Hedge Funds

Hedge Funds Based on the book More Money Than God, and a Hedge Fund course I took at Harvard University and my own experiences. Hedge funds have fascinated people for the last three decades. Question is, what is a hedge fund, how do they work and who runs them? Goals of hedge funds Reduce volatility Use correlation Reduce drawdowns Manage distributions of returns Hedge funds are built on the premise that the markets are not efficient; this goes directly against the Efficient Market Hypothesis “EMH”. Hedge funds are able to implement a variety of strategies that prove EMH is false. Hedge funds are able to increase returns at lower risk than the market. These strategies include the following: Long short-this involves taking long and short positions in investment. Relative value-this is a market neutral strategy that takes advantage of mispricing between investments. Event driven strategies-events such as mergers and acquisitions can present opportunities for investment when there is a perceived mismatch between the purchase price and the agreed upon price. Tactical trading-this strategy is meant to take advantage of global macro trends, interest rates and currencies (Connor, 2018). Do Hedge Funds work? The goal of a hedge fund is to earn above-average market returns called alpha. For example, the S&P 500 fund is earning 15% so you would expect hedge funds to earn 20% to 25%. You would expect them to do this with little or no additional risk. Some of the giants in the hedge fund industry are: Alfred Winslow Jones “Jones”, the father of hedge funds My favorite personality in the hedge fund industry is Alfred Winslow Jones. Jones is commonly referred to as the father of hedge funds. He was in his 40’s when he started his hedge fund, which is considered late. He also had an unorthodox background which included journalism and other non-finance related jobs. Though he started late in life, before computers and advance analysis platforms, many of his initial hedge fund practices are still used to this day (Mallaby, 2010). Jones is most famous for his shorting stocks in order to hedge risk. When he started his fund in 1949 Wall Street was a different world. It was full of bankers that enjoyed the “fluffy life”, little work for guaranteed paychecks. Jones had many breakthroughs that helped him thrive in the 50’s and 60’s, a time when the market was steadily rising. Some of his main breakthroughs are as follows: He set up a partnership investment company so that he could avoid regulation from the Fed and only let well-heeled investors into the fund. This not only kept bureaucrats and regulations at an all-time low but also made sure he had plenty of capital (investors withdrawals were limited) which he could rely on consistently. He also set up a competitive system in which stockbrokers would be paid for leads that performed. At the time this was new for Wall Street. This ensured that he would get analysts’ recommendations for the stocks they thought were going to increase in value and those that were heading into trouble. Because he had long, and short positions Jones could make money on both good and bad companies. Operating as a partnership allowed Jones to set up a unique arrangement with investors. He had a small fee at 1% to cover overhead and a 20% charge he would earn if the investments performed well. He was also the first to use beta ratios to balance risk, leverage and risk parity concepts and alpha calculations.   In Exhibit A you can see how he utilized the long short strategy to make above-average profits. In the first scenario, stocks drop by 10% but Jones only lost 5% of capital while the traditional investors lost over 6%. In the second scenario, Jones only lost 15% when the traditional investor lost over 20% (Mallaby, 2010). Jones was very successful during his fund’s history mainly because he was a maverick and started the hedge fund industry utilizing unique and groundbreaking management techniques that consistently outperformed the market. George Soros, theory of reflexivity Stanley Druckenmiller Julian Robertson, value manager Momentum of Dot Com bust Paul Tudor Jones, set up a script-based theory Example of a hedge fund strategy 10 Hour Rule-Time I take to become good at something This strategy was originally started by Jones who opened the first hedge fund in 1949. My favorite strategy is long short strategy because I feel that it enables you to take advantage of proprietary information. Long short strategies can help in many of situations, but mainly I like its ability to separate individual stock risk from market risk (ResearchGate, 2014). The three main types of long short strategies are as follows (ResearchGate, 2014): Equity Market Neutral Strategy Equity Long Short Dedicated Short Bias   The Equity Market Neutral Strategy allows you to isolate and separate risk. If you want to separate market risk from a company you can short the S&P 500 and long that company (ResearchGate, 2014). This strategy is very effective when the investor manager has the ability to find over and undervalued companies. By eliminating the market risk and shorting overvalued investments and going long on undervalued investments, the investor will have the ability to earn Portable Alpha. The Equity Market Neutral Strategy is particularly applicable to investing in emerging market companies in risky foreign markets. An investor can isolate the stock market or the sovereign currency risk by shorting those risks they do not want.  For example, in Exhibit C you can see that I have classified the various risk that a foreign stock would have in an emerging markets economy (Marber, 2020). In this pyramid I have listed all the types of risk premiums you would encounter if you were investing in an emerging market company. By realizing the different types of risk, you would be able to hedge those risks that you did not want. If you did not want FX Emerging Market Risk Premium you could hedge that away. In this way that risk would not affect the EM company you were buying (Marber, 2020). The Equity Long Short method is similar to the Equity Market Neutral Strategy, except you are not hedging away the overall market risk. The Equity Long Short method can be utilized in Pair Trading. With this strategy you have two similar stocks with different betas and allocate capital based on the ratio. On the following page you can see how you would use the hedge ratio. In Exhibit A I have provided an example of how the long short strategy would be implemented utilizing two scenarios. From this exhibit you can see that the long short strategy has many advantages over traditional investing. Another example would be if you believe that online retail is going to continue to outperform the brick and mortar stores. If you thought that Amazon and Chewy were going to outperform Sears and PetSmart you may want to go long on Amazon and Chewy and short on Sears and PetSmart. It is interesting to note that there is an ETF called CLIX that implements this strategy. Dedicated Short Bias relies on the fact that the vast majority of people go long on stocks. Therefore, in a declining market the shorts will far outperform those who have a long bias. By concentrating solely on shorts, you would be contrary to the vast majority of other investors.