

Event Driven: Event Driven Managers maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, nancial distress, tender oers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specic developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specic development exogenous to the existing capital structure.

Global Macro: Global macro strategies trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, xed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ relative value techniques, macro strategies are distinct from relative value strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposed to long/short equity, in which the fundamental characteristics on the company are the most signi cant and integral to investment thesis.

Long/Short Equity: Long/short equity strategies (a/k/a equity hedge strategies) maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversied or narrowly focused on specic sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. Long/short equity managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short.

Managed Futures: Managed futures strategies include both discretionary and systematic commodity strategies. Systematic commodity have investment processes typically as function of mathematical, algorithmic and technical models, with little or no inuence of individuals over the portfolio positioning. Strategies employ an investment process designed to identify opportunities in markets exhibiting trending or momentum characteristics across commodity assets classes, frequently with related ancillary exposure in commodity sensitive equities or other derivative instruments. Strategies typically employ quantitative process which focus on statistically robust or technical patterns in the return series of the asset, and typically focus on highly liquid instruments and maintain shorter holding periods than either discretionary or mean reverting strategies. Although some strategies seek to employ counter trend models, strategies benet most from an environment characterized by persistent, discernible trending behavior. Systematic Commodity strategies typically would expect to have greater than 35% of portfolio in dedicated commodity exposure over a given market cycle. Discretionary Commodity strategies are reliant on the fundamental evaluation of market data, relationships and inuences as they pertain primarily to commodity markets including positions in energy, agricultural, resources or metal assets. Portfolio positions typically are predicated on the evolution of investment themes the Manager expect to materialize over a relevant time frame, which in many cases contain contrarian or volatility focused components. Investment Managers also may trade actively in developed and emerging markets, focusing on both absolute and relative levels on equity markets, interest rates/fixed income markets, currency; frequently employing spread trades to isolate a differential between instrument identified by the Investment Manager to be inconsistent with expected value. Discretionary Commodity strategies typically would expect to have greater than 35% of portfolio in dedicated commodity exposure over a given market cycle.

Multi Strategy: The investment objective of multi-strategy hedge funds is to deliver consistently positive returns regardless of the directional movement in equity, interest rate or currency markets. In general, the risk prole of the multi-strategy classication is signicantly lower than equity market risk. By denition, multi-strategy funds engage in a variety of investment strategies. The diversication benets help to smooth returns, reduce volatility and decrease asset-class and single-strategy risks. Strategies adopted in a multi-strategy fund may include, but are not limited to, convertible bond arbitrage, equity long/short, statistical arbitrage and merger arbitrage.

Relative Value Arbitrage: Relative Value investment managers maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, xed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. RV position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.

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For more information about the content of this article, please contact John Chatmas at jchatmas@waterloocap.com or call (512) 693-4363.

(1) HFR Global Hedge Fund Industry Report 8/2013
(2) Source: Hedge Fund Association
(5) Source: Hedge Fund Research, Inc. and Eurekahedge Pte Ltd.

IMPORTANT DISCLOSURE

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