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How do hedge funds work?

Hedge funds have the unusual characteristic of causing both anxiety and excitement. Most investors remember the time that George Soros - probably the most famous hedge fund manager - “broke the Bank of England” in 1992, and the near-collapse of Long-Term Capital Management in 1998.

Friday, August 31st 2001, 4:20PM 1 Comment

But they also suspect that such funds offer ways to get spectacular returns which are not available to the average person.

Hedge funds are essentially vehicles that use unconventional techniques to allow them to prosper in all market conditions. For example, hedge funds can "short-sell" or bet on falling markets or securities, and can therefore perform well even when sharemarkets are falling.

The ability of hedge funds to grow, or at least fall less, even when markets are falling is one of their main attractions. According to the weighted index calculated by the Hedge Fund Research Institute, from January 1991 to May 2001 the average returns of hedge funds on a global level were 13.67%, which is slightly less than the 14.84% of the S&P500 Index.

However, the average volatility of the hedge funds was 8.11%, compared with 14.9% for the S&P500. If the Sharpe ratio - which measures return relative to risk - is taken into account, then hedge funds perform substantially better than the S&P500.

A comparison of hedge fund performance with that of the S&P500 over four discrete periods gives some insight into their relative performance: from February 1994 to January 1995, July to October 1998, from March to December 2000 and the first five months of this year. In all these intervals except the third, hedge funds increased more than the S&P500. (It is important to note that the return of hedge funds is uncorrelated with that of the stockmarket. In fact, the correlation between the S&P500 and the average returns on hedge funds rarely exceeds 10%.)

These general results show the potential hedge funds can offer investors, but it is useful to remember that these results represent an average for the sector as a whole.

To properly understand hedge funds, it is important to classify them according to the strategies that they follow.

Long/short equity
This strategy includes constructing a portfolio with a long position (buying) in undervalued shares, and a short position (selling) in overvalued shares. The difference between the long position and the short is the net exposure to the market. The average return of this strategy from 1990 until today has greatly exceeded both the S&P500 and the MSCI World Index. In addition, the average volatility was lower than both of these indices, and accordingly these hedge funds have had the best ratio of risk to returns.

The strategy is not risk-free. The hedge fund manager must not only be on top of the individual share position, but must also decide on the net exposure to the market. Investors should also remember that managers with a short position face the possibility that the intermediaries may recall the borrowed shares.

This strategy is a more specialised version of the long/short strategy. It consists of selling shares in companies with specific problems, or selling shares because of the market sentiment. In other words, it means betting on falling markets or securities.

The stockmarket boom of the last few years has not benefitted this strategy. Short-sellers tend to perform best when markets fall: between March and December of last year, the short-selling hedge funds gained 60 percent compared to negative returns for almost all the main world stockmarket indices. These funds are valid instruments for hedging against a fall in the market, because they are characterized by a strong negative correlation with stockmarket indices. But they are not free of risk, as fund managers who pursue this strategy must get their timing right.

The event-driven strategies are focused on particular events, which can produce a rise in the price of the shares. The underlying principles are represented by merger arbitrage and distressed securities. The strategy of merger arbitrage is focused on mergers and acquisitions. These hedge funds buy, after the announcement of mergers, the shares of the company that is being acquired, and sell those of the purchaser, in an amount that depends on the prefixed exchange rate between the two sets of shares. The objective is to gain the spread between the market price and the offer price (the premium). If the transaction proceeds without a problem, the market quotes will reflect the offer price.

This strategy has generally attained positive returns in recent years, as the funds have benefitted from a favourable market environment. The most common risk of this strategy is that the mergers are not completed. The situation depends on many factors: government disposition, willingness of the shareholders, the nature of the operation - hostile or willing - and interests of other companies. There is also the risk spread, that is, that the estimated premium is lower than it seems.

Distressed securities
Hedge fund managers which follow the 'distressed securities' strategy focus on the opportunities that arise from situations of bankruptcy, liquidation, and restructuring. These funds typically invest in different fixed income securities, such as high-yield bonds or "junk bonds" (the debt of companies with a poor credit rating). The typical risk for these hedge funds is that market conditions might move against them. An economic downturn or an increase in interest rates typically hit the profit margins of distressed companies.

Convertible arbitrage
This strategy consists of the acquisition of convertibles (bonds which can convert to shares), and the sale of a specific amount of shares from the same company. The hedge fund manager aims to take advantage of mispriced situations with relation to the price between the convertible bonds and shares. These hedge funds have given satisfaction to their investors in the 1990s, with a Sharpe ratio more than double that of the S&P500 Index. But it is once again important to take into account the specifics of this time period. This strategy does not generally benefit from changes in interest rates or market volatility.

Fixed income arbitrage
There are numerous variables that exist within this strategy. In general, the short position is composed of securities with the highest credit rating, such as Treasury bills, while the long positions are corporate bonds or emerging markets debt. The objective is to gain from the convergence of interest rates. Although this strategy has not attained exciting results over the last years, it has enjoyed low volatility.
The risks characterising this strategy are those typical of bond investments: the exposure to interest rate fluctuations and credit risk.

Equity market neutral
The portfolios of this strategy are composed of long positions in undervalued shares, equally balanced with a short position in overvalued firms, to cancel the fluctuations of the market. This method of investment is equivalent to the long/short, with no market exposure. For the choice of shares in general, it uses quantitative models to discover those that are inefficiently priced.

The strategy has produced optimum results over the 1990s, and has a low volatility. It has also generated positive results in all of the four negative periods discussed above. The returns of this strategy are almost completely attributable to the ability of the manager, and/or to the quantitative methods, to support the share selection. Therefore, the risk resides in these two factors, but also in the possible lack of correlation between the long and short parts of the portfolio.

The macro funds take long and short positions in shares, bonds, options, futures, and commodities, using high financial instruments. The name of the strategy derives from the fact that these funds are not simply interested in the future evolution of the companies, but of the entire country or sector. This strategy has provided consistent returns with low volatility. It is important to note that compared to other hedge fund strategies, macro funds are characterised by a strong correlation with stockmarket indices.

« Demystifying Hedge FundsPortfolio Talk: Hedge Funds smooth rough ride »

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Comments from our readers

On 3 April 2011 at 4:49 am helmuth lechner said:
The profits of hedge fund managers is obscene they produce nothing and should be regulated
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