Hedge Fund Strategies

Hedge Fund Strategies

Hedge Fund Strategies for Mutual Fund Investors

Every now and then hedge funds become fashionable in the news – sometimes it’s pundits clamoring for increased regulation; sometimes it’s chicken littles sounding the market crash alarm. But most of us don’t have the $1 million to invest in a hedge fund, so we tend to ignore them. Doing so limits our ability to examine them for what they really are and effectively use their strategies.

What is a Hedge Fund?

A hedge fund, put simply, is a private investment organization that uses multiple strategies to protect wealth from the inherent risks of volatile markets.
Okay, simpler: a hedge fund is a fund that uses unconventional investments to offset losses when the market turns sour.

How is a Hedge Fund Different from a Mutual Fund?

First, a hedge fund will generally have a different investment philosophy than a mutual fund. A mutual fund may cite “growth” or “income,” while hedge funds tend to be much more philosophical. These are the investment vehicles of the wealthy, and the wealthy have already experienced growth. So, while capital growth (building wealth) is indeed a goal of hedge fund investors, capital preservation (maintaining wealth) can be even more important.
Typically, a hedge fund manager will be given much more control over the fund’s investments. While a mutual fund prospectus will usually outline maximum and minimum allocations for different asset classes and will sometimes expressly forbid the manager from riskier strategies such as shorting, a hedge fund prospectus will offer general guidelines to be followed but the investments are up to the sole discretion of the manager.
A hedge fund will use any number of investment strategies to limit the fund’s exposure to any given strategy. It’s sort of like asset allocation, but it’s actually strategy-based. One might call it strategy allocation.
So, what strategies do hedge funds employ to hedge against market downturns?

Hard Assets

Since hedge fund managers don’t have a prohibitive prospectus that they must follow under all circumstances, they may sell a large percentage of the fund’s securities and hold cash (typically US dollars and/or Euros, depending on the market conditions) or other hard assets. This includes commodities futures (gold, oil, pork bellies…you get the picture).

Short Selling

Short selling is selling securities that one does not own in order to buy them back at a discount. Anyone with a margin account can do this, but most mutual funds do not because it is highly risky.
Basically, the investor (or fund manager) decides that a stock is overvalued for one reason or another. Let’s say XYZ is trading at $75. So the investor calls her broker and says she wants to sell short 1,000 shares of XYZ. She already has a $200,000 account with the broker, so the broker goes ahead and sells the shares, depositing the $75,000 ($75 per share X 1,000 shares) into her account. She now has $275,000, but she is obligated to buy back those 1,000 shares of XYZ at some point in time. Should the stock skyrocket to $280 a share, she will be broke (of course, the broker would not let that happen; generally a short must buy back the stock if it has risen by 15%).
Luckily, a week passes and the company starts to falter and the stock price drops to $65. Our investor calls her broker and purchases 1,000 shares for $65,000, keeping the remaining $10,000 for herself.
Such trading requires a healthy amount of assets (or a margin account) to cover in the case that the security actually rises in value.

Long-Short

In hedge funds, short selling is almost always accompanied by “long” positions, hence the name long-short. Long-short strategies purchase securities that they believe will rise in value while simultaneously short selling those they believe will fall. Some consider this to be a defining aspect of hedge funds.
Long-short funds are either net short or net long, meaning that over 50% of the fund can be long or short, depending on what direction the manager sees the market going. Some mutual funds, notably Prudent Bear (BEARX), are always net short.

Equity Market Neutral

An equity market neutral strategy earns returns from stock-picking within an industry or market and hedges against volatility using a long-short method within that asset class. For example, a manager may believe that UnitedHealth Group is a better health insurance stock than Aetna. The manager will then buy, or “long,” UnitedHealth while simultaneously short selling Aetna. With this strategy all that matters is the relative performance of these two companies. If UnitedHealth stock rises more than Aetna rises (or falls), the investment makes money. If UnitedHealth stock gains less (or drops) while Aetna stock surges higher, the investment lost money.
This strategy hedges against market risk. In our example, it does not matter what happens to the healthcare sector, or even the U.S. stock market in general. Even if all healthcare stocks plummet, all that matters is that UnitedHealth does better, falling less, than Aetna.

Market Neutral Arbitrage

Equity market neutral funds may employ a similar strategy called market neutral arbitrage. The term arbitrage means to exploit imbalances in pricing between securities.
Market neutral arbitrage seeks out imbalances in multiple securities from the same issuer. This strategy hedges market risk by investing in opposing positions (long and short) in different asset classes of the same issuer. A manager, then, may short sell a company’s stock while simultaneously purchasing the same company’s convertible bonds.
This is an investment in a vacuum, because the only factor that affects performance is how well the two different securities perform in relation to each other. Even if the company does poorly, the investment may do well.