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Basics about Hedge funds

Updated: Mar 29, 2023

What are hedge funds?

Hedge funds are investment vehicles that pool capital from a limited number of accredited investors, such as high net worth individuals, pension funds, and endowments. These funds are usually managed by teams of investment professionals who employ a wide range of investment strategies, which can include both traditional and alternative investments.


Unlike mutual funds, which are regulated by the Securities and Exchange Commission (SEC) and are available to retail investors, hedge funds are only available to accredited investors and are not subject to the same level of regulatory oversight. This is because hedge funds are considered to be more sophisticated investors who can handle the risks associated with the investment strategies employed by these funds.


How do hedge funds make money?

Hedge funds typically charge a management fee and a performance fee. The management fee is usually a percentage of the assets under management, while the performance fee is a percentage of the profits generated by the fund. This fee structure incentivizes hedge fund managers to generate positive returns for their investors, as they only receive a performance fee if the fund performs well.


Hedge funds employ a wide range of investment strategies, which can include long/short equity, global macro, event-driven, and quantitative strategies. Long/short equity involves buying stocks that the fund manager believes will increase in value while simultaneously shorting stocks that the fund manager believes will decrease in value. Global macro involves making bets on macroeconomic trends, such as changes in interest rates or currency fluctuations. Event-driven strategies involve investing in companies that are going through mergers and acquisitions or other corporate events. Quantitative strategies involve using mathematical models to identify mispricings in the market.


Hedge funds can also use leverage, which is borrowing money to invest, to magnify returns. This can increase the risk associated with the investment, but it can also increase the potential rewards. Hedge funds are known for their more complex and flexible investment strategies in comparison to mutual funds, which have been experiencing difficulty in generating positive returns in recent times. In the first two months of 2023, hedge funds only achieved growth of 1.8% compared to the 3.4% increase seen in US stocks. The collapse of Silicon Valley Bank in March further impacted hedge fund returns.


Originally, the objective of hedge funds was to "hedge" or protect against investment risks resulting from long-only investments. This was accomplished by offsetting long investment positions with "short" investment positions, which involves borrowing securities, selling them on the open market, and then later buying them back at a lower price to earn a profit. However, hedge funds have evolved to offer a range of investment strategies designed to generate higher returns than traditional long-only investments. These strategies often involve the use of leverage, options, and other financial instruments to generate returns for investors.


Insights into the fundamental working of hedge funds :

  • Insight 1: The collapse of Silicon Valley Bank (SVB) had a negative impact on several hedge funds. This was mainly due to the wild movements that occurred in the bond market, as hedge funds scrambled to reassess their bets on the interest rate hike policy ahead. Additionally, many hedge funds had expected the yen to devalue, but SVB's collapse suddenly boosted demand for the yen as a safe haven asset. This unexpected turn of events caused significant losses for many hedge funds.

  • Insight 2: Despite the struggles faced by the hedge fund industry, two strategies stand out as top performers in 2023 - Credit and Event Driven.

    • Credit is an investment strategy focusing primarily on debt instruments, such as bonds, mortgages, treasury bills, and loans. Managers who use this strategy aim to profit from efficiencies in this space, such as the difference in senior and junior debt of the same issuer. They may also look to exploit specific risks related to credit instruments, such as default risk, credit spread risk, and illiquidity risk. The YTD return for Credit in 2023 is +2.5%.

    • Event Driven is an investing strategy where investors capitalize on pricing inefficiencies caused by corporate events such as mergers, acquisitions, spin-offs, and bankruptcies. With this strategy, an investor seeks to profit from targeting certain corporate or market-related events that may create temporary stock mispricing. For example, in a merger event, investors may target companies that are being acquired and purchase their shares, ideally at a discount. The YTD return for Event Driven in 2023 is +2.3%. These two strategies have performed well in 2023 and have been able to generate positive returns for investors despite the challenges faced by the hedge fund industry as a whole.


Hedge fund industry has faced significant hurdles in generating positive returns in recent times. However, Credit and Event Driven strategies have been able to buck the trend and successfully generate returns for investors, showcasing the importance of effective investment strategies and the ability to adapt to market conditions.


Hedge funds have faced a number of challenges in recent times, which have impacted their ability to generate positive returns for their investors. Some of the key challenges include:


  1. Increased competition: The hedge fund industry has become increasingly crowded in recent years, with more funds competing for the same investment opportunities. This has put pressure on hedge funds to differentiate themselves and find unique investment opportunities that can generate alpha.

  2. Low interest rates: With interest rates at historic lows, it has become more difficult for hedge funds to generate returns from traditional fixed-income investments. This has forced many hedge funds to take on more risk in pursuit of higher returns.

  3. Market volatility: The global financial markets have become increasingly volatile in recent years, which has made it more difficult for hedge funds to generate consistent returns. This is particularly true for funds that employ long/short equity strategies, as sharp market movements can cause significant losses.

  4. Regulation: While hedge funds are subject to less regulatory oversight than mutual funds, they still face a range of regulations that can impact their ability to generate returns. For example, new regulations around insider trading and short selling can limit the investment strategies available to hedge funds.

  5. Investor expectations: Many hedge fund investors have high expectations for returns, and expect their funds to consistently outperform the market. This can put pressure on hedge fund managers to take on more risk in pursuit of higher returns, which can lead to significant losses if the investments do not perform as expected.


Overall, hedge funds face a range of challenges in generating positive returns for their investors. While the industry has evolved to offer a wide range of investment strategies, hedge funds must be able to adapt to changing market conditions and find unique investment opportunities to generate alpha.


Disclaimer

Any information or communication I provide is for educational or informational purposes only and should not be construed as investment advice. It is important to conduct your research and seek the advice of a professional financial advisor before making any investment decisions. Any investment you make is solely at your own risk, and I am not liable for any losses or damages that may occur as a result of your investment decisions.



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