Introduction to hedge funds

[HowardM1]

A Hedge Fund Primer: Understanding the Complex World of High Finance

If you've ever been curious about the high-stakes world of hedge funds, you've come to the right place. These investment vehicles are often shrouded in mystery, and the strategies they employ can be incredibly complex. But don't worry, we're going to demystify hedge funds in this article, examining their defining characteristics, the various types, and even take a look at some famous examples from history.

What is a Hedge Fund?

A hedge fund is a type of investment vehicle that pools capital from accredited individuals or institutional investors and invests in a variety of assets, often with complex portfolio-construction and risk-management techniques. The name "hedge fund" originated from the hedging techniques these funds originally used to protect investors against downside risk. However, over time, the term has evolved to include a broad range of investment strategies.

How is a Hedge Fund Different from a Typical Investment Fund?

Hedge funds differ from traditional investment funds in several key ways:

1. Investor Base: Hedge funds typically cater to high-net-worth individuals and institutional investors such as pension funds and endowments. This is due to their higher risk tolerance and capacity to meet the minimum investment requirements often set by hedge funds.
2. Investment Strategies: While traditional funds tend to follow a relatively straightforward approach (like tracking an index or investing in a specific sector), hedge funds employ a variety of complex strategies designed to generate high returns.
3. Regulatory Oversight: Hedge funds are less regulated than traditional funds, giving them more flexibility in their investment strategies.
4. Fee Structure: Hedge funds typically charge a management fee (usually 2% of assets under management) and a performance fee (often 20% of any profits), famously known as the "two and twenty" structure.

Different Types of Hedge Funds

Hedge funds can be broadly categorized into several types based on their investment strategies:

1. Macro Funds: These funds invest in stocks, bonds, currencies, commodities, and other securities in the global financial markets. They aim to profit from shifts in global economies and their impact on markets, using macroeconomic analysis to develop their trading strategies.
2. Event-Driven Funds: These funds seek to profit from price distortions that may occur before or after a corporate event, such as a merger, acquisition, bankruptcy, or earnings announcement.
3. Quantitative Funds: Also known as "quant" funds, these use complex mathematical models to identify and exploit patterns in the market. They are typically heavily reliant on technology and may use algorithmic trading.
4. Long/Short Equity Funds: These funds take long positions in stocks they expect to appreciate and short positions in stocks they expect to depreciate. The goal is to minimize market risk while focusing on stock selection.
5. Relative Value or Arbitrage Funds: These funds take advantage of price differentials between related financial instruments, such as stocks and bonds of the same company.

A Closer Look at Hedge Fund Strategies

Let's delve deeper into each of these strategies:

Types of Hedge Funds

Long/Short Equity

The first hedge fund used a long/short equity strategy. This strategy involves taking long positions in expected winners as collateral to finance short positions in expected losers. The combined portfolio creates more opportunities for idiosyncratic (i.e., stock-specific) gains while reducing market risk with the shorts offsetting long market exposure1.

Market Neutral

By contrast to long/short equity hedge funds, market-neutral hedge funds target zero net-market exposure, meaning shorts and longs have an equal market value. This means managers generate their entire return from stock selection. This strategy has a lower risk than a long-biased strategy, but the expected returns are also lower1.

Merger Arbitrage

Merger arbitrage is a riskier version of market neutral and derives its returns from takeover activity. It's often considered an event-driven strategy. After a share-exchange transaction is announced, the hedge fund manager may buy shares in the target company and short sell the buying company's shares at the ratio prescribed by the merger agreement. The target company's shares trade for less than the merger consideration's per-share value, a spread that compensates the investor for the risk of the transaction not closing, as well as for the time value of money until closing1.

Global Macro

A global macro strategy is a hedge fund or mutual fund strategy that bases its holdings primarily on the overall economic and political views of various countries or their macroeconomic principles. Holdings may include long and short positions in various equity, fixed income, currency, commodities, and futures markets. Global macro funds build portfolios around predictions and projections of large-scale events on the country-wide, continental, and global scale, implementing opportunistic investment strategies to capitalize on macroeconomic and geopolitical trends2.

Quantitative (Quant) Hedge Fund Strategy:

Quant hedge funds use advanced mathematical models to identify and execute trades. This approach is heavily reliant on technology and often uses sophisticated algorithms to forecast price movements and identify trading opportunities.

1. Statistical Arbitrage: This strategy is based on quantitative models that look for price discrepancies across related securities. The fund will take a long position in the undervalued security and a short position in the overvalued security, expecting the prices to converge over time.
2. Quantitative Macro: This strategy uses quantitative models to predict macroeconomic trends, such as changes in interest rates or GDP growth. These predictions are then used to make directional bets on assets that would be impacted by these macroeconomic changes.
3. High-Frequency Trading (HFT): This strategy uses algorithms to execute a large number of trades in fractions of a second. The goal is to take advantage of very small price inefficiencies that exist for a very short time period.
4. Machine Learning/AI: Some quant funds use machine learning or artificial intelligence to analyze large amounts of data and identify trading signals. This could involve analyzing traditional financial data, like company earnings, or non-traditional data, like social media sentiment.

Commodity Trading Advisor (CTA) Hedge Fund Strategy:

CTA funds trade in commodity futures or other futures contracts. They typically use trend-following strategies, but some may also use counter-trend strategies or pattern recognition based on historical price movements.

1. Trend Following: This strategy involves taking long positions in futures contracts that are in an uptrend and short positions in futures contracts that are in a downtrend. CTAs typically use technical analysis to identify these trends.
2. Counter-Trend: This strategy involves betting against the prevailing trend. For example, if a particular commodity has been in a prolonged uptrend, a CTA might take a short position expecting a price reversal.
3. Spread Trading: Some CTAs engage in spread trading, which involves taking a long position in one futures contract and a short position in a related futures contract. The goal is to profit from the change in the price difference between the two contracts.
4. Option-Based Strategies: Some CTAs use options on futures contracts to create asymmetric payoff profiles or to hedge their positions.

Both Quant and CTA strategies rely heavily on sophisticated mathematical models and computer systems. They are often less correlated to traditional asset classes like stocks and bonds, which can make them attractive for investors looking for diversification. However, they can also be more complex and opaque, which can increase their risk.

Some notable Hedge funds

As you can see the number of strategies a hedge fund can engage in significant we don’t have the space here to go through each and every one and list examples but here I have tried to capture some of the more well known funds some of which are still in existence.

George Soros and Quantum Fund

George Soros is one of the most famous hedge fund managers in the world, known for his macroeconomic acumen. He founded the Quantum Fund in 1969 with Jim Rogers. The fund has been incredibly successful over its lifetime, but it's perhaps best known for its bet against the British pound in 1992. Soros correctly predicted that the pound would be devalued, and he made a massive short bet against the currency. When the pound was indeed devalued, Soros reportedly made $1 billion in a single day, earning him the nickname "the man who broke the Bank of England."

Renaissance Technologies and the Medallion Fund

Renaissance Technologies, founded by Jim Simons in 1982, is a quantitative hedge fund known for using mathematical models and algorithms to identify and execute trades. The firm's Medallion Fund is particularly notable for its extraordinary performance. According to various reports, it has averaged over 35% annual returns after fees since its inception, making it one of the most successful hedge funds in history. The fund's trading strategies are kept highly secret, but it's known that they involve a lot of data analysis and high-frequency trading.

Bridgewater Associates

Founded by Ray Dalio in 1975, Bridgewater Associates is one of the world's largest hedge funds. It's known for its macroeconomic approach to investing, and specifically for its "Pure Alpha" and "All Weather" strategies. The Pure Alpha strategy aims to make money in any economic environment by making both long and short bets on various assets. The All Weather strategy is designed to perform well over the long term by balancing different asset classes to reduce risk. Dalio is also known for his "radical transparency" philosophy, which involves encouraging brutal honesty among his employees.

Long-Term Capital Management (LTCM)

Although it ended in disaster, Long-Term Capital Management is worth mentioning due to the lessons it provided for the hedge fund industry. Founded in 1994 by John Meriwether, a former vice-chairman and head of bond trading at Salomon Brothers, LTCM included two Nobel laureate economists, Myron Scholes and Robert C. Merton, on its board. The fund initially produced strong returns with its arbitrage strategies, but it was highly leveraged some say of the order of 30-50 times, as a comparison a typical global macro fund might be 4x levered. In 1998, during the Russian financial crisis, the fund suffered massive losses and had to be bailed out by a consortium of banks to prevent a wider financial market meltdown. This incident highlighted the systemic risk posed by large, leveraged hedge funds.

To conclude…

In conclusion, the world of hedge funds is a thrilling and challenging arena for those of you considering a career in finance. It's a sector that offers a unique blend of intellectual stimulation, financial reward, and the opportunity to shape the financial landscape. The industry's trailblazers, such as George Soros, Jim Simons, and Ray Dalio, have not only made their mark on the financial world but have also paved the way for future generations of hedge fund managers. Their stories highlight the power of strategic investing and the importance of understanding global economic trends.

However, it's important to note that a career in hedge funds is not for the faint-hearted. The high stakes, combined with the potential for systemic impact, make it a sector that demands responsibility, integrity, and a deep understanding of risk management. The pressure to perform is intense, and the hours can be long. Unlike traditional asset management roles, compensation in hedge funds is heavily tied to performance, and not everyone can consistently deliver high returns.

In fact, when you factor in the long hours and high stress, the per-hour compensation at a hedge fund can sometimes be less than at a traditional asset manager, especially for those that don’t perform, but they tend not to last long anyway. And while the potential for high earnings is there, remember that it's typically the top performers who reap the biggest rewards, your compensation is salary plus bonus, the salary may well be less than a portfolio manager at an asset management house, but the bonus can be huge. This can often be a formulaic pay-out based on how much money you make, if you make no money you don’t get a bonus, and you won’t last long. Many people find that the pressure-cooker environment of a hedge fund is not sustainable in the long term.

On the flip side, for those who thrive under pressure, the rewards can be substantial. Not only in terms of financial compensation but also in terms of the intellectual satisfaction that comes from developing and implementing complex investment strategies. And for those with a strong entrepreneurial spirit, there's the potential to start your own fund and truly make your mark on the industry, just remember the barriers to entry are very high and you will need to ideally start with more than 1 billion in assets.

As you consider your future career path, understanding the workings of hedge funds and their strategies is an invaluable part of your financial education. Whether you're aspiring to manage a hedge fund, seeking to innovate with new financial models, or simply want to understand the forces that move the markets, I hope this primer can serve as a stepping stone into the fascinating world of hedge funds.

Remember, as you embark on your career journey, the lessons from the hedge fund industry are clear: continuous learning, strategic thinking, and a keen understanding of risk are crucial. And above all, never underestimate the power of innovative thinking in shaping the future of finance. But also, be aware of the challenges and pressures that come with the territory, and make sure to consider them carefully as you plan your future in finance, as someone once said it’s a long and winding road…

 

[magellan1]

Very detailed and insightful post, thanks for sharing. I have a few thoughts.
1. Long/short and market-neutral hedge funds are quite popular but the problem with them is that things are great until they aren't. Imagine that you are a fund manager, you identify some patterns based on historical data, for instance, when the oil price goes up, stock prices of oil producers increase while airline stocks go down. You expect oil prices to increase in the near future because of constrained supply, buy stocks of the best oil producers and short the worst airlines to have a market-neutral position (measured by B). A few days later, the US decides to release some oil reserves, Saudi announce an increase in oil production and sanctions on Iran are lifted. Now you find yourself losing on both sides of the trade...
My point is that these strategies are intended to have a lower risk but in many cases, they turn out to be much riskier than expected and can produce terrible results.
2. The roots of hedge funds can be traced back to Ancient Greece. Some merchants and farmers wanted to lock in or speculate on the profit from the future olive harvest. The practices of hedging and speculation must have merit if they are still used (more than two thousand years since their first use).
3. Some of the best-performing hedge funds including Ray Dalio's All Weather strategy have underperformed gold over long periods of time (20 years). This brings up the question of whether hedge funds really generate value or they just exploit their clients (charging high fees and delivering results that can be achieved with passive instruments at a much lower cost).

 

[oldtimer1]

Possibly you're understanding of L/S HFs and assumptions in your comment are incorrect. Expectations for a rise in any input or a determinant of pricing for a business is one theme or component of the underlying thesis. This doesn't mean the fund is taking their exposure and putting it all on that one theme. Across an entire L/S portfolio there is a theme for each position which should diversify the exposure if the themes are uncorrelated. That's how a smart manager constructs their book.

 

[oldtimer1]

Possibly you're understanding of L/S HFs and assumptions in your comment are incorrect. Expectations for a rise in any input or a determinant of pricing for a business is one theme or component of the underlying thesis. This doesn't mean the fund is taking their exposure and putting it all on that one theme. Across an entire L/S portfolio there is a theme for each position which should diversify the exposure if the themes are uncorrelated. That's how a smart manager constructs their book.

 

[JFH1]

It is interesting how the investment sector has evolved from being dominated by active fund managers (performance judged against a benchmark index) to a much more polarised world with, at one end, the hedge funds (judged on absolute performance) and at the other end pure index funds. It is probably a bit of an indictment of active fund manager performance (statistically, not all can outperform an index anyway, particularly after costs and fees have been deducted). It is also interesting to observe the huge variety of hedge fund strategies. Of course, the word "hedge" implies a reduction in risk, while many of these are in fact very high risk, often with no hedging at all.

 

[JFH1]

I would also be interested to know how many hedge funds provide graduate recruitment opportunities. I would expect that it is not very many, given their nature, but any hard data would be useful.

 

[HowardM1]

Very detailed and insightful post, thanks for sharing. I have a few thoughts.
1. Long/short and market-neutral hedge funds are quite popular but the problem with them is that things are great until they aren't. Imagine that you are a fund manager, you identify some patterns based on historical data, for instance, when the oil price goes up, stock prices of oil producers increase while airline stocks go down. You expect oil prices to increase in the near future because of constrained supply, buy stocks of the best oil producers and short the worst airlines to have a market-neutral position (measured by B). A few days later, the US decides to release some oil reserves, Saudi announce an increase in oil production and sanctions on Iran are lifted. Now you find yourself losing on both sides of the trade...
My point is that these strategies are intended to have a lower risk but in many cases, they turn out to be much riskier than expected and can produce terrible results.
2. The roots of hedge funds can be traced back to Ancient Greece. Some merchants and farmers wanted to lock in or speculate on the profit from the future olive harvest. The practices of hedging and speculation must have merit if they are still used (more than two thousand years since their first use).
3. Some of the best-performing hedge funds including Ray Dalio's All Weather strategy have underperformed gold over long periods of time (20 years). This brings up the question of whether hedge funds really generate value or they just exploit their clients (charging high fees and delivering results that can be achieved with passive instruments at a much lower cost).

Sorry I missed this. I see you already have a sensible reply, but just to add my two cents.

Point no 1: If you're right 60% of the time with any macro bet, you're a star. If you're right 50% of the time, you can still be successful. It all comes down to portfolio construction, bet sizing, and at the end of the day, having an edge. An edge is what the casino has over its clients; on average, it makes more than it loses and it compounds those gains. The same gig applies to running money. Consistently make more than you lose, tilt the odds so that you're more likely to win big than lose big, and if (big IF) you have an edge, you will be successful. Whether it's directional or relative value, long or short, the style doesn't matter.

Point no 3: The best performing hedge funds smashed it. Soros, Simmons, Millennium, Citadel, etc. Bridgewater's All Weather is not really a hedge fund strategy; it's comparable to a diversified growth fund. But yes, there's a lot of mediocrity out there, and the fee model is not for those who can't tell the chancers from the real deal. Hedge funds are for sophisticated investors and institutions, and the two are not always synonymous either!

As for outperformance, a room of monkeys throwing darts at a list of stocks on a monthly rebalancing basis will outperform most market cap weighted indices over the last 20 years. That's a fact.

 

[HowardM1]

It is interesting how the investment sector has evolved from being dominated by active fund managers (performance judged against a benchmark index) to a much more polarised world with, at one end, the hedge funds (judged on absolute performance) and at the other end pure index funds. It is probably a bit of an indictment of active fund manager performance (statistically, not all can outperform an index anyway, particularly after costs and fees have been deducted). It is also interesting to observe the huge variety of hedge fund strategies. Of course, the word "hedge" implies a reduction in risk, while many of these are in fact very high risk, often with no hedging at all.

Is it?

So-called active managers traditionally picked stocks to beat a benchmark. That benchmark was set by the peer group or whatever the manager could come up with, typically without considering the client's objectives in any way. Many star fund managers over the last 20 years just ran a small to mid-cap overweight versus a large-cap benchmark. So, they had one bet: small cap vs large. It worked great, but they told clients they were picking individual stocks. If you're saving for retirement, absolute return matters for you, not relative. You can't eat relative returns. So, post-2008, when many active managers "outperformed" by losing only 20-30%, interest picked up in absolute/diversified return or simply owning the market (passive). That seems logical to me. While there are stock pickers out there that have real skill, in my opinion, the majority just hug benchmarks or tilt. Security selection "alpha" often tends to zero over time. Hedge funds charge higher fees (but not always by much) compared to stock pickers, but they eat what they kill, so to speak.

While I think you identify the extremes correctly, there's also a lot in the middle. Quite a few asset managers offer hedge fund lite UCITS funds with no performance fees.

I agree the "hedge" in the name is an artifact. Some are just high vol strats, but some multi-strat funds, when they work as they have done recently, can deliver uncorrelated returns which are, in a sense, a hedge to a traditional portfolio.

 

[JFH1]

Is it?

So-called active managers traditionally picked stocks to beat a benchmark. That benchmark was set by the peer group or whatever the manager could come up with, typically without considering the client's objectives in any way. Many star fund managers over the last 20 years just ran a small to mid-cap overweight versus a large-cap benchmark. So, they had one bet: small cap vs large. It worked great, but they told clients they were picking individual stocks. If you're saving for retirement, absolute return matters for you, not relative. You can't eat relative returns. So, post-2008, when many active managers "outperformed" by losing only 20-30%, interest picked up in absolute/diversified return or simply owning the market (passive). That seems logical to me. While there are stock pickers out there that have real skill, in my opinion, the majority just hug benchmarks or tilt. Security selection "alpha" often tends to zero over time. Hedge funds charge higher fees (but not always by much) compared to stock pickers, but they eat what they kill, so to speak.

While I think you identify the extremes correctly, there's also a lot in the middle. Quite a few asset managers offer hedge fund lite UCITS funds with no performance fees.

I agree the "hedge" in the name is an artifact. Some are just high vol strats, but some multi-strat funds, when they work as they have done recently, can deliver uncorrelated returns which are, in a sense, a hedge to a traditional portfolio.

I think this cuts both ways - I am not defending index huggers who then charge active manager fees, nor active managers. who are simply playing a momentum bet, but there is also a risk/reward trade-off between hedge fund strategies (that are often obscure, sometimes deliberately so) and more traditional active manager strategies. When hedge funds go wrong, it can be spectacular - nobody would want to be relying on LTCM for their pension. Active funds are at worst going to underperform their benchmark, but you are highly unlikely to lose everything.

Furthermore, most savers will not have all their eggs in one basket - if they have put money in a particular fund it is (or should be) because they want exposure to which ever markets or sectors it invests in and they think that the manager is competent - this should form part of an active portfolio of funds which is effectively the saver's asset allocation decision (for which they may take advice). If they are averse to equity risk, there are safer options available.

 

[HowardM1]

I think this cuts both ways - I am not defending index huggers who then charge active manager fees, nor active managers. who are simply playing a momentum bet, but there is also a risk/reward trade-off between hedge fund strategies (that are often obscure, sometimes deliberately so) and more traditional active manager strategies. When hedge funds go wrong, it can be spectacular - nobody would want to be relying on LTCM for their pension. Active funds are at worst going to underperform their benchmark, but you are highly unlikely to lose everything.

Furthermore, most savers will not have all their eggs in one basket - if they have put money in a particular fund it is (or should be) because they want exposure to which ever markets or sectors it invests in and they think that the manager is competent - this should form part of an active portfolio of funds which is effectively the saver's asset allocation decision (for which they may take advice). If they are averse to equity risk, there are safer options available.

Completely agree, hedge funds are not a suitable investment for the majority of retail investors partly for the reasons you outline, and I am certainly not trying to tar all active managers with the same brush. There are skilled managers out there.

I do think if one wants exposure to a sector or a market the passive approach is often a better bet unless you are confident of your ability to do sufficient due diligence on active managers, and you understand the cumulative impact of fee's.

Of course one must also be aware that not all passive products are created equal, so passive does not necessarily obviate the need for due diligence.

 

[JFH1]

I agree - passive products do provide the most obvious choice for an asset allocation decision. This is really the active manager’s dilemma and why I believe they have been badly squeezed (in some cases deservedly so) over the last few decades.