Hedge Funds, basic facts ?

[samfarrell]

I was in the US recently and they seem so bullish about Hedge Funds and the great returns they are showing. my question is how exactly does a hedge fund differ from a normal managed fund, or where could i get more information on these ?

 

[tiger]

have a look at wikipedia to start with.

 

[tiger]

A link to a link lead to [broken link removed] article on how mutual funds & hedge funds differ.

U.S. mutual funds are among the most strictly regulated financial products. They are subject to numerous requirements designed to ensure they operate in the best interests of their shareholders. Hedge funds are private investment pools subject to far less regulatory oversight.

(Again, both articles are US focused)

 

[samfarrell]

thanks for the info Tiger
People with the time and inclination maybe would be better off setting up their own trading clubs , manage their own money. hedge funds seem to be an elaborate version of this

 

[charttrader]

A quick summary from www.investopedia.com

Hedge funds are managed much more aggressively than their mutual fund counterparts. They are able to take speculative positions in derivativeoptions and have the ability to short sell stocks. This will typically increase the leverage - and thus the risk - of the fund. This also means that it's possible for hedge funds to make money when the market is falling. Mutual funds, on the other hand, are not permitted to take these highly leveraged positions and are therefore typically safer.

http://www.investopedia.com/ask/answers/173.asp

I'm not sure why people in the US would be "so bullish about Hedge Funds and the great returns they are showing", however. In the early days of hedge funds, managers were able to easily exploit market inefficiencies and enjoy outsized returns. It's a lot more competitive these days and the proliferation of hedge funds has eroded returns. Hedge fund returns in 2006 lagged the overall market.

 

[ClubMan]

There are some existing threads on AAM discussing hedge funds that might be worth seeking out.

 

[Guest126]

thanks for the info Tiger
People with the time and inclination maybe would be better off setting up their own trading clubs , manage their own money. hedge funds seem to be an elaborate version of this

I could not agree with this statement.

Hedge funds are perhaps the most sophisitcated and technically involved form of fund management - they are about as far removed from a trading club as you can get!

 

[Fintan]

thanks for the info Tiger
People with the time and inclination maybe would be better off setting up their own trading clubs , manage their own money. hedge funds seem to be an elaborate version of this

Where I can sort of see where you are coming from, comparing a hedge fund to a trading club is like comparing an F1 car to a go-kart.

 

[RedJoker]

Hedge funds are different to both mutual and index funds. I'll explain why in a sec. First there are two terms you need to understand, alpha and beta.

Beta is matching the market. If you invest in an index fund you will get the beta return less fees. If you invest in an ETF (Exchange Traded Fund) then you'll make the beta return less commissions. Passive investors should always look to get the beta return by investing in index funds or ETFs. Beta investing is positive sum, the market has risen historically.

Alpha is beating the market or underperforming the market. This is what active investors try to achieve. Alpha investing is a zero sum game, when one person beats the market another person underperforms by the same amount.

Index funds/ETFs are long only and get beta return only. They do not attempt to get alpha return.

Mutual funds are long only so they get the beta return and attempt to get alpha returns as well. Once fees are taken into account the majority fail to get a positive alpha return for their clients, and hence underperform the market.

Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name. They get zero beta return. They attempt to achieve alpha returns and, because they have the best managers, usually do. Hedge funds are far less volatile then mutual funds/index funds/ETFs because they suffer much, much less of the volatility of the market (which is approx 17-18% standard deviation I think).

Hedge funds are a low risk asset. If you leveraged Hedge funds to the same risk as the market then Hedge funds have consistently outperformed the market historically. Or, in other words, Hedge funds outperform the market on a risk adjusted basis. However, Hedge funds shouldn't really be compared to standard market benchmarks, such as the SP-500, in this way because they are very different investment vehicles.

Hedge funds are less regulated then mutual funds, this means they have far more choice over what companies to invest in and can move money around easier, even taking it out of the market if it suits them. This also means that they are a lot less transparent then mutual funds and there have been some notable blow ups. Hedge funds (at least the best ones) have very high minimum investments (low millions) and often do not allow you to withdraw your funds for a certain length of time.

Links for more info on hedge funds:

http://www.hedgeworld.com/



http://www.vanhedge.com/

 

[room305]

Hedge funds are a low risk asset. If you leveraged Hedge funds to the same risk as the market then Hedge funds have consistently outperformed the market historically.

I think these statements are misleading. Hedge funds are not "low risk", there is a very real chance of incurring significant loss of capital as there is with any highly leveraged vehicle. Most hedge funds underperform the market. To all intents and purposes, they are the market now, it is impossible for them all to outperform.

What you failed to mention is the huge fees that they charge. Usually they work on a 2/20 rule - they charge 2% management fees on capital invested and keep 20% of profits generated. Only the very best hedge funds can return alpha returns for investors with these kinds of fees.

 

[Guest126]

I agree that the term hedge is misleading - a lot of them now specialise in 'Special Situation' companies (amongst other things)...there is no hedging going on at all, and they are often high risk.

 

[Sunny]

Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name.

Well, thats just not true.

Hedge funds are a low risk asset.
Hedge funds are less regulated then mutual funds, This also means that they are a lot less transparent then mutual funds and there have been some notable blow ups.

Do you not contradict yourself there? I would never describe hedge funds as low risk assets. I don't know many people who would.

 

[samfarrell]

wow, 20% seems a lot to take off profits. I would assume from this that, initially at least, hedge funds were far outperforming the market return. maybe some still are

 

[CCOVICH]

The theory (with most funds with higher charges) is that they will outperform the market. This isn't always the case of course.

Bear in mind that in order to invest directly in a hedge fund you would need to be a 'high net worth individual', i.e. you can't just call them up and invest €10k-minimum investments are generally much higher.

There may be other ways to get exposure, e.g. through ETFs etc.

 

[efm]

Passive investors should always look to get the beta return by investing in index funds or ETFs. Beta investing is positive sum, the market has risen historically.

That is a gross generalisation for two reasons - one, index funds or ETF's are not the only vehicle for passive investors and are not suitable for all investors and two Beta investing is only positive sum if returns are greater than costs and also you're assuming that markets will continue to rise.

Mutual funds are long only so they get the beta return and attempt to get alpha returns as well. Once fees are taken into account the majority fail to get a positive alpha return for their clients, and hence under perform the market.

Further gross generalisation - mutual funds are not all long only and I would like to see the backup for your claim that the majority fail to get positive alpha

Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name. They get zero beta return. They attempt to achieve alpha returns and, because they have the best managers, usually do. Hedge funds are far less volatile then mutual funds/index funds/ETFs because they suffer much, much less of the volatility of the market (which is approx 17-18% standard deviation I think).

This has got to be the daftest thing I have ever heard. Hedge funds are not 50% long / 50% short (some may be but I doubt if they are in the majority). Hedges do get beta against hedge indices. Can you categorically say that the majority of hedge funds achieve positive alpha? - I think not! Hedges are not less volatile than non-hedges

Hedge funds are a low risk asset

Saving the best 'till last - hedges are not a low risk assets - by their definition they invest in riskier investments and are not as closely regulated as mutual funds so for the investor the risk when investing in hedges is much higher than when investing in mutuals

 

[samfarrell]

just getting back to the question, i found some good info


Key Characteristics of Hedge Funds

• Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets.
• Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.).
• Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded.
• Many hedge funds have the ability to deliver non-market correlated returns. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.
• Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent.
• Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns. Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage.
• Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund

 

[RedJoker]

Sigh, it looks like I've got my work cut out for me, I will try to answer as much as I know.

I think these statements are misleading. Hedge funds are not "low risk", there is a very real chance of incurring significant loss of capital as there is with any highly leveraged vehicle. Most hedge funds underperform the market. To all intents and purposes, they are the market now, it is impossible for them all to outperform.

I'm using low risk to mean low volatility, as far as I'm aware the majority of hedge funds are low volatility. As I mentioned, comparing Hedge funds to the market is not the best way of thinking about them. Yes; I think a lot of hedge funds underperform the market but not on a risk (volatility) adjusted basis.

What you failed to mention is the huge fees that they charge. Usually they work on a 2/20 rule - they charge 2% management fees on capital invested and keep 20% of profits generated. Only the very best hedge funds can return alpha returns for investors with these kinds of fees.

Yes; I did forget to mention this. I was planning to include it in the last paragaph but forgot, nice catch.

I agree that the term hedge is misleading - a lot of them now specialise in 'Special Situation' companies (amongst other things)...there is no hedging going on at all, and they are often high risk.

Yes; because they have far more investment tools to work with, [SIZE=-1]including selling short, leverage, program trading, swaps, arbitrage, and derivatives,[/SIZE] there are a number of aggressive funds. Many of these would not be 'hedged' and may be higly leveraged as well. These funds serve a different purpose for the investor and I think this is the main reason for my differing opinion. I'm focusing on the 'hedged' funds. An investor should be well aware what type of fund they are getting into before they invest.

Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name.

Well, thats just not true.

Well you've certainly proved your point and it's hard to argue with that logic.

Allow me to rephrase my sentence:
Most hedge funds are 50% long and 50% short, I'm assuming that's where the term hedge in the name comes from.

Hedge funds are a low risk asset.
Hedge funds are less regulated then mutual funds, This also means that they are a lot less transparent then mutual funds and there have been some notable blow ups.

Do you not contradict yourself there? I would never describe hedge funds as low risk assets. I don't know many people who would.

I meant low risk as in low volatility, I can see how this looks like a contradiction.

Passive investors should always look to get the beta return by investing in index funds or ETFs. Beta investing is positive sum, the market has risen historically.

That is a gross generalisation for two reasons - one, index funds or ETF's are not the only vehicle for passive investors and are not suitable for all investors

You are correct; however if you do not have the time/experience to pick outperforming mutual funds then index funds/ETFs are the best alternative. Unless you want to invest in something other than equities or you have a very short time frame.

and two Beta investing is only positive sum if returns are greater than costs and also you're assuming that markets will continue to rise.

Why else would you invest in equities unless you expected markets to rise? The reason index funds are so good is because they have extremely low fees, over significant lengths of time beta returns should far exceed fees.

Mutual funds are long only so they get the beta return and attempt to get alpha returns as well. Once fees are taken into account the majority fail to get a positive alpha return for their clients, and hence under perform the market.

Further gross generalisation - mutual funds are not all long only and I would like to see the backup for your claim that the majority fail to get positive alpha

Please forgive my generalisations but I can't go in to every specific detail without making this thread extremely long, and some of the finer points are outside my field of knowledge.

Hedge funds on the other hand, are 50% long and 50% short, hence the term hedge in the name. They get zero beta return. They attempt to achieve alpha returns and, because they have the best managers, usually do. Hedge funds are far less volatile then mutual funds/index funds/ETFs because they suffer much, much less of the volatility of the market (which is approx 17-18% standard deviation I think).

This has got to be the daftest thing I have ever heard. Hedge funds are not 50% long / 50% short (some may be but I doubt if they are in the majority).

As far as I'm aware the majority are 50% long, 50% short.

Hedges do get beta against hedge indices.

I'm talking about standard market benchmarks such as the SP-500 for beta returns.

Can you categorically say that the majority of hedge funds achieve positive alpha? - I think not!

I don't have any papers to back it up but I'd be confident saying yes; the majority of hedge funds achieve positive alpha.

Hedges are not less volatile than non-hedges

Looks like we'll have to agree to disagree on this.

Hedge funds are a low risk asset

Saving the best 'till last - hedges are not a low risk assets

I'm talking about the actually 'hedged' funds and using risk to mean volatility.

- by their definition they invest in riskier investments

I'm talking about the equity hedge funds and not specifically about the ones trading high leverage, high risk investment tools.

and are not as closely regulated as mutual funds so for the investor the risk when investing in hedges is much higher than when investing in mutuals

You are correct that hedge funds are not as closely regulated. That's a different type of risk than the one I'm talking about.

just getting back to the question, i found some good info


Key Characteristics of Hedge Funds

• Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets.
• Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.).
• Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded.
• Many hedge funds have the ability to deliver non-market correlated returns. Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.
• Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent.
• Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns. Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage.
• Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund

I would agree with this and a lot of it backs up some of my points.


It seems that a lot of our disagreements here stem from definition of certain words.

 

[Nermal]

I would like to see the backup for your claim that the majority fail to get positive alpha

Conceivably the majority of mutual funds could get positive alpha, but only if the non-mutual fund part of the market got negative alpha. There's no reason to think this would be the case.

 

[RedJoker]

I would like to see the backup for your claim that the majority fail to get positive alpha

Conceivably the majority of mutual funds could get positive alpha, but only if the non-mutual fund part of the market got negative alpha. There's no reason to think this would be the case.

Not to take this thread too far off topic but the reason mutual funds underperform is because of excessive fees and poor execution. Some out perform the market but it is very hard to find those that will continue to do so because:

1) the best managers will get snapped up by the hedge fund industry and
2) because the fund is outperforming it will have more money than it used to have, especially if new investors are allowed to come in. Getting market beating returns on a small fund is far easier then it is on a large fund.

 

[Fintan]

Hi RedJoker

To say a hedge fund is 50% long and 50% short is completely innacurrate, while some trading strategies still employ some sort of arbitrage using this technique, due to the large number of active hedge funds these techniques are less effective, therefore hedge funds have to become even more leveraged to makes gains which leads nicely onto my second point

To say hedge funds are low risk / low volaility again is extremely innaccurate eg. due to their high leverage small movements in prices will cause huge swings in P&L


Maybe a read of a book on Long Term Capital Management would be in order. (LTCM was an Uber hedge fund that went bust and nearly collapsed the world econonmy).