"All I had done was to improve on their strategy, and it was the beginning of a very important lesson in life - that anytime you find someone more successful than you are, especially when you're both engaged in the same business - you know they're doing something you aren't" - Malcolm X
Hedge fund strategies have been used for well over 6 decades, if not longer, and have been a key source of extraordinary returns and portfolio performance for many a privileged investor. Though once the sole-domain of institutional investors (pension funds, endowment funds) and wealthy families, since the 1990's more and more "mum and dad" investors have been able to gain access to these alternative investment vehicles.
But what are hedge funds? And why are they important?
In essence, hedge funds are run with the intent of taking advantage of asset pricing discrepancies and market inefficiencies. This could be a real, arbitrage (risk-free) opportunity or perceived (calculated) opportunity. In today's world, with largely informed investors, high-speed trading and other-wise efficient markets, the returns from such opportunistic trading can be small, but when repeated 100s or 1000s of times a day, feasible gains are made. And such gains tend not to be correlated with the traditional investments of shares and bonds. The hunt for this extra, uncorrelated profit is the reason hedge funds continue to form a key component of an investor's portfolio.
And how exactly do hedge funds operate? That's probably best answered by looking at some of the different strategies employed by fund managers. Most hedge funds just focus on one strategy, though there are a handful that like to dabble across the hedge fund spectrum. In no particular order the main hedge fund strategies are:
- Discretionary Global Macro Strategy - Big title, but this pretty much means the fund can invest in anything it likes. Generally, the manager will take a look at the big picture of world economics and try and find stories or themes that it believes will force certain markets or assets to go up (buy these ones) or down (sell these ones) - E.g. Manager believes North Korea will start a war in the NW Pacific and shutdown Japanese and Korean industry and thus it decides to shortsell indices of these equity markets.
- Systematic Global Macro Strategy - Similar to the above in that it invests in most any market (equities, bonds, currencies, commodities, gold, though not usually in direct equities), but instead of looking at economic fundamentals, this manager looks primarily at trading patterns and trends. For the most part, the large players in this field have built heavily researched computer algorithms and execution models that will take 1000s of positions (both long and short) in 100s of markets simultaneously - E.g. Manager (computer) sells gold based on trade volume, retracement level and strong downside momentum.
- Market Neutral Strategy - In this strategy, the manager takes relative value bets usually based on analysis of fundamentals. This means that she finds an asset that she believes will perform better than another asset (usually in the same asset class or sector) and she will buy the former and sell the latter to the same value. This means that no matter which way the market moves, the strategy makes money as long as the asset bought outperforms the asset sold. Pure long/short equity funds are the main type of market neutral strategy, but funds covering other markets or multiple markets are also very popular - E.g. Manager believes National Australia Bank has unfairly underperformed other bank shares for a period and thus decides to buy NAB and sell ANZ.
- Event Driven Strategy - This area of hedge funds actually incorporates a number of different, opportunistic strategies not mentioned above. These include Merger Arbitrage funds (generally profit by buying the takeover target and selling the company doing the takeover), Distressed Securities funds (funds that buy the debt and sometimes the equity of companies entering into bankruptcy at significant discounts), and other opportunistic-style funds (Leveraged Buy-Out funds, Vulture funds, Activist funds, Legal Catalyst funds, etc).
As stated earlier, there are also Multi-Strategy fund managers who incorporate a number of these opportunity sets into their investing Further there are plenty of Fund of Hedge funds, that look to build a portfolio of hedge funds.
Some of these strategies tend to be a bit riskier than others (event driven and discretionary global macro), but would also be expected to compensate investors with a bit extra return as well. And some funds (particularly equity long/short funds) tend to have more correlation with traditional markets than you might hope. Overall, the more diversified multi-strategy funds and fund of hedge funds tend to offer more conservative performance, and by and large most of these strategies attempt to provide a reasonable stable return above cash rates over an investment horizon.
Transparency and liquidity tend to be the major detractor from investing in hedge funds, with slow redemptions and failed and fraudulent funds remaining an issue despite industry progress. But the more these strategies are understood, along with further technological advancements to allow faster redemptions and greater disclosure of information, the more space hedge funds will occupy in investor portfolios.