You hear the term quite a bit these days, in all sorts of contexts. What is a hedge fund and why are they so special?
Most investment funds are “long only” meaning that they buy securities and hope to profit when the value of those securities rises. Take your typical mutual fund. When stocks (or bonds) in the portfolio go up, the fund makes money. They go down and you are hosed.
The term ‘hedge’ means “an act or means of preventing a complete loss”. So if a portfolio engages in hedging, it seeks to protect itself from possible falling values of the investments it holds. Typically this is done using shorting or derivatives. For example, say a portfolio holds IBM and the stock is trading around $90. The portfolio manager could buy a put option on IBM which gives them the right to “put” the stock to the seller of that put at a certain set price. If IBM falls in value, the put becomes more valuable, offsetting the decline in value of the IBM shares themselves. In other words, the IBM position is hedged from loss. With me?
There are many variations on this theme. Another common one is to manage a “long/short” portfolio. This strategy will buy investments expected to go up (“long”) and short investments deemed overvalued or weaker than the longs. For example, say you really think Toyota is the best auto company and is going to do very well. Yet you are also afraid of the slow auto market and economy. You might buy Toyota shares and short GM shares, helping to insulate this “paired” trade from the general tide of the market. If both go up or both go down, you don’t gain or lose; you only gain if Toyota outpaces GM. Shorting in this case helps you isolate the difference in performance between two firms. (Recall an earlier post about how shorting is not evil).
Another variation is to hedge by using seemingly unrelated trades. Suppose you want to buy a food company, but you know their profits will suffer if the cost of corn rises (the food company’s biggest input factor). You could own the food company stock and buy options or futures on corn. If corn rises thereby hurting the food company’s profits, your corn options will rise in value thus hedging the investment.
Mutual funds are heavily regulated and it is difficult to employ these strategies in the typical fund. Hedge funds were developed to employ these more esoteric strategies. To get around the rules, hedge funds are available to wealthy investors with certain net worth or income requirements as private investments. This structure complies with SEC rules and laws under the logic that wealthy investors are more sophisticated and thus more capable of understanding the risks involved than the general public. I vehemently disagree with this thinking as do many of my collegues. Wealth has little to do with undertanding the sophistication of an investment. Ask any professional athlete or Hollywood star for example. Yet this is just one of the ways our government tries to protect us. Sigh.
Moving on. Hedge funds have evolved since this rather simple beginning. They now employ much more complicated strategies and the term has come to describe just about any private pool of professionally managed money that isn’t strictly long-only. Arbitrage, global macro, event driven, relative value, absolute return and other strategies can be their focus- or they can focus on any opportunity.
As private partnerships, hedge funds can be regulated (or not) in a number of ways including being domeciled offshore. They typically employ generous fee structures such as the standard “two and twenty” where the fund’s management takes a 2% management fee and 20% of any profits. The average mutual fund carries a management fee of around 1.5% by comparison. Investors are willing to pay these fees because of the uncorrelated aspect of returns (hopefully) or the ability to invest in things regular funds cannot.
Also fairly unique to hedge funds is the ability to use leverage and tie up investor’s money. Investors can be required to keep their money in the fund for set periods of time or require lengthy notice to withdraw funds. This allows hedge funds to invest in relatively illiquid, but hopefully very profitable, investments.
The fee structure and “sticky” nature of the assets makes managing a hedge fund an extremely attractive proposition. Bright minds have fled traditional money management roles to work in the industry which has exploded to something around $1.5 trillion in assets.
So that’s what a hedge fund is. In due time we’ll discuss the pros, cons and misconceptions of hedge funds, but for now you can curse the SEC and Congress for preventing the general public from having access to them. Whether you want access is another matter, but I’m all for choice.
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