‘Hedge funds are investment funds that indulge in a variety of investment and trading activities, but which are only open for investment from particular types of investors as specified by regulators’. They utilise a number of different strategies which are aimed at giving positive returns regardless of whether the market is bullish or bearish. One of the advantages of hedge funds is that hedge fund managers typically invest their own money in the fund they manage, which serves to align their interests with investors in the fund.
Hedge funds primarily hedge risk and provide substantial returns simultaneously. Another one of the advantages of hedge funds is that they are flexible in their investment options as they can employ strategies such as leveraging, diversification, short selling and derivatives trading.
Though different hedge funds vary enormously on grounds of investment returns, volatility and risk taken, however, they all maintain the same objective – maintaining consistency in returns as opposed to maximising returns. This objective is maintained by hedging against market risks and deliver non-market correlated returns.
Hedge Fund Strategies
Hedge funds are classified on the basis of the strategies they follow. Arbitrage gives assured returns while hedging provides some coverage against the risk that is encountered while investing. Another method of hedging risk is through diversification of portfolio. This distributes the invested capital among a range of geographically varied and genre varied instruments, as explained later below. In the following section the various strategies are listed and a few important ones are explained.
Arbitrage : Arbitrage makes use of inefficiencies or gaps in market movements to book assured profits using certain instruments. For instance, a fall in the value of the USD from $1.3/€1 to $1.5/€1 in USA, which does not immediately register in France, provides an arbitrage opportunity where a trader can buy Euros in USA for $1.3 per Euro and sell them immediately in France to receive $1.5 per Euro. This creates a $0.2 profit per Euro and when carried out in large quantities, it translates to huge, assured returns. Other kinds of arbitrage include convertible arbitrage, fixed income arbitrage, merger arbitrage etc.
Hedging : Hedging most commonly uses a concept of short selling where a stock that is expected to fall in value is first borrowed (from a broker) and sold at a high price, only to be repurchased later at a lower price and returned to the broker. Through this method profits can be earned even on badly performing stocks. If a long position is held on stocks in a particular industry, then the risk on this position is countered by shorting other stocks in the same industry. Various hedging strategies are hedged equity, equity market neutral funds, equity hedges etc.
Diversification : The term is self explanatory. Diversifying a portfolio into different instruments and in various markets around the world insulates the investment from being affected majorly by fluctuations in a certain market. Emerging markets are popular destinations for such diversification ventures. Distributing capital among assets in the global market is known as global asset allocation. Fund of funds are funds which invest in a combination of other funds providing double the diversification.
Regulation of Hedge Funds
There is no legally binding definition of the term “Hedge Fund”, which easily allows them to escape statutory regulations. Hedge funds are often viewed with suspicion due to their secretive nature and risky dealings. Although mostly unregulated, they are subject to a few regulations. These have been divided into two categories:
- Statutory Regulations – In the United States, hedge funds are not required to register with the SEC if they fulfil two criteria of the Investment Company Act of 1940 – they must have 100 or fewer investors and all investors need to meet the “qualified purchaser” criterion. These are high net worth individuals with at least $5 million in investment assets while institutional investors are required to have at least $25 million in investment assets. Also, these hedge fund securities cannot be sold via a public offering.
- Self regulation – Although hedge funds are not bound to disclose their investment strategies to clients, most hedge funds do provide their investors with a private placement memorandum that contains such information. Also the performance fee, as charged by top hedge funds which is intended to link the manager’s interests with those of the investors, is usually fixed at 20%.
The Dodd-Frank Wall Street Reform Act, passed in July 2010, is directed at increasing the regulation on fund managers and money management firms in the US. Not only does it bring several categories of advisers and fund managers under the purview of State and Federal government rules, it also requires these funds to make information about transactions available to regulators in order to reduce risk. The Act has brought many funds which were earlier free to function as they pleased, under direct supervision of SEC regulations. Many regard this Act as a knee-jerk reaction to the financial crisis of 2008.
Do Hedge Funds provide Financial Insulation ?
Hedge funds are generally regarded as safe investment options due to their risk cancelling hedging strategies. As mentioned earlier, major advantages of hedge funds include the fact that they employ a variety of investment strategies, mostly with the aim of hedging risk and making moderate profits in the process. However recent developments in hedge funds worldwide indicate that hedge funds are shifting their investment portfolios from hedging based to more profit maximising ventures. The ongoing Eurozone crisis presents an apt scenario to judge whether hedge funds actually provide their clients with financial insulation from market volatilities or not.
However it is also worth noting that all four primary hedge fund strategies as defined by Hedge Fund Research Inc. (equity hedge, event driven, macro and relative value) generated positive annualised returns over the past five years as ending in 2011. Also between 2007 and 2011, the cumulative hedge fund indices have recorded higher returns as compared to stock market indices (refer figure). Further, in the midst of the Eurozone crisis, hedge funds limited losses to approximately 40% of the fall in global equities in 2011.
Thus the role of hedge funds in providing financial insulation is debatable as there are many industry statistics to support both sides of the argument. It is safe to say that while they do not provide a complete hedge against market volatility, they do limit losses to a certain extent.
Hedge Fund Debates
Most investors pooling their money into hedge funds are high net worth individuals or enterprises. They are an accredited class of investors and mull over the future of their money to great extents. This is important since hedge funds deal in large sums of money and face close scrutiny by their clients. A few of the major advantages of hedge funds have been listed out below:
- Diversification, which is employed frequently by hedge funds, provides varied returns and insulation from fluctuations in domestic markets.
- Since hedge fund managers are allowed a certain degree of freedom in their operations, it allows them to respond quickly to market changes.
- If a hedge fund strategy works as expected (positively), then the returns are much higher than those obtained through traditional funds. This happens due to the vast amount of leveraging used by hedge funds.
That concludes some of the advantages of hedge funds prevalent today. They have been the topic of much speculation and debate in the financial world lately. Despite these doubts, hedge funds remain popular among the high end investors. The consistent returns and aggressive investment strategies make hedge funds a rich man’s mutual fund! They have their upsides, as has been threshed out through this article, and hence will continue to stay around for quite a while. The advantages of hedge funds may seem few and far in between at times like these, but the fact that they are so popular among a certain section of investors, makes them an important entity to consider.