Hedge funds play a very important role in investment markets and come in many shapes and sizes. Because of this, it’s important for investors to understand what they are, how they operate and the role they play in a fully functioning market.
What's a hedge fund and how do they work?
Hedge funds typically play an important role in financial markets. In fact, when markets are volatile, hedge fund managers are often able to spot, and take advantage of, interesting investment opportunities and inconsistencies in markets that can generate extra returns for a portfolio.
Alfred W Jones is widely considered to have started the first hedge fund in 1949 in the US when he raised US$100,000 to start his fund. Of this money, US$40,000 was his. Jones’ aim was to use some of the money he raised to establish the fund to minimise its losses.
Back then, the fund was known as a ‘hedged’ fund. That is, it tried to hedge its investments by using different types of financial instruments to offset the risks it took on its positions. This is a trait of hedge funds that continues to this day.
Hedge funds can invest in many different asset classes – shares, bonds, listed property trusts, as well as all the derivative instruments they use to hedge their positions such as options, futures and foreign exchange contracts. They can also invest in listed and unlisted investments.
This style of fund also has a number of other defining features, such as investors needing a large minimum amount to invest (an initial outlay of $50,000 or more is typical).
Usually only sophisticated investors or professional fund managers allocate money to them, because of the significant risks to which hedge funds are exposed - they have the potential to make, but also lose, lots of money. So it’s not usually appropriate for retail investors to have significant exposure to them, unless it’s through an investment fund managed by professionals.
Hedge funds are also relatively illiquid. This means it can be hard to withdraw money from them at short notice. They are often largely unregulated, which also increases the risks to which they are exposed. For instance, unlike other managed funds, they don’t have to produce extensive disclosure documents that clearly outline their risks.
In terms of fees, hedge fund managers are rewarded for the returns they produce. So while their fees can be quite high, so too can their returns.
So, how do they invest?
Let’s take a look at some of the common strategies hedge funds use:
How are hedge funds used in an investment portfolio?
An allocation to hedge funds can provide an important source of diversification, not just when markets are volatile, but over time. Hedge funds invest in many different strategies that are uncorrelated to equities markets, such as fixed income funds and emerging markets opportunities, so an exposure to hedge funds has the potential to smooth out a portfolio’s returns over time.
There are many, many different types of hedge funds, all with different target returns and investment profiles. So it’s often useful to delegate the choice of hedge funds to professional managers who are able to select funds based on their risk/return profile, to suit the investor’s objectives.
References:
https://www.cfainstitute.org/en/research/cfa-digest/2007/11/hedge-funds-past-present-and-future-digest-summary
FAQs
Hedge funds can invest in many different asset classes – shares, bonds, listed property trusts, as well as all the derivative instruments they use to hedge their positions such as options, futures and foreign exchange contracts. They can also invest in listed and unlisted investments.
How to hedge in a volatile market? ›
Stocks have a tendency to be correlated; they generally move in the same direction, especially during times of higher volatility. Investors can hedge with put options on the indexes to minimize their risk. Bear put spreads are a possible strategy to minimize risk.
How do hedge funds work? ›
A hedge fund is a limited partnership of private investors whose money is pooled and managed by professional fund managers. These managers use a wide range of strategies, including leverage (borrowed money) and the trading of non-traditional assets, to earn above-average investment returns.
What are volatility strategies for hedge funds? ›
Volatility traders strive to capture relative timing and strike pricing opportunities due to changes in the term structure of volatility. They try to capture volatility smile and skew by using various types of option spreads, such as bull and bear spreads, straddles, and calendar spreads.
Can a hedge fund profit in times of market volatility? ›
The more the shares bounce around, the more opportunities arise to adjust the delta-neutral hedge and book trading profits. Funds thrive when volatility is high or declining, but struggle when volatility spikes—as it always does in times of market stress.
Why are hedge funds so volatile? ›
They are often largely unregulated, which also increases the risks to which they are exposed. For instance, unlike other managed funds, they don't have to produce extensive disclosure documents that clearly outline their risks. In terms of fees, hedge fund managers are rewarded for the returns they produce.
Which strategy is best for a volatile market? ›
Common strategies to trade volatility include going long puts, shorting calls, shorting straddles or strangles, ratio writing, and iron condors.
What do hedge funds do all day? ›
A typical day in the life of a hedge fund manager usually involves constant market monitoring and investment evaluation, along with research and sales work.
How do hedge funds make money in a down market? ›
Hedge funds typically employ the use of long-short strategies to meet their objective of profiting in risky environments. A long strategy simply means you are betting for the price to go up and a short strategy means you expect the price to fall and you position yourself appropriately.
How do hedge funds pay themselves? ›
Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM). Funds typically receive a flat fee plus a percentage of positive returns that exceed some benchmark or hurdle rate.
Focus on stocks trending with the market
A short seller trading in a volatile market should look for a stock that has been declining but which has not already experienced a collapse or "waterfall" decline. The goal is to get in before an acceleration in price, not after.
What is a volatility strategy? ›
- A 'long volatility' strategy usually involves buying options and profits when either realised or implied volatility rises, and vice versa for a 'short volatility' strategy. - The 'volatility risk premium' refers to the compensation an option seller receives in return for.
What is the average volatility of a hedge fund? ›
Hedge Fund Summary Statistics
Hedge funds posted 8.0% average annual excess returns over cash (13.2% compound total returns) net of fees for the period, with 10.0% annualized monthly volatility, resulting in a 0.80 Sharpe ratio.
Why do investors dislike volatility? ›
They are, by nature or by circ*mstances, unwilling to accept volatility in their investment portfolios. They want their investments to be highly liquid. That is, that money must be there in full when they're ready to make a withdrawal. No waiting for the markets to swing up again.
Can hedge funds manipulate the market? ›
Some hedge funds manipulate stock prices on key reporting dates. The authors find that the returns of stocks with significant hedge fund ownership exhibit an increase of 0.30% on the last day of the quarter and a decrease of 0.25% the following day.
How do hedge funds execute trades? ›
The transaction is generally simple and straightforward, but hedge funds, in their effort to squeeze out every possible gain, tend to run trades through multiple brokers, depending on which offers the best commission, the best execution, or other services to assist the hedge fund.
Where to put money in a volatile market? ›
Money that you'll need soon or that you can't afford to lose shouldn't be in the stock market—it's best invested in relatively stable assets, such as money market funds, certificates of deposit (CDs), or Treasury bills.
How do you hedge currency volatility? ›
Currency Swaps and Forward Contracts
Many funds and ETFs also hedge currency risk using forward contracts. A currency forward contract, or currency forward, allows the purchaser to lock in the price they pay for a currency. In other words, the exchange rate is set in place for a specific period of time.
How do you hedge implied volatility? ›
Vega neutral is a risk management method in options trading that works by establishing a hedge against the implied volatility of the underlying asset. Options traders may use a vega neutral strategy when they believe volatility presents a risk to the profits.
