Every now and then hedge funds become fashionable in the news – sometimes it’s pundits clamoring for increased regulation; sometimes it’s chicken littles sounding the market crash alarm. But most of us don’t have the $1 million to invest in a hedge fund, so we tend to ignore them. Doing so limits our ability to examine them for what they really are and effectively use their strategies.
A hedge fund, put simply, is a private investment organization that uses multiple strategies to protect wealth from the inherent risks of volatile markets.
Okay, simpler: a hedge fund is a fund that uses unconventional investments to offset losses when the market turns sour.
First, a hedge fund will generally have a different investment philosophy than a mutual fund. A mutual fund may cite “growth” or “income,” while hedge funds tend to be much more philosophical. These are the investment vehicles of the wealthy, and the wealthy have already experienced growth. So, while capital growth (building wealth) is indeed a goal of hedge fund investors, capital preservation (maintaining wealth) can be even more important.
Typically, a hedge fund manager will be given much more control over the fund’s investments. While a mutual fund prospectus will usually outline maximum and minimum allocations for different asset classes and will sometimes expressly forbid the manager from riskier strategies such as shorting, a hedge fund prospectus will offer general guidelines to be followed but the investments are up to the sole discretion of the manager.
A hedge fund will use any number of investment strategies to limit the fund’s exposure to any given strategy. It’s sort of like asset allocation, but it’s actually strategy-based. One might call it strategy allocation.
So, what strategies do hedge funds employ to hedge against market downturns?
Since hedge fund managers don’t have a prohibitive prospectus that they must follow under all circumstances, they may sell a large percentage of the fund’s securities and hold cash (typically US dollars and/or Euros, depending on the market conditions) or other hard assets. This includes commodities futures (gold, oil, pork bellies…you get the picture).
Short selling is selling securities that one does not own in order to buy them back at a discount. Anyone with a margin account can do this, but most mutual funds do not because it is highly risky.
Basically, the investor (or fund manager) decides that a stock is overvalued for one reason or another. Let’s say XYZ is trading at $75. So the investor calls her broker and says she wants to sell short 1,000 shares of XYZ. She already has a $200,000 account with the broker, so the broker goes ahead and sells the shares, depositing the $75,000 ($75 per share X 1,000 shares) into her account. She now has $275,000, but she is obligated to buy back those 1,000 shares of XYZ at some point in time. Should the stock skyrocket to $280 a share, she will be broke (of course, the broker would not let that happen; generally a short must buy back the stock if it has risen by 15%).
Luckily, a week passes and the company starts to falter and the stock price drops to $65. Our investor calls her broker and purchases 1,000 shares for $65,000, keeping the remaining $10,000 for herself.
Such trading requires a healthy amount of assets (or a margin account) to cover in the case that the security actually rises in value.
In hedge funds, short selling is almost always accompanied by “long” positions, hence the name long-short. Long-short strategies purchase securities that they believe will rise in value while simultaneously short selling those they believe will fall. Some consider this to be a defining aspect of hedge funds.
Long-short funds are either net short or net long, meaning that over 50% of the fund can be long or short, depending on what direction the manager sees the market going. Some mutual funds, notably Prudent Bear (BEARX), are always net short.
An equity market neutral strategy earns returns from stock-picking within an industry or market and hedges against volatility using a long-short method within that asset class. For example, a manager may believe that UnitedHealth Group is a better health insurance stock than Aetna. The manager will then buy, or “long,” UnitedHealth while simultaneously short selling Aetna. With this strategy all that matters is the relative performance of these two companies. If UnitedHealth stock rises more than Aetna rises (or falls), the investment makes money. If UnitedHealth stock gains less (or drops) while Aetna stock surges higher, the investment lost money.
This strategy hedges against market risk. In our example, it does not matter what happens to the healthcare sector, or even the U.S. stock market in general. Even if all healthcare stocks plummet, all that matters is that UnitedHealth does better, falling less, than Aetna.
Equity market neutral funds may employ a similar strategy called market neutral arbitrage. The term arbitrage means to exploit imbalances in pricing between securities.
Market neutral arbitrage seeks out imbalances in multiple securities from the same issuer. This strategy hedges market risk by investing in opposing positions (long and short) in different asset classes of the same issuer. A manager, then, may short sell a company’s stock while simultaneously purchasing the same company’s convertible bonds.
This is an investment in a vacuum, because the only factor that affects performance is how well the two different securities perform in relation to each other. Even if the company does poorly, the investment may do well.
Merger arbitrage, also called risk arbitrage, narrowly focuses on companies involved in a takeover or merger. When Company A announces that it is going to buy Company B for a set price (let’s say, $25 per share), Company B’s stock will rise to a point just below that of Company A’s purchasing price ($24 per share). The difference between the acquiring price ($25) and the stock price of Company B ($24) is called the spread ($1 in our example). The point of merger arbitrage is to turn that spread into profit.
As the deal nears completion, Company B’s stock will slowly rise until the acquirer will pay cash ($25) for all shares .A merger arbitrage strategy that purchased Company B’s shares for $24 has made the spread, $1 per share.
If Company C announces that it will merge with Company D, offering one share of C stock for every two shares of D stock, the manager purchases shares of Company D while short selling Company C until the deal is complete.
This strategy provides relatively consistent returns regardless of market conditions. The only risk is deal risk – the possibility that the merger or acquisition will fall through.
Convertible arbitrage relies on the fluctuations of convertible bond prices. A convertible bond is a corporate bond that can be redeemed for a fixed number of shares of stock in the company at a fixed point in time (similar to options). Like any bond, its price deteriorates if a company’s creditworthiness falls or if interest rates rise. Convertible arbitrage capitalizes on the difference between the price of the bond and the value of the underlying stock it can be redeemed for. It is, in essence, buying stock options at a discount to market value.
Distressed securities are investments (usually bonds) in companies that are facing bankruptcy or reorganization. The strategy depends on large scale selling of the securities by mutual funds and other institutional investors (pension funds, for example) that are bound by contract not to hold below-investment grade securities. The downward pressure creates a discounted price. The securities are sold at a premium either when the market corrects the discounted price, or when the company emerges from bankruptcy. In the case of bankruptcy the bonds are redeemed as the bankrupt company’s assets are liquidated.
High-yield bonds, also known as “junk bonds,” and emerging market bonds are hardly limited to hedge funds. There are many mutual funds that invest a small portion of their assets in such bonds, but investors should be aware of how these asset classes figure into their portfolios, as they can provide strong returns when equities are lagging and U.S. bonds are stagnant. Some hedge funds invest solely in one or both of these types of bonds, but they should only represent a very small part of a well-diversified portfolio.
A fund of funds will, as its name implies, invest in multiple mutual funds or hedge funds. Multiple funds may serve to diversify a single strategy over multiple regions or sectors, or they may serve to employ various strategies. Such a fund limits the risk of having too much exposure with a single manager or management team, spreading the investment out over multiple hedges.
The following is a partial list of mutual funds that use the strategies described above. Remember that these are often high-risk investments that are best used to hedge against volatility in your larger portfolio. They should, therefore, account only for a small portion of your portfolio.
Hard Assets
a portion of your portfolio should always be held in cash;
American Century Global Gold Inv (BGEIX)
Leuthold Core Investment (LCORX)
Long-Short
Diamond Hill Focus Long-Short Fund (DIAMX)
Templeton Global Long-Short Fund (TLSAX)
Legg Mason Opportunity Trust (LMOPX)
Prudent Bear (BEARX)
Hussman Strategic Growth (HSGFX)
CGM Focus Fund (CGMFX)
Oppenheimer Quest Opportunity Value (QVOPX)
Market Neutral
James Market Neutral Fund (JAMNX)
Phoenix Market Neutral (EMNAX)
Laudus Rosenberg Value Long/Short (BRMIX)
Merger Arbitrage
Arbitrage Fund (ARBFX)
Gabelli ABC (GABCX)
Merger (MERFX)
Convertible Arbitrage
Calamos Market Neutral Income (CVSIX)
Calamos Convertible (CCVIX)
Distressed Securities and High Yield Debt
Mutual Discovery (TEDIX)
Merrill Lynch Bond – High Income (MAHIX)
Fidelity Capital and Income (FAGIX)
Third Avenue Value (TAVFX)
Norhteast Investors (NTHEX)
Putnam High Yield (PHIGX)
Emerging Market Debt
PIMCO Diversified Income (PDVAX)
PIMCO Emerging Markets Bond (PAEMX)
T. Rowe Price Emerging Markets Bond (PREMX)
Fidelity New Markets Income (FNMIX)
Fund of Funds
Pimco All Asset (PASDX)
JP Morgan Investor Growth (ONGAX)
What's Best for Your Retirement
Asset Allocation and Portfolio Diversification: the Keys to Successful Retirement Planning