Tuesday, November 2, 2010

Looking For Mr. GoodFund: Chapter 1 - The Different Types of Hedge Funds

There is a large number of investment managers and managed products in Canada. Our task is to be able to sift through the invesment products to indentify the hedge funds and then choose which ones we believe will have superior performance in the future. The first step is to understand what we are looking for.

The term hedge fund covers a very diverse field of organizations, and investment strategies that defy a simple definition. Hedge funds are part of larger class of investment called alternative investments or strategies. In simplest terms an alternative investment or strategy is an investment that is not a simple stock or bond or an investment product that is long stocks or bonds. Alternatives can include real estate, infrastructure, private equity, commodities, currencies and hedge funds.

Hedge funds are considered absolute return investments. A fund manager will “hedge their bets” by shorting securities against their long positions. In theory,  a hedge fund can make money in both up and down markets. The returns they generate are not tied to the overall market like most stocks portfolios, but to the skill of the manager. Consequently, hedge funds can have a low or even negative correlation to the market. That is a very desirable characteristics for investors who are looking to diversify the risk of their investment portfolios.

Hedge Fund Strategies
Hedge fund managers can use a wide assortment of investment strategies and securities to take advantage of specific investment opportunities. The use of derivaties and leverage are common as each mager will craft a uniqe strategy. Below are some of different types of hedge fund strategies.

Equity Market-Neutral
An equity market-neutral strategy is designed to create an absolute return, independent of the direction of the underlying market.  The strategy involves creating a long and short portfolio of approximately the same size. A well-designed equity market-neutral portfolios will have very limited market risk. Leverage is sometimes used to enhance the returns.

Equity Long/Short
An equity long/short strategy involves holding both long and short equity positions with either a net long or net short exposure. The objective is not to be market neutral but opportunistic, looking for money making investment ideas. This strategy is not only heavily reliant on a manager’s skill in picking stocks but their skill in market timing – i.e. knowing when to be net long or net short. This strategy will generally have greater risk than a market-neutral strategy.

Merger Arbitrage or Risk Arbitrage  
This strategy tries to generate investment returns by capturing the spread between the current market values of securities and their values in the event of a merger, restructuring, or other corporate transaction. Most merger arbitrage strategies will exploit both cash-only deals and stock deals. Whenever a merger or acqusition is announced, the risk arbitrage hedge funds become very active.

Convertible Arbitrage
A convertible arbitrage strategy aims to profit from mispricing opportunities within convertible bonds and other hybrid debt/equity securities. Convertible securities are a combination of various instruments typically an option and a bond. The convertible security may have a different price than the sum of the component parts. A typical strategy is to buy the convertible bond and sell short the common stock of the same company, to take advantage of the stock’s price volatility.

Fixed Income Arbitrage
Fixed-income arbitrage managers aim to profit from price anomalies between related interest-rate securities. As an example, if the yield spread between corporate bonds and governement bonds are historically high, a hedge fund manager will be long corporate bonds and then short government bonds. The strategy would then be profitable if the yield spread narrows.

Global Macro
A global macro strategy can  involve a wide variety of strategies and asset classes. Global macro is the considered the most flexible hedge fund strategy. Unlike most hedge fund strategies which are typically bottom up, global macro managers typically take a top-down  approach to investing. With a top-down approach, managers can move between countries, markets and different financial securities based on expected changes in interest rates, exchange rates and liquidity. A variety of trading strategies are used depending on the opportunities identified.

Managed Futures
A managed futures strategy is based on speculating on the direction in market prices of currencies, commodities, equities and fixed-income securities. These managers trade futures markets globally and are referred to as Commodity Trading Advisors (CTAs).  Since many commodities such as agricultural commodites have no real correlation to the underlying equity markets, the returns generated from a managed futures program will look considerably different from most hedge funds.

An excellent introduction and description of hedge funds can be found in Alternative Investment Management Association (AIMA ) Canada Hedge Fund Primer.

Bottom Line
The strategies of hedge funds are not only comlex but not very transparent as well. It requires considerably more due diligence on the part of the investor to understand a hedge fund versus a plain vanilla equity fund. However, the benfits of well designed hedge funds makes it worthwhile to spend the extra time it might take to understand them.

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