While most investment funds adopt traditional buy-and-hold strategies, hedge funds may use a variety of alternative investment strategies. That is why some people refer to them as "alternative investments".
The diversity of investment strategies and the use of different instruments mean that hedge funds may vary enormously in terms of risks and returns. Because of their complexity, hedge funds are only suitable for those who are able to understand and bear the risks involved.
What kinds of basic investment strategies are employed by hedge funds? What are their risks?
Apart from traditional techniques like portfolio planning and diversification, hedge funds may also employ one or more of the following strategies.
Hedging: It is a defensive strategy to mitigate risk by taking a secondary position in order to offset the risk associated with a primary position. A typical example is selling an option or futures contract to hedge against the downside risk of the underlying security. An effective hedging strategy could be costly as it requires precise estimations of the relative movements of the primary and secondary positions, such as the hedge ratio, and continuous rebalancing.
Short selling: It is the sale of a borrowed security in an attempt to buy it back at a lower price. If the price of the security declines, then the profit is the difference between the two prices. However, if the price of the security appreciates, then the loss equal to the price difference results. Short selling can be used for different purposes. Some use it as a trading technique to make profits, while others employ it as a hedge against market declines.
Leverage: This involves making an investment by putting up only a small amount of money so as to magnify the returns. However, leverage works both ways. If the price of the investment goes against one's view, the loss will be magnified. Both margin trading (making an investment by borrowed money) and derivatives, such as futures and options, involve leverage.
Arbitrage: This strategy attempts to exploit a temporary price discrepancy between related instruments by simultaneously buying low and selling high. For instance, convertible arbitrage involves buying an undervalued convertible bond (a bond convertible into the underlying stock) and selling short the underlying stock, or vice versa. As price discrepancies are usually very small, leverage is often employed to gear up the positions.
Market neutral: This strategy attempts to minimize exposure to systemic movements of the market as a whole. This could be done by simultaneously holding long and short matched positions, hedging and/or arbitrage. Market-neutral strategies are not risk neutral and do not necessarily imply low volatility. They do take special risks associated with, say, price differentials and volatility, and the robustness of the models and trading processes used by the fund managers.
What are the different hedge fund classifications?
Hedge funds are generally categorised by the instruments or markets they invest in and the investment strategies they adopt. But different persons may have different classifications for hedge funds. The followings are some examples of hedge fund classes.
Long/short equity: These funds carry long and/or short positions in equities. Typically, their objectives are not to be market neutral. They can shift from net long (majority of positions are long) to net short (majority of positions are short), depending on the managers' views on the price movements of their investments.
Equity market neutral: This strategy is designed to exploit equity market inefficiencies and usually involves simultaneously taking long and short positions in under- and over-valued equities, while maintaining market neutral.
Convertible arbitrage: This strategy attempts to profit from price discrepancies between convertible bonds and their underlying stocks. A typical investment is buying an undervalued convertible bond and selling short the underlying stock, or vice versa.
Global macro: These funds may carry long and/or short positions in different instruments, such as stocks, bonds, currencies and derivatives, in any markets in the world. Typically, they use a top-down approach to analyse the world's economies, and then invest on their views of major economic and political events or trends. Some of these funds may use leverage to capitalize on price movements that they anticipate in these markets. The well-known George Soro's Quantum Fund and the collapsed Tiger Fund fall into this category.
Managed futures: These funds take long and/or short positions in derivative instruments, such as futures, options and warrants. The fund managers are usually referred to as commodity trading advisors (CTAs).
Fixed income arbitrage: This strategy aims to profit from price anomalies between related interest rate securities, such as government bonds of different maturities. It takes offsetting long and short positions in interest rate securities and/or their derivatives whose values are interrelated but their relationship is temporarily dislocated or will change soon.
Event driven: This strategy is designed to capture price movements arising from anticipated corporate events. One of its sub-strategies is merger or risk arbitrage which will consider anticipated mergers or acquisitions. Typically, it will buy the stock of a company being acquired and sell short the stock of the acquiring company. The principal risk is deal risk, if the deal fails to close. Another sub-strategy involves investing in the securities of companies in financial distress, restructuring and bankruptcy. Such kinds of distressed securities are typically traded at discounts and therefore attract investments. The major risk is credit risk, if the company defaults.
What is a fund-of-hedge-funds?
A "Fund-of-Hedge-Funds" (FoHFs) is a fund that exclusively invests in other hedge funds. You can think of a FoHFs as a basket of hedge funds, with the FoHFs being the parent with a number of underlying baby funds in its portfolio. Usually, the FoHFs manager will try to achieve diversification and improve the FoHFs' risk and return profile by having a variety of baby funds. Any FoHFs authorized by the SFC must invest in at least five underlying funds, and not more than 30% of its total net asset value may be invested in any one underlying fund.
There are two main categories of FoHFs: "diversified", in which assets are invested in different types of hedge funds; and "niche", in which assets are all invested in hedge funds of a similar type.
Since the FoHFs manager performs additional service in selecting the baby funds and monitoring their performance, a FoHFs has an extra layer of fees - one at the parent level and one at the baby funds level.
How can I know more about the strategy used by a hedge fund and the risks involved?
Read the offering document, in particular pay attention to the warning statements on the front cover. Don't treat it as the usual boilerplate.
The offering document should explain the nature of the scheme, the markets covered, the instruments used, the risk and reward characteristics of the strategy, the circumstances under which the scheme would work best and the circumstances hostile to the performance of the scheme, the risk control mechanism, and so on.
A FoHFs should also clearly explain its diversification strategy in the offering document.