What is a hedge fund? What is a financial hedging strategy?

A hedge fund is essentially an unregulated investment vehicle which is able to engage in diverse investment strategies. Defining a hedge fund is not easy, because there are several types.

Put simply, it is a private partnership with a large pool of money that operates with little to no regulation from the authorities, such as the US Securities and Exchange Commission.

Hedge funds can be traced back to the 1940s. However, most lay people would not have heard of them until George Soros bet against the pound sterling in the early 1990s, and made a fortune doing it. Until then, hedge funds had been quietly operating in the background as a marginal part of the market. Over recent years, however, they have mushroomed.

hedge fundsHedge funds have mushroomed since the 1990s.

Unlike a regular mutual fund, hedge funds are allowed to carry out techniques such as short-selling (betting that future stock prices will decline), buying financial derivatives (credit default swaps or financial options), and purchasing securities using high leverage.

Think of hedging as a set of operations aimed at eliminating or reducing the risk of a financial asset or liability held by a company.



This is achieved by placing an investment position which offsets any potential losses or gains that may be incurred by a separate investment position.

In finance this is typically carried out using derivative instruments such as options put and call, short sales and futures contracts (contractual agreements to sell/buy a commodity at a specific month at a pre-determined price).

An infographic intended to help simplify the concept of hedging. 

hedging infographic

Hedge fund strategies

Hedge funds use a variety of investment strategies:

Global Macro: This is a big picture and global analysis approach which tries to identify extreme price valuations and other anticipated price movements in a variety of different securities. These opportunities are realized through equity markets, fixed-income markets, commodities markets, and currency markets.

Equity long-short: Analysis of the differences in performance between different shares or classes of shares.

Fixed income arbitrage: Exploitation of the pricing of bonds for fixed income. Arbitrage involves buying something somewhere at one price and selling it somewhere else at a higher price simultaneously.

Merger arbitrage: Stocks of two merging companies are simultaneously bought and sold to create a risk-less profit.

Distressed securities: Buying shares in companies going through difficulties which are expected to overcome them.

Controversy

Systemic risk

When one or more hedge funds suffer it can have a disruptive effect on the financial system. An example of this occured when the hedge fund Long-Term Capital Management went bankrupt after suffering severe losses in 1998. Wall Street was worried that the failure of Long-Term Capital would result in a chain reaction in numerous markets. The Federal Reserve intervened and organized banks to inject capital in order to stabilize the financial markets.

The value of $1000 invested in the hedge fund Long-Term Capital Management, of $1,000 invested in the Dow Jones Industrial Average, and of $1,000 invested monthly in U.S. Treasuries at constant maturity.

The value of $1000 invested in the hedge fund Long-Term Capital Management,

 

In 2007, two hedge funds managed by Bear Sterns & Co found themselves in deep trouble after borrowing money invested in structured products based on subprime mortgages.

Lack of transparency 

The not so transparent nature of hedge funds is a serious concern. In 2010, new regulations were adopted in the US and the EU which require all hedge fund managers to report more information, resulting in more transparency.

Hedge funds differ from asset management in that an asset manager charges his/her client a fee (percentage of funds being managed), rather than a percentage of profits. Although, in some cases both occur and the dividing line between them becomes more blurred.

Currency hedging is a strategy taken by companies and investors that buy equities abroad or sell goods abroad.

List of the largest hedge funds

According to Bloomberg’s “The Largest Hedge Fund Firms“, the largest hedge funds (in terms of revenue) are:


1 Bridgewater Associates (Westport, Connecticut)

Revenue: 77.6 billion USD


2 Man Group (London)

Revenue: 64.5 billion USD


3 JPMorgan Asset Management (New York)

Revenue: 46.6 billion USD


4 Brevan Howard Asset Management (London)

Revenue: 32.6 billion USD


5.  Och-Ziff Capital Management Group (New York)

Revenue 28.5 billion USD


Video – What are hedge funds?