When people outside the financial world hear the words “hedge fund” many are immediately taken back to the 1987 classic movie ‘Wall Street’ and Gordon Gekko, or Bobby Axelrod in the HBO series ‘Billion’ including big money, fast cars and a winner takes all mentality.
A hedge fund is an alternative investment vehicle available only to sophisticated investors, such as institutions and individuals with significant assets.
While many hedge funds exist to invest in traditional securities, such as stocks, bonds, commodities and real estate, they are best known for using more sophisticated (and risky) investments and techniques.
What is a hedge fund?
As with all funds, a hedge fund is a pool of money used to invest in ‘alternative assets or strategies’, including the use of derivatives, alternative investments and leverage in both domestic and international markets.
There are many different types of hedge funds that all operate differently depending on their risk tolerance, the fund’s particular strategy, what assets are being invested in & where they are located, the investment tools used and the fund manager’s skills.
It is important to outline several key terms that will pop up in this and other associated articles, those of sophisticated investors and alternative assets.
Only wholesale investors are typically able to invest in hedge funds due to their complex and often risky nature. As at the writing of this book (Jan 2020), by definition, a sophisticated investor is “an investor who has had a gross annual income of $250,000 or more in each of the previous two years or has net assets of at least $2.5 million, as prescribed by the Corporations Regulations 2001 (reg 6D.2.03 and reg 7.1.28)”.
How does a hedge fund work?
Like all funds, a hedge fund is set up to ‘pool’ capital from investors and create a larger pot of money so the fund can gain economies of scale when looking to take a position.
The fund is created by the institution and the fund manager to meet certain goals or to incorporate a certain strategy. These goals surround the type of assets the fund will focus on, their risk, their location and a range of other factors.
Hedge funds are often leveraged, meaning the fund borrows money in an attempt to magnify the returns and capitalise upon market movement, knowledge on insights with a larger position than otherwise available from investor funds alone.
Hedge funds have the ability to make or break companies, industries with some of them having as much (or more) available capital than many countries! For example, the largest hedge fund manager in the world – Bridgewater Associates manages $150 billion in invested capital for around 350 of the largest and most sophisticated investors around the world.
How do hedge funds make their money?
Hedge fund managers don’t just run their funds out of the goodness of their hearts; they are in it – like the investors – to make money. Viewers of the TV program Billions, will be more than familiar with the term “2 and 20”.
“2 and 20” refers to the fees that the fund manager receives for service. That gives the manager 2% of the asset invested and 20% of the profit every year. Regardless of whether the fund makes a profit or not, the 2% is payable, while the 20% is only on the profits generated by the fund. Although this may seem rather high, due to the fact hedge funds often have very aggressive investment goals, and are very lucrative in producing strong profits.
What types of hedge funds are there?
There are nine (9) key hedge funds that investors should be aware of if they are considering investing in a hedge fund as part of their portfolio.
Long-Short Funds:
As the name suggests, the manager holds both long and short positions to capitalise on stocks they feel will over and underperform and to capitalise upon this market movement.
There are two main types of long-short funds:
Market neutral funds are used to hedge against market movement, as they have the same level of exposure to bullish (long) and bearish (short) positions in the market, making them as the name suggests.
Convertible arbitrage funds, purchase ‘convertible securities’ such as bonds in a company and short sell its common stock.
An example of such a fund is offered by Invesco in the Australian market.
Event-Driven Funds:
Event-driven strategies are equity-oriented strategies involving investments, long or short, in the securities of companies undergoing significant change such as spin-offs, mergers, liquidations, bankruptcies and other corporate events. Examples of these funds are those such as Blackrock.
These funds offer huge profit-making potential for funds that can predict the potential outcome that the event has not only on the company, but the market as a whole – regardless of being a long or short position. Often this is where hedge funds get a bad reputation for betting against companies and essentially sending them to ruin to make a profit.
Macro Funds:
Macro funds are those such as Bridgewater Associates that invest based on economic trends, such as inflation and FX rates, as well as gross domestic product readings.
As the name suggests, it is looking at the large ‘macro’ trends rather than at an industry, company or market specifically.
Distressed Securities Funds:
Hedge funds such as Oaktree Capital look at distressed securities that are primarily debt securities, which originate from companies that are in the process of reorganisation or liquidation under local bankruptcy law or companies engaged in other extraordinary transactions, such as balance sheet restructurings.
Trading in distressed securities can be inefficient, due to the fact the company is being forced to sell.
These funds often look to either pump the company for sale, or dismantle it and sell off the individual assets should they hold higher market value than the price they are able to negotiate to often desperate company shareholders and executives that will often take ‘pennies on the dollar’.
Emerging Market Funds:
As the name suggests, these hedge funds look to capitalise on markets or portfolios of companies in emerging markets that offer untapped growth opportunities.
In terms of location, these are often in markets across China, India, Indonesia and even developed economies such as Australia & the USA who have markets that are emerging or moving. Examples of these funds are that held by Fidelity International.
Long Only Funds:
These hedge funds look at high-quality funds that can be considered ‘undervalued’ and having a positive outlook for the future company, market or industry development.
The fund takes a long-term position to purchase and hold the stocks in generally 25 to 35 companies in the hope the capital growth is realised. Examples of these funds are the Australian based L1 Capital Investment Fund.
Short Only Funds:
On the opposite side of the coin, short only hedge funds – although rare – look to provide exposure to declining markets such as that offered by Tradewind Capital – this is essentially betting that the market or value of a company will go down, not up.
These are often created by activist investors, who are looking to create a negative impact on a reprehensible business model, such as those run by Bill Ackman who tackled companies such as Herbalife in the USA.
Fixed Income Arbitrage Funds:
These hedge funds look to capitalise upon mortgage-backed securities (MBS), government bonds, corporate bonds, municipal bonds and even more complex financial instruments such as credit default swaps (CDS) which ultimately caused some of the mass losses (and gains for some) when the property market crashed leading to the 2008 GFC and was the subject of the movie, The Big Short.
When there are signs of mispricing in the same or similar issues, fixed-income arbitrage hedge funds take a combination of leveraged long and short positions to profit when the market pricing is correct.
Aberdeen Standard has such fixed-income funds available within the Australian market.
Merger Arbitrage Funds:
These hedge funds seek to create ‘risk-free profits’ by purchasing & selling simultaneously the shares of two merging companies to create a profit in the discrepancy in share price and the price being offered by the acquiring parties of the companies.
Timing is everything with these merger arbitrage funds, however, they can yield significant results. Silver-Pepper investments have such a fund available to sophisticated hedge fund investors.
Hedge funds are incredibly high stakes, high reward, high-risk instruments that are not for your average mum & dad investor – unlike an Exchange Traded Fund (ETF). They are geared towards sophisticated investors who have access to large amounts of capital or assets and are looking to either profit, hedge or influence markets.
Should a hedge fund be included as part of your personal investment strategy, it is always best to get independent, expert advice before committing to a fund and ensure that your due diligence and research is complete and accurate, as losses can occur on a much larger scale due to the size of the required outlay.