A modern hedge fund is an aggressively managed (less restricted) portfolio that takes long/short position, uses leverage and/or derivatives, in an attempt to generate a high return, either in absolute or with reference to some benchmark. It is structured such that it is available to a limited number of investors who are each capable of investing a large sum, who may redeem/withdraw their funds during the lock-up period. Further, some funds may require prior notice and/or may charge a fee for the redemption. They promise excess return which is independent of the broad market movements.
A fund of hedge funds (also called fund of funds) provides hedge funds accessible to smaller investors. They conduct the due diligence on funds, diversify between funds (based on location, strategy, asset class), negotiate better redemption terms, etc. However, they have an extra layer of fees.
Hedge fund strategies
Hedge funds are most commonly classified based on the strategies they adopt. The broad classifications include event-driven, relative value, macro, and equity hedge strategies.
Event-driven strategies attempt from profit from short-term company-level events, typically acquisitions and restructurings using long and short positions in stocks, debt and/or options. The further classification includes:
- Merger arbitrage is executed by buying the stock of target and selling stock of the acquirer hoping to profit from deal spread, the additional return due to uncertainty, or from acquirer overpaying for the target. Primary risk includes the merger not going through.
- Distressed/restructuring strategy is executed either by going long the senior debt and short the junior debt or going long the preferred stock and going short the common stock or less commonly (due to high risk) shorting the common stock. It attempts to profit from widening spread due to a company’s financial distress.
- Activist strategy requires obtaining a significant stake in a company so as to influence a company’s policies and decisions regarding divestiture, restructuring, etc.
- Special situations strategy covers events other than those covered above, such as security issuance, special capital distributions, and asset sales/spin-offs.
Relative value strategies
Relative-value strategies attempt to profit from a short-term pricing discrepancy. They include:
- Fixed-income convertible arbitrage strategy is a zero-beta (market neutral) strategy commonly executed by buying convertible bonds and selling common stock to benefit from the price difference between the convertible bond and its constituent parts (plain bond and embedded stock option).
- Fixed-income asset-backed strategy focuses on pricing discrepancies in asset-backed securities.
- Fixed-income general is executed by trades using bonds with different credit risk, different yield curve exposure, different issuers, different sectors, etc.
- Volatility strategy uses options to benefit from an increase or decrease in volatility.
- Multi-strategy uses a combination of the aforementioned strategies.
Macro strategies adopt a top-down approach and use general economic outlook and expected changes in economic variables to trade different asset classes.
Equity hedge strategies
Equity-hedge strategies use a bottom-up approach to exploit mispricing in public equity markets using long and short positions and derivatives. These are the original hedge fund strategies and may be adopted by other investors. Further classifications include:
- Market-neutral strategies are zero-beta strategies executed by going long undervalued stocks and short overvalued stocks to exploit mispricing while avoiding market risk.
- Fundamental growth strategies take long positions in stocks with high growth potential.
- Fundamental value strategies take a long position in undervalued stocks.
- Quantitative directional strategies use technical analysis to identify undervalued and overvalued stocks and then going long undervalued and short overvalued stock with a net long or short position keeping in view the anticipated market conditions and cycles.
- Short bias strategies use technical and fundamental analysis to identify and short overvalued securities such that maintaining a net short position and going full short in declining markets.
- Sector-specific strategies transact in particular sectors of equities.
Hedge funds and diversification benefits
Hedge funds attempt to make money regardless of market conditions by attempting to capture market fluctuations. They are thought of as arbitrage vehicles, attempting to profit while hedging risks. Even though pure arbitrage opportunities are few and far between in efficient markets, hedge funds participation in markets provides liquidity to markets and causes them to be more efficient. However, recently many other investors have adopted typical hedge fund strategies forcing them to seek riskier strategies.
Hedge fund fees
Hedge funds typically have a 2% management fee based on assets under management and 20% incentive fee (based on gross profit or profit net of management fee) and fund of funds have 1% management fee and 10% incentive fee. Sometimes a hurdle rate is specified, and an incentive fee is paid on return in excess of hurdle rate (hard hurdle rate) or whole return (soft hurdle rate). High-water market provision is also common. However, different funds/strategies may have a different fee structure. Most hedge fund indexes report hedge fund performance net of funds. However, since many hedge funds fail and only successful fund performance is reflected in indexes, hedge fund indexes suffer from survivorship and backfill biases.
Hedge funds use leverage to magnify returns either by using derivatives and/or borrowing. The use of derivatives requires maintenance of collateral which means that at least some of the assets will be invested outside the fund’s strategy and may cause a performance drag. Hedge funds typically trade through prime brokers which also lend money to the fund in return of margin requirements depending on the riskiness of the fund’s investment and its creditworthiness. But leverage is a double-edged sword. When a fund’s positions deteriorate, it might receive a margin call, a request to put up more funds. Since this happens typically during financial stress when liquidity has already dried up, a hedge fund is forced to liquidate at significant losses. This is why hedge funds either earn very high returns or suffer very heavy losses.
Another factor that may force a hedge fund manager to liquidate its losses includes redemptions by investors, which normally happens when the fund is already incurring losses. Even though some safeguards such as lock-up period, redemption fees and notice period may alleviate the negative implications of such drawdowns.
Even though hedge funds have been traditionally subject to little regulation, the trend is towards more regulation. This is why the selection of locations for a hedge fund is important.
Hedge fund valuation issues
Hedge fund positions are valued using either market quotes or estimated quotes. When market quotes are used, the average of the bid and ask quotes is a common measure, but it is more conservative (and theoretically better) to use bid prices for longs and ask prices for shorts. In the case of less frequently traded and illiquid assets, estimation is necessary which is normally carried out using statistical models. It is important to have a consistent approach free from conflicts of interest. Some funds also report two NAV, one called trading NAV which applies liquidity discounts to positions in convertible bonds, ABS, CDOs, and reporting NAV which reports performance gross of discounts.
Due diligence for investing in hedge funds
The first consideration in selecting investment is hedge funds is whether an investor is willing to pay the additional layer for a fee for a fund of funds in return for its due diligence expertise, better ability to negotiate and flexibility in redemptions.
Since hedge funds restrict disclosure of information to preserve their competitive advantage, their due diligence is challenging. If an investor wants to invest directly in a hedge fund, it needs to consider the following:
- Identify investment strategy and process (despite the less disclosure).
- Obtain track record i.e. historical risk and return, their calculation methods and compare with a benchmark.
- Find out the fund’s size (AUM) and longevity: larger and older funds are better.
- Qualitative factors such as management style, key person risk, reputation, investor relations, and plans for growth; and review of management procedures regarding leverage, brokerage, etc.
- See if the auditor is independent and competent.
- Ensure that the fund has a rigorous risk management framework.