Hedge funds: tools and strategies for alternative investments

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Hedge fund management

Hedge fund management refers to a highly varied assortment of strategies to manage assets on well-defined market niches. Hedge funds strive to generate absolute, preferably stable, performance levels, uncorrelated with the general market trend, while minimising risk of loss and protecting the invested capital. Below we review some examples of hedge fund strategies.

Hedge fund tools

Selling short consists of selling underlying securities without actually owning them in the hope of buying them later at a lower price. In order to do this, the manager borrows these same underlyings on the period covered by the contract. (When securities are lent, ownership is transferred to the borrower who then has the right to sell them; he must simply make sure to acquire the same quantity of these securities at the time he must return them!).

Arbitrage consists of taking advantage of unwarranted price spreads: for example, by buying convertible bonds that appear to be undervalued while shorting the underlying share.

The search for leverage consists of borrowing cash to bolster the effective size of the portfolio (initially formed with funds brought by investors).

Derivatives (options, futures or forward contracts) are frequently used, either for speculative reasons or to hedge against portfolio losses.

Hedge funds also use microeconomic and macroeconomic research with a view to flushing out fundamental trends in the economy or financial markets, or to identify high-potential or struggling firms.

Strategies

Risk/return ratios vary enormously among the different hedge fund strategies. There are many different descriptions of hedge fund strategies. For more information, see: http://www.magnum.com/

Convertible arbitrage entails the investment in convertible bonds that are inefficiently priced on the market. This strategy typical entails the simultaneous purchase of convertible bonds and the short sale of the same issuer’s ordinary shares.

Long/short equity consists of taking simultaneous long (buy) and short (sell) positions on selected equities belonging to the same sector or regional zones, with either a market-neutral or long or short bias. It requires full mastery of stock-picking tools.

The global macro manager seeks to profit from shifts in the world economy, notably changes in interest rates stemming from governmental economic policies. He/she uses an assortment of instruments or assets as a function of the world economic situation: currencies, indices, yield curves, commodities, etc.

A fixed-income arbitrage manager strives to take advantage of shifts and discrepancies in the yield curve. He/she makes use of Treasury securities, futures and rate swaps.

Merger arbitrage is a strategy based on the spread between the announced purchase price and the price at which the target company is actually trading.

In an event-driven strategy, the manager seeks to exploit special events that unlock the value of companies: business spin-offs, mergers or distressed securities.

The emerging markets manager invests in developing markets. This is a very high-risk strategy, because hedging instruments are not always available on this type of market.

These are the most popular strategies, but there are others.

Hedge funds

A hedge fund operates much like a UCITS or mutual fund, but is unregulated common fund, and therefore has much more investment leeway. Unlike traditional funds, hedge funds performances are uncorrelated with general share or bond market trends.

Note: to hedge means to cover one position by taking another, symmetrical position. This does not mean that all hedge funds follow no-risk strategies; such an approach would prevent them from achieving their performance goals.

The hedge fund field is highly technical and its managers are generally very experienced, independent-minded and often invested in the funds they manage. Fund managers are generally compensated on fund performance.

Because hedge funds base their strategy on a single approach and may make ample use of derivatives, they do not fit traditional mutual fund categories. Hedge funds face little regulatory oversight: they are popular in the United States and offshore sites. A hedge fund generally focuses on a single strategy, which is why there are as many types of hedge funds as there are strategies.

Hedge funds attract wealthy and well-informed investors, due to their positive performances on both growth and slumping markets.

Fund of hedge funds

A hedge fund is expected to focus on a single strategy and consistently stick to it: This is a matter of transparency, and one of the risks of investing in a hedge fund is precisely that of style drift, should the initial strategy not pan out.

The performances of hedge funds vary widely. Since volatility is often high, an investor may seek out a fund offering less return but greater stability, as well as the ability to pull out at will.

Funds of hedge funds were created to meet this need. Managers invest the funds collected in a basket of hedge funds representing the range of known strategies. Despite what one might think, this does not entail creating a sort of melting pot of funds and then letting each manager run his/her fund. A thorough research and financial engineering effort is required to select the fund managers, evaluate risk levels and determine the asset weight of each fund.

One characteristic of charted hedge fund returns is that they never rise as much in times of growth or decline as steeply during downturns as a chart of market returns.

On the Web

A number of highly informative articles can be found at the following sites: