The words ‘hedge fund manager’ feature heavily in mega-rich lists. Often seen as the most sophisticated investors out there, their high salaries come with high perceived skill. So, what’s so different about a hedge fund, and how can I get involved?
Do hedge funds fund…hedges?
I don’t think the likes of Jim Simons, Ray Dalio, or Bill Ackman know much about hedges, hedge rows, or even hedgehogs. Their team of gardeners might though – easy enough to fund with a few billion lying around. What they do know well is how to make money for investors. Bucket loads of money. (Links to great YouTube videos with these guys, including a very recent one with Mr Ackman with platform Interactive Investor).
Hedge funds employ sophisticated investment strategies and instruments and seek profits in unusual areas of the market. Funds are often complex, risky, and a hodgepodge of seemingly random investments. If executed skilfully however, they can make big returns for investors, and reap fat fees for their specialist work. Typically, a hedge fund will charge 2% per annum, and then lop off 20% of any gains made.
With so much money on the table, a few bad apples are inevitable and make for scintillating reading. Most notable are Bernie Madoff, who it turns out was running a Ponzi scheme rather than a fund; and Raj Rajaratnum, a hedgie of the $7billion Galleon fund, who was dealing on inside information from buddies in high up places.
Hedge funds sit in the realm of alternative investments. Traditionally, due to their complexity, they have not been available to ordinary investors. This is changing: certain hedge strategies are being replicated in funds available to private investors. Here, we run through how they work, and the types of hedge fund strategies available to private investors.
What are hedge funds?
Global markets are enormous and complex, with many potential opportunities on offer. Hedge funds seek profits wherever they see these opportunities, and are typified by the unusual and specialist nature of their strategies. They may involve specialist financial instruments such as derivatives, use leverage, or employ unusual trading strategies. Often, there’s little to no regulation. In essence, the gloves are off.
Where these strategies come from is very much down to the ideas the hedge fund manager generates and their knowledge of global markets. Consistently developing profitable ideas is where the big bucks come from because it’s very hard to do.
Most funds do not work like this: they have a narrow set of rules in what they can do with investors’ money, and are tightly regulated. As an example, a UK bond fund is obliged to invest in bonds in the UK, regardless of whether its manager woke up one morning and saw a mind-bending opportunity in US shares. As a result, hedge funds can make profits in different ways to traditional funds, and potentially perform better when the latter is not.
What kind of weird strategies do they employ?
The big one is shorting shares. So, most of the time funds buy shares long, which means they buy them with the hope that the value will rise for them to sell them and bag a profit. Shorting is the opposite. Through a process known as stock lending, investors profit when shares fall in value. This technique became particularly famed this year with the Gamestop trading saga, which saw Reddit retail investors buy lots of the stock to drive up its price, and cause the hedge funds who were shorting the stock to then lose lots of money. Collectively they lost $5bn. A real ‘stick to Wall Street’ type affair. Shorting will appear in lots of hedge strategies. A notable one is funds investing both long and short, known as long / short funds.
Another really interesting strategy has been the emergence of using algorithms to trade. The master of this is Jim Simons – a former codebreaker for the NSA and mathematical genius. He decided to go into the investing business and set up Renaissance Technologies. It’s flagship fund, the Medallion fund, is the stuff of legend. Since 1988, it’s returned around 66% per annum, of which no other fund has ever come close to. Unfortunately, it’s also only available to RenTech employees.
Other specialist techniques include trading around unusual company events, such as mergers or bankruptcies; seizing on big global macroeconomic events and the impact they have on certain assets; using lots of leverage, which means borrowings, to exaggerate returns; or initiating very complex positions using specialist financial instruments known as derivatives.
Are there different categories of hedge fund?
Very broadly, there are two types. The first is absolute return funds, which are trying to generate a positive return in any market environment. Importantly, this is not guaranteed. These types of funds are more akin to what the original hedge fund was designed to do – to hedge the risks of a fund losing money. As such, these likely won’t produce exceptional returns, but shouldn’t lose too big either.
The second type are the sexy ones associated with all those big hedgie names – they’re known as directional funds, meaning they’re trying to post strong positive returns. They also tend to be much more risky.
Why would I buy one?
Well, for directional hedge funds, it’s the potential for strong returns; with absolute return funds, it’s some protection against falls in the market. Although I must add that during times of proper market stress like the pandemic they will still fall in value.
As hedge funds are in the alternative asset class, both also offer the potential for diversification from regular funds which hold mainstream assets. This is useful as it’s important for us to balance out our portfolios with lots of different types of investments to counter the risks of being in one market or asset class.
What can private retail investors buy?
Hedge funds available to retail investors are much more tightly regulated than ones available to professionals, so their strategies might be watered down a little and less complex. These funds are regulated under UCITS, which is a European regulatory directive that details things like the allowable investments or leverage a fund can use if it is to be sold to private investors like you and me. Popular funds here are absolute return funds for slightly less risky investing, or in the racier directional space – long / short equity funds, macro funds, funds of hedge funds, and hedge fund ETFs.
Alternatively, there are a handful of investment trusts that you can see on the AIC’s website, which have much more freedom in using techniques such as leverage or concentrating holdings. Pershing Square Holdings run by billionaire American Bill Ackman is a great example, with its top 10 holdings representing 73% of the trust.
Key Takeaways
- Hedge funds have lots of freedom in where to invest when compared to regular funds.
- This enable them to find profits in unusual corners of the market.
- As an alternative investment, returns may be generated when those from mainstream assets are lacklustre.
- Strategies available for retail may be watered down a little, but there are plenty still to choose from.