Hedge funds date back to the mid-20th century, but they have become much more significant in the world of finance over the last 20 years. It is estimated that the industry has ballooned from US$118 billion of assets under management to almost US$3 trillion (see Figure 1) over that period.
So what exactly is a hedge fund and how can investors make money from them?
Fundamentals of a hedge fund
In investor terms, to hedge is to protect yourself against risk and adverse financial circumstances. Still, the definition of a hedge fund is not straightforward as there are numerous investment strategies hedge funds use, many which are complex.
Put simply, you could think of hedge funds as loosely regulated pools of capital that are typically used by professional investors, high-net-worth individuals and other institutions. Often hedge funds are more flexible in their approach than other types of investment funds, where managers are generally required to conform to a more structured investment strategy.
Traditionally, hedge funds had two key characteristics. First, they ‘hedged’ out market risk by profiting when the value of an investment decreased. Second, they increased profits through the use of leverage, or debt, much like the returns one would earn on a property with a mortgage.
Hedge funds often use a technique called ‘shorting’. This means they sell an asset because they believe its value will fall only to buy the asset back more cheaply, making a profit in the process.
The generally accepted fee structure of a hedge fund is ‘Two-and-20’: hedge funds charge 2 per cent to manage your assets and then take a 20 per cent cut of profits, sometimes above a specified benchmark. That’s quite expensive compared to the average fund manager.
The market for hedge funds
Hedge funds are quite common in the US and Europe. Hong Kong and Singapore are the regional hubs for hedge funds in Asia, but you don’t hear of them very often in New Zealand. The hedge fund industry is also relatively small in Australia.
Recently though, hedge funds have been in the spotlight for different reasons. A sharp rise in the volume of money managed by hedge funds was followed by a period of underperformance, and investors have been pulling their money out.
According to Bloomberg, investors withdrew almost US$50 billion from hedge funds in June and July. At this rate, 2016 could be the first year hedge funds experience net cash outflows since the global financial crisis.
However, this by no means spells the end of hedge funds. A record-low interest rate environment means that strongly performing hedge funds are still attracting capital from sovereign wealth funds and pension funds, who quite simply need to allocate their capital somewhere. Commodity-focused hedge funds have performed particularly well this year.
With low interest rates propping up asset prices around the world, hedge funds might also appeal to those seeking some protection against a tumble in market values.
Common hedge-fund strategies
Hedge funds use many different investment strategies. Here is a summary of five of the more common strategies:
1. Long/short: These funds profit from both buying and selling securities. For example, they may buy shares in Apple, expecting its share price to appreciate as profits increase, due to strong iPhone 7 sales. That’s a ‘long’. The fund could also ‘short’ Samsung shares based on the view that Apple will take market share from Samsung, hurting profits in light of the Galaxy Note 7 issues around the safety of its components (see Shorting 101 below).
2. Market neutral: An extension of long/short, matching long investments with shorts. This strategy aims to decrease exposure to the market with increasing returns from individual asset selection.
3. Merger arbitrage: Aims to profit from share-price fluctuations as a result of mergers and acquisitions. This strategy is sometimes called risk arbitrage. For instance, if Company A makes an offer to acquire Company B for NZ$100 a share, company B’s shares will usually trade at less than NZ$100 (for example NZ$97) until the deal is done. When the deal closes, Company B’s shareholders will receive NZ$100 per share. The NZ$3 discount that the shares trade at represents the risk that the deal will not close. Merger arbitrage funds conduct extensive research to understand whether a risk is worth taking.
4. Distressed/restructuring: A strategy focused on corporate credit products, such as bonds. Distressed hedge funds acquire these investments, often at deeply discounted prices. This could be because the company is bankrupt, or is on the verge of going under. The fund then plays an active role in the restructuring process, with a view to profit from the outcome.
5. Activist: Where the fund takes a stake in a company so it can influence its management and strategy, to deliver value to shareholders. This could include lobbying a company’s management to sell parts of the company, or even the entire company, to realise financial gain. This strategy is more common in the US.
SOVEREIGN WEALTH FUND: Large, government-owned investing institutions. A New Zealand example is the NZ Super Fund.
An investor can profit from the decline in value of an investment.
Step one: Borrow a share from a broker
Step two: Sell the borrowed share today for NZ$10 (cash inflow of NZ$10)
Step three: Buy the share back when the price declines to NZ$5 (cash outflow of NZ$5)
Step four: Deliver shares back to broker
Profit: NZ$10 - NZ$5 = NZ$5 (less transaction costs)
First published 23 February, 2017
By Mike Ross
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