How do Hedge Funds Work? Part 1

A typical trading desk at a hedge fund
A typical trading desk at a hedge fund

How Do Hedge Funds Work?

In essence, hedge funds can actually work in a variety of different ways – there is no one strategy that hedge funds adhere to. Instead, a multitude of strategies exist that a hedge fund may employ. However, within these varying strategies there do lie some common characteristics that most hedge funds share. Here is an informative video from Moneyweek describing what a hedge fund is:

Aren’t they just like Mutual Funds?

In some respects, yes. Hedge funds, like mutual funds, invest in publicly traded securities. They are also pooled investment vehicles – that is, several investors entrust their money to a manager. However, there are some key differences between hedge funds and mutual funds. For starters, and the whole raison d’etre of hedge funds is that, investors give hedge funds the freedom to pursue absolute return strategies. Mutual funds on the other hand seek relative returns.

Starting a Hedge Fund – the Hedge Fund Manager

All hedge funds begin with a hedge fund manager. This manager sets up his stall with a specific investment strategy or philosophy. All manner of investment strategies can be used, from leveraging, to a global-macro approach. Whatever strategy is chosen, he then seeks accredited investors and qualified clients to pool their money, and lots of it, in order to invest in his strategy. In many cases, the manager him or herself will invest a hefty chunk of their own cash, so it is in his or her interest that the fund does will. And frequently, the amount of money invested is large, upwards of a half million dollars.

Common Investment Strategies

The hedge fund manager then invests this hefty chunk of money in a variety of ways.

Arbitrage Strategies (Relative Value)

Arbitrage is the exploitation of an observable price inefficiency and, as such, pure arbitrage is considered riskless. For example, very simply, take a stock currently trading at $10 where a single stock futures contract due in six months is priced at $17. This futures contract is essentially a promise to buy or sell the stock at a predetermined price. So, without taking any risk, you can buy the stock and simultaneously sell the futures contract, thereby locking in a $7 gain before transaction and borrowing costs.

Not many funds operate solely as arbitrageurs, but those that do traditionally tend to offer a good source of low-risk reliably-moderate returns.

Event-Driven Strategies

Event-driven strategies take advantage of transaction announcements and other one-time events. For example, merger arbitrage, which is used in the event of an acquisition announcement, involves purchasing the stock of the target company and hedging the purchase by selling short the stock of the acquiring company.

There are various types of event-driven strategies. Another example is distressed securities, which involves investing in companies that are reorganizing or have been unfairly beaten down, as well as ‘activist funds’, which are very predatory. This kind of fund type takes not inconsiderable positions in small, flawed companies, then it uses its position to force management changes or a restructuring of the balance sheet.

Directional or Tactical Strategies

Most hedge funds use directional or tactical strategies. The famous Quantum Fund was one of these hedge funds. It operated as a ‘macro fund’, which means it was global, and made “top-down” bets on currencies, interest rates, commodities or foreign economies. Because these macro funds are for “big picture” investors, they don’t often analyze individual companies.

Other common examples of directional or tactical strategies include:

• Long/short strategies that combine purchases (long positions) with short sales.

• Market neutral strategies – a specific kind of long/short which aims to negate the impact and risk of general market movements, trying to isolate the pure returns of individual stocks.

• Dedicated short strategies – specialising in the short sale of over-valued securities.

Other articles in this series:

How do Hedge Funds Work? Part 2