Level 1 CFA® Exam:
Hedge Funds
A hedge fund is a type of investment fund whose primary purpose is to manage the capital entrusted to it by investors. Hedge fund managers engage in purchase and sale transactions in the capital market to reduce the risk of price volatility. The main objective of a hedge fund is to maximize profits.
Hedge funds investments are based on various investment strategies but all of them aim at maximizing profits no matter the circumstances and have a relatively high risk tolerance. Compared with traditional investments, managers of hedge funds use unconventional investment strategies and advanced and complex financial instruments. They make use of financial leverage, short selling, derivatives, etc.
All this translates into higher flexibility of investing but also increases the risk. So, even if the word "hedge" may remind you of "hedging", which is a security measure, hedge funds are usually investments that carry a lot of risk.
Hedge fund investments have relatively low liquidity in comparison with traditional funds like stock funds. In some cases, there are restrictions on withdrawing money from the fund. A lockup period is an obligation imposed on hedge fund investors not to sell shares in the fund for a specified time. The duration of a lockup usually ranges from one to three years.
There may be also a notice period required if you wish to make a withdrawal or redeem shares. This period usually lasts from 30 to 90 days and allows the managers to reduce the number of investment portfolio assets rationally and in accordance with the applied strategy.
Remember that the rate of return on the fund should reflect its investment objective and may be expressed as an absolute return or a relative return. A relative return relates to some equity or fixed-income benchmark.
If you invest in a hedge fund you will not only pay the management fee, which is usually the percentage of the managed assets, but also the incentive fee. Additionally, in most cases withdrawal of money from hedge funds is subject to redemption fees.
Investing in hedge funds requires a relatively big amount of money. Additionally, in many cases the number of investors in a given fund is limited.
Therefore, an interesting solution for small investors is the possibility of investing in funds of (hedge) funds.
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How are hedge funds different from other funds?
Hedge fund investments may involve any class of assets or any financial instrument. Fund managers are fully independent as regards the selection of an investment strategy. This is why a fund's results depend mostly on the manager's skill. Additional returns generated thanks to the manager's skill are called alpha. What matters less is the rate of return on a market portfolio. Again, the main objective of a fund is to achieve positive returns. Because of greater flexibility as regards investment strategies, exceeding the benchmark is far less important.
There are 4 main groups of hedge fund strategies:
- equity hedge strategies,
- event-driven strategies,
- relative value strategies,
- macro strategies.
Equity hedge strategies include:
- market neutral strategy,
- fundamental long-short growth strategy,
- fundamental value strategy,
- short bias strategy, and
- sector specific strategy.
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Event-driven strategies are about maximizing returns using events such as share repurchases, sales of assets, or financial difficulties of companies. These strategies are used, e.g., by distressed debt funds that take both long and short positions in instruments issued by the same entity (e.g. long positions in bonds and short positions in stocks).
Event-driven strategies include:
- merger arbitrage strategy,
- distressed/restructuring strategy,
- activist strategy, and
- special situations strategy.
Merger arbitrage strategies exploit overvaluation or undervaluation of companies that can potentially be the target in an acquisition transaction or a party to a merger transaction. Merger arbitrage strategy very often consists in purchasing shares of an acquired company and short selling shares of the acquiring company.
Distressed/restructuring strategy is about purchasing securities of a company with financial problems that can be solved by restructuring. For example, it may take the form of purchasing bonds that trade at a huge discount to par.
Activist strategy consists in purchasing quite a big number of shares of a company to obtain the right to affect its policy.
Special situations strategy consists in purchasing shares of special situations companies, that is companies that have undergone events such as repurchase of shares, sale of assets, capital distribution, etc.
Relative value strategies include:
- convertible bond arbitrage strategy,
- fixed income (general) strategy,
- fixed income (asset-backed, mortgage-backed, and high-yield) strategy,
- volatility strategy, and
- multi-strategy.
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The last group of hedge funds strategies is macro and CTA strategies. Macro and CTA strategies are based on global events and economic trends.
A global macro strategy makes investment decisions conditional on the current macroeconomic conditions. Unlike the strategies discussed so far, it's based more on price dynamics forecasts and not on taking advantage of market inefficiency. Global macro funds invest in different classes of assets, which translates into a low correlation of assets within the portfolio.
A managed futures strategy (aka. commodity trading advisers (CTA) strategy) is based on the application of statistical models to forecasting market trends and momentum. Managed futures funds invest mainly in commodities but also in other assets like currencies, stocks, fixed income, etc. Long positions are taken in a bull market and short positions – in a bearish market. This strategy is characterized by a greater level of diversification than the other ones we've discussed. Additionally, it involves a lower level of risk.
- A hedge fund is a type of investment fund whose primary purpose is to manage the capital entrusted by investors.
- The main objective of a hedge fund is to maximize profits.
- A lockup period is an obligation imposed on hedge fund investors not to sell shares in the fund for a specified time.
- If you invest in a hedge fund you will not only pay the management fee, which is usually the percentage of the managed assets, but also the incentive fee.
- A fund of funds is an intermediary that specializes in investing in other hedge funds.
- There are 4 main groups of hedge fund strategies: equity hedge strategies, event-driven strategies, relative value strategies, and macro strategies.
- Equity hedge strategies include: market neutral strategy, fundamental long-short growth strategy, fundamental value strategy, short bias strategy, and sector specific strategy.
- Event-driven strategies include: merger arbitrage strategy, distressed/restructuring strategy, activist strategy, and special situations strategy.
- Relative value strategies include: convertible bond arbitrage strategy, fixed income (general) strategy, fixed income (asset-backed, mortgage-backed, and high-yield) strategy, volatility strategy, and multi-strategy.