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Hedge Funds Explained: What, when, and how Hedge Funds work.

May 31, 2005

 

It can seem like an alphabet soup sometimes for those trying to move away from the staid world of individual stocks and mutual funds. Hedge Funds, Fund of Funds, CPOS, CTAs....exactly what are these different alternative investments?

With over $1 Trillion dollars now under management, most of us have heard of "Hedge Funds" by now. Indeed, hedge funds have been all over the news in the last few weeks as rumors swirled that General Motor's (GM) bonds being downgraded to junk status and GM's stock rallying on news of a potential takeover could see some hedge fund "blow ups" on par with the infamous melt down of Long Term Capital Management in 1998.

This "double whammy" by GM was supposed to have severely hurt many hedge funds, and talk of a hedge fund bubble and too much money chasing too few deals has been commonplace over the past few weeks, culminating in this week's Barron's cover story asking "Is the Party Over?" for hedge funds. But despite the huge growth and recent press, the term hedge fund is still shrouded in some mystery and is usually defined somewhat oddly in the financial press.

Hedge Fund:

So what is a hedge fund? The American Heritage Dictionary defines a hedge fund as:

An investment company that uses high-risk techniques, such as borrowing money and selling short, in an effort to make extraordinary capital gains.

This definition leaves a little to be desired, as it requires the further explanation of an investment company and misrepresents hedge funds as high-risk and going for big gains.

First, an investment company is merely a partnership, LLC, or similar legal entity formed for the purpose of investing. The money of multiple investors is pooled together in order for those investors to realize the benefits of a larger total pool of capital (such as more diversification) and allowing the same strategy to be employed simultaneously for all of the company members. The most well known investment companies are mutual funds. With a mutual fund, thousands of investors each invest a relatively small sum of money ($10,000 to $100,000), and participate in the gains and losses of the company (of the fund) as it buys and sells different stocks according to its investment strategy.

A hedge fund is nearly identical to a mutual fund in its general premise of pooling the money of multiple investors, but unlike mutual funds, hedge funds purposely keep the number of investors in the company(fund) under 100 people. This allows hedge funds to qualify for an exemption under the Investment Company Act of 1940 by which they do not have to register as an investment company and undergo rigorous regulatory and reporting requirements. While the laws require a company investing on behalf of greater than 100 people to be registered, there is no restriction on the total amount of money that is pooled together, thus hedge funds usually set their minimums at $1 Million and higher so they can still manage a significant amount of money while staying under the 100 investor limit.

Because of this exemption, hedge funds are not required to redeem investor's money within 7 days or report their positions like mutual funds must. As practically unregulated entities, they have much greater freedom in their investments and how they fund those investments. They can borrow money, do short sales, invest in complex derivatives, and more in their search for higher returns.

There's one downside to hedge fund's unregulated nature, and that is the regulations prohibit unregistered firms from advertising or soliciting new clients. That is why you don't see advertisements for big hedge funds right next to the Fidelity and Janus ads in the Wall Street Journal, and one of the reasons hedge funds are surrounded by so much mystique.

The last unique characteristic of hedge funds is their fee structure. Unlike mutual funds which generally charge annual fees of under 1% of assets with that fund, hedge funds generally charge an annual management fee of 1% to 2% and a performance fee of 20%. That's right, hedge funds take up to 20% of the profits. The performance fee is usually on realized and unrealized appreciation of the fund's assets and is payable on a yearly or quarterly basis. Many funds require the fund's assets to surpass the old "high water mark" before taking profits, thus the manager is only rewarded when the fund hits new all time highs.

Types of Hedge Funds:

Convertible Arbitrage: Convertible bonds are loans made by publicly traded companies which can be exchanged for common stocks at a certain price. This type of fund attempts to profit from the inefficient pricing of the convertible bonds versus the underlying stock by usually buying the bond and shorting the stock. By shorting one security and being long another of the same company, these funds are theoretically protected from a sharp move in one direction or the other. However, much of the recent news and rumors of hedge fund "blow ups" have centered around convertible "arb" funds which were long GM bonds and short the stock. In a move no one saw coming, the bonds sold off and the stock rallied as GM"s debt rating as downgraded and a tender offer for the common stock was made at a healthy premium in the same week.

Dedicated Short: Just like its name implies, these types of funds attempt to profit from declines in individual stocks and the overall market. Dedicated short funds usually attempt to be neutral or flat in upwards trending markets, then use leverage to accelerate profits when markets are in a down trend.

Emerging Markets: Another strategy aptly named, these types of funds invest in the stock, indices, and bonds of emerging markets. Examples of emerging markets include China, India, South Korea, Brazil, Malaysia, countries in Eastern Europe, and parts of Africa.

Equity Market Neutral: These types of funds are the closest thing to a "hedged" fund as you get in the different hedge fund strategies, as they attempt to remove market risk by going long and short similar securities simultaneously. By attempting to remove the risk of a falling or rising market, profits come from exploiting the inefficiencies between the pricings of "pairs" of stocks. A typical trade would be going long Fed Ex and short UPS.

Event Driven (Special Situation): These types of funds invest in the equity, stock, bonds, or legal claims of companies facing a special event driven situation such as a merger, takeover, bankruptcy. The two most common type of event driven funds are risk (or merger) arbitrage and distressed. Risk (merger) arbitrage deals in merger activity, usually by being long the stock of the company to be taken over and shorting the stock of the acquirer. The long/short profile theoretically hedges away market risk, and profits come from successful deal completions. Distressed hedge funds invest in companies in bankruptcy, facing legal trouble, or lagging their industry peers or market in general. The recent revival of Kmart and its merger with Sears was the result of hedge fund ESL Investments buying up Kmart's debt , and thus controlling interest, for pennies on the dollar in bankruptcy.

Fixed Income Arbitrage: This style looks to profit from the pricing inefficiencies between related interest rate securities (bonds). A common trade among this style of funds (and the trade that took down Long Term Capital Management) is selling on the run (just released) Treasury Bonds and buying off the run (Treasury Bonds released in the past) when the off the run treasuries are cheaper than the on the run treasuries. The bonds are the same exact asset, just released at different dates, thus in theory should be priced the same. A global liquidity crisis brought on by Russia defaulting on its debt caused a flight to not just quality, but on the run quality, shooting those prices up and off the run prices down and sinking LTCM.

Global Macro: These types of funds invest in broad reaching macro economic trends in markets around the globe, such as betting US interest rates will rise, the Japanese Yen exchange rate will fall, or Crude Oil will be at $100 in five years. The most famous Global Macro example is George Soros, who "broke the bank of England" by profiting from the Bank's stubborn reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism countries or to float its currency. Finally, the Bank of England was forced to withdraw the currency out of the European Exchange Rate Mechanism and to devaluate the Pound Sterling, and Soros earned an estimated US$ 1.1 billion in the process.

Long/Short Equity: Just like the name implies, these types of funds focus on the stock market by picking stocks and either buying (long) or selling them short. Many of these type of funds focus on specific sectors (like financials, health care, technology), market capitlizations (small, mid, & large cap), and pricing (value, growth) just like mutual funds - and do extensive research within that sector to determine which stocks are undervalued and which are overvalued. The difference is these funds can go short and can use leverage to multiply returns.

Managed Futures: Our favorite category at Attain, this style of hedge fund refers to products offered by registered Commodity Trading Advisors, or CTAs. In effect, these types of strategies are similar to global macro hedge funds except they operate exclusively in listed futures and commodities markets. Most managed futures programs are systematic in nature (using trading systems just like you and me), while some rely on the discretionary picks of its manager. Unlike hedge funds, where your funds are commingled into a partnership account, a CTA investment is usually held in a segregated account in the individual investor's name, meaning greater liquidity and transparency. Attain Capital runs its own managed futures program called Attain Portfolio Advisors, which has a $1 Million minimum.

Fund of Funds: These types of funds invest in a diversified portfolio of other hedge fund strategies. With hedge fund minimums typically $1 MM to $5 MM, it is unrealistic for anyone but the insanely wealthy to be able to diversify into all of the different hedge fund types, and a fund of funds approach allows investors to get complete diversification with just one investment. One issue with fund of funds is the layering of fees, as the fund of funds manager usually charges fees on top of the steep fees already charged by the underlying managers.

Conclusion:

While hedge funds are usually described as an alternative asset class, the descriptions above show that most hedge funds are actually heavily invested in the fate of publicly traded companies in one way or another. For that reason, we believe hedge funds should be viewed as alternative strategies instead of an alternative asset class, and great care should be taken if assuming hedge funds will protect you from another stock market downturn.

The only true alternative asset class investment among the hedge fund strategies is managed futures. A managed futures investment brings exposure to a truly different asset class in commodities, which provide economic value through being consumed or transformed - not on the basis of future cash flows like stocks and bonds.

Whether or not the "party is over" for hedge funds remains to be seen. The growth of assets under management has been staggering since the Internet bubble burst in 2000, but returns have been lagging behind the stock market and historical norms for the last two years. This may be caused by too much money fighting for too few opportunities. As an example, with a finite amount of stock and bonds outstanding for any one company - you can definitely see the case where several firms all recognizing a mispricing between the two would be removing the inefficiency in their very attempt to exploit it. Likewise, several firms seeing the value in a bankrupt airline, for example, would all start buying the airlines assets or debt simultaneously, thereby driving up the price of those distressed assets and cutting into the potential return.

There is a lot of validity to these arguments, but the financial markets still dwarf the amount of hedge fund assets, at hundreds of trillions of dollars to one. So in effect there is enough money to go around. Don't be surprised to see hedge fund returns a little lower than their historical norms, however.

- Jeff Malec