What are real hedge funds & the methods used for their success?

Hedge funds are not widely famous as mutual funds. Nevertheless, they are on a continuous surge of popularity everywhere. Though, they share certain similarities with mutual funds. They pool resources (investments) from a myriad of investors and use unique strategies to “hedge” risks and maximize returns.

Let’s try to understand how hedge funds work and what methods/strategies are used to achieve the highest rate of success. For the same, the first step is to understand what real hedge funds actually are.

What are real hedge funds?

In a layman’s language, the word “hedge” means to protect/guard. So, in financial language, it means to safeguard against risks. In hedge funds, the funds are pooled from a variety of official investors like banks, insurance firms, High Net-worth Individuals (HNIs) or families, endowments, and pension funds. The intention behind this is to earn profits or realize a high return on investment.

Hedge funding relies on institutional investors to put forth non-conventional strategies to mitigate risk. Because of this, these funds operate as overseas investment corporations. Hence, there is no mandate for them to be registered in SEBI or disclose their NAV periodically.

Any typical hedge fund portfolio will be a combination of a variety of asset classes like derivatives, equities, convertible securities, currencies, etc. Thus, they are also called alternative investments. It is through this collection that the managers can stay immune to risk on investor’s money against market fluctuations. By employing a variety of strategies, they try to stay immune to the market.

Hedge exactly funds are for?

Hedge funds are nothing but mutual funds managed privately by expert wealth managers. Due to this, investments in hedge funds are a little pricey. Hence, they are only affordable by elite investors who not only have surplus funds but are also risk-takers.

Methods used for the success of hedge funds

Returns from hedge funds depend on the acumen of your fund manager instead of the fluctuations in the market. Wealth managers try their best to mitigate exposure to the market and yield good returns despite the highs and lows. Diversification is the key to success in the market. Some of the methods used to achieve success are:

  • Sell fast

In this case, the hedge fund managers sell the stock/shares at the present moment, hoping that the prices will drop in the future. Then, they can buy back the shares at a lowered price to profit from them.

  • Arbitrage and volatility arbitrage

At times, the securities reflect contradictory pricing. Managers, then, indulge in simultaneous buying and selling of securities in different markets to take advantage of different prices. This is a relatively new strategy that involves getting access to market data to try and spot inconsistencies. Through this data, the managers can monitor the errors in how individual securities are priced. It places more importance on overall market behavior instead of a particular company.

Some major events in the market such as acquisitions, mergers, or spin-offs can play a huge role in manager’s investment decisions. Also known as event-driven investments, these events have a major role in market prices. These are done on the belief that one particular event in the company’s history will tremendously affect security prices. Some of the popular strategies include merger arbitrage and distressed funds.

  • Buying securities offered at a heavy discount

Sometimes companies go through critical financial distressor even insolvency. Thus, they are willing to offer their securities at throwaway prices. Any manager can decide in favor or against such a buying decision after weighing all possibilities.

Equity is the most commonly used strategy of all. Equity hedges used both long and short positions in the public market to lessen the risk and yield high returns. It is further categorized into three renowned categories: market-neutral, long-short, and short-long.

  • Macro

In this strategy, the investors invest the funds in a broad array of securities, from bonds, stocks to commodities and derivatives. The idea here is to gauge how market forces like weather, politics can play a role in causing a change in the financial market

Case Study:

On how PWE Capital turned to MetaTrader 5 platform for hedge funds.

PWE Capital is an Australian fintech company that develops trading algorithms combined with a Direct-To-Bank trading environment to allow effective trading in currency, commodities, and derivative markets. This makes it easy for people to have confidence while dealing with Hedge funds. In 2021, they switched to MetaTrader 5 for hedge funds because the platform assured a comfortable and productive environment for increasing client asset growth. 

Manas D. Kumaar, PWE Capital Group CEO mentioned that his experience with MetaTrader 5 has been overwhelmingly positive from the outset. Speed is obviously of paramount importance to the high-frequency trading industry. According to him, the MQL5 programming language that powers MetaTrader 5 is incredibly fast. It can beat the industry standard C++ in terms of execution. Furthermore, he added his expertise and shared, “It’s geared towards traders, making it more intuitive and faster for quants to implement. Additionally, the ‘algo’ engine provides a flexible interface that allows for rapid testing and encourages innovation.”

Other languages such as MQL5, SQL and Python allow for prompt data analysis and development, but their execution speeds are not fast enough for our purposes. This makes MQL5 the best of both worlds.

According to Manas D. Kumaar, MetaTrader 5 has run incredibly smoothly for them so far. The platform’s fund setup is very simple, yet flexible enough to cater for most use cases.

The CEO says that looking at the future, block-chain technology has the potential to enhance fund accounting and administration efficiency. The future of finance will be built on smart contracts. These developments will reduce friction and improve the liquidity profile of alternative investment vehicles. Software providers that cater to custom fee structures, different NAV reporting timeframes, or other accounting considerations such as vesting schedules and master-feeder structures, will be well placed going forward. From a trading perspective, the industry needs to bridge the gap between traders and developers. MetaTrader 5 serves this purpose well.

The CEO proclaims that they have a unique business model. They don’t charge any fund management fee. Unlike others, their fee calculation is 100% performance based. Therefore, they would welcome a flexible fee option whereby they can customize how fees are charged for fund accounting purposes. Given the requirement for our licensed funds to have an independent fund administrator, using the MetaTrader 5 setup they can still handle fund accounting without any significant administrative cost. Secondly, they would welcome a centralized algo engine that can distribute execution to multiple accounts. Such a setup would be similar to the widely-used master-feeder structure, but would allow for even greater flexibility, custody and operational efficiencies at the account level.