Hedge Funds

What is a Hedge Fund?

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

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.

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.
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.
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.
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.
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.
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.

Popular Hedge Fund Strategies

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.
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.
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.
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.

Key Themes Shaping the Hedge Fund Industry

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

Trends in Hedge Fund Strategies

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.

Hedge funds using artificial intelligence/machine learning (‘AIML’) are delivering long-term outperformance. The proportion of systematic hedge funds launched in 2019 that use AIML is over double the proportion in 2016 (23% vs. 10% respectively) and in a tough fundraising environment, AIML can help fund managers to differentiate themselves from competitors and appeal to investors.

Case Study

One of the most successful hedge funds to date is the Medallion Fund, a famous portfolio established by Renaissance Technologies in 1988. It has shown immense trading success, with an annualised return of 66%. Interestingly enough, the Medallion Fund was founded by Jim Simons, an ex-codebreaker and mathematician, who in unison with other mathematicians and cryptologists, was able to produce a mathematical model that predicted price changes in easily-traded financial instruments. Later, Robert Mercer and Peter Brown developed a highly profitable arbitrage system which complemented Medallion’s model. By employing cutting-edge computer models, advanced mathematics and being fed abundant financial data, the algorithms of the Medallion Fund were able to exploit patterns, generating small profits which amounted to impressive gains, evident from 1990 and onwards.

Strangely, the proliferation of other hedge funds has barely affected Medallion’s performance. This could be due to its intricate models and unique strategies in the works – even a minutely superior execution relative to Medallion’s competitors, when summed up over millions of trades, leads to immense profits. Indeed, given such exceptional performance, Renaissance Technologies’ Medallion Fund is a unique and famous case, but also a rather secretive one – its funds have been closed to external investors since 2003, and are currently owned by Jim Simmons and other Renaissance employees.