Hedge Funds

 

What is a Hedge Fund?

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Hedge Funds are an alternative investment vehicle that pools capital from accredited and/or institutional investors to invest aggressively in relatively liquid assets. Unlike the PE and VC industry, the investment strategies employed by hedge fund managers vary drastically between firms as they actively search for excess returns, or alpha, for their investors.

 

Characteristics of a Hedge Fund

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Given that hedge funds engage in a diverse range of investment strategies and financial instruments, it is more practical to focus on the defining characteristics of a hedge fund.

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1. Market Direction Neutrality – A form of investment strategy that aims to profit regardless of which direction the market moves. This is typically accomplished by taking both long and short positions in different stocks. Returns are generated through good stock selection rather than market movement.

2. Accredited Investors –  Accredited investors consist of banks, insurance companies and also high net-worth individuals. Accreditation is earnt by meeting the requirements set out by the SEC such as annual income and net worth.

3. Leverage-Reliant – The capital used by the fund manager is only borrowed from investors. Fund managers may also use credit lines or buy securities on a margin to increase the size of their market bet.

4. Fee Structure – The fee is usually structured with a fixed management fee and an additional performance fee. The most common structure is known as the ‘2 and 20’ where the fund manager takes 2% as fixed fees and an additional 20% of all the profits earned as a performance fee.

5. Lock-in Period – This is a period where investors are not allowed to withdraw their money. Generally, the fund manager is given a 30 to 90-day notice so that they have time to liquidate some shares in their portfolio.

6. Little Regulatory Oversight –  Hedge funds are not subject to the same degree of regulatory oversight as other investment types such as mutual funds. This is because the US Securities Exchange Commission believes that accredited investors who run the hedge fund have a fundamental idea about the strategies they will be utilising and their associated risks.

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Popular Hedge Fund Strategies

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1. Long/Short Equity –  The fundamental concept of this investment strategy is to take a long position on a stock that is projected to outperform a competing company whilst holding a short position with the competing company.  This investment strategy hedges the firm’s market exposure and generates returns based on the idiosyncrasies associated with individual stocks.

2. Equity Market Neutral –  Similar to the Long/Short Equity strategy where stocks are both longed and shorted to decrease market risk exposure. The returns are generated by exploiting the idiosyncrasies and investment opportunities unique to different industries, sectors or regions.

3. Global Macro –  This investment strategy is heavily reliant on the macroeconomic trends that affect the interest rates, exchange rates, commodity prices and equity prices. Fund managers will take either a long or short position in the asset classes that are most sensitive to price movements. Global macro funds usually trade futures due to its high liquidity.

4. Quantitative Trading –  These hedge funds engage in quantitative analysis and systematic strategies to execute trades. The success of these hedge funds are typically reliant on the firm’s algorithmic model that is created and back tested against historical data. Quantitative hedge funds will then engage in high-frequency trading strategies that exploit price volatility, leveraging on small price fluctuations through large transactions.

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Key Themes Shaping the Hedge Fund Industry

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1. Emerging Manager Demand: Investors are increasingly looking to smaller or newer funds in search of outperformance or favourable fee terms

2. Industry Consolidation: The number of fund launches in 2019 trailed fund liquidations for the first time on record. The number of active hedge funds is therefore shrinking, creating a consolidated and leaner industry

3. Market Slowdown: 43% of surveyed investors are looking to position their hedge fund portfolio more defensively in 2020 in response to our position in the business cycle

4. Recovering Performance: Capitalizing on strong equity market tailwinds, the asset class returned +11.45% over 2019, bouncing back from the -3.06% return recorded the year before. It is the only time in the last 6 years that the annual return has reached two digits.

5. Fee Pressure: Following pressure from investors, the mean management fee of funds launching in the market has been decreasing. Managers are altering their structures in a bid to attract capital in a competitive market. Although a 3% increase in assets is expected, it will not be enough to offset record low fees of 1.51% on average, causing overall revenue to decline.

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Trends in Hedge Fund Strategies

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Despite the 11-year bull market during which hedge funds have faced tougher market conditions, investors are still looking to the asset class in search of portfolio diversification and high uncorrelated returns. Over the last decade, robust economic growth and narrow credit spreads have seen credit strategies succeed, while niche strategies have also been picking up inflows with investors looking for something different in the crowd. However, with 69% of investors believing that we may be at the peak of the cycle amidst slowing global economic growth more defensive strategies such as relative value strategies are in higher demand.