The Art of Hedge Funds

There once was a time when working at a hedge fund was a sure-fire way to show that you had made it.

It was a path to potential life-changing wealth, a chance to work with the best and brightest. And for a decade or two, hedge funds were the place to work.

Many regularly beat their benchmark year after year. Exorbitant performance fees meant there was plenty of money to share around. Bonuses showered down like confetti at a parade.

But something happened to change all that. The very thing that hedge funds were supposed to do, came a cropper in the sub-prime disaster.

If a fund is fully hedged, it should be immune to falls in the stock market. Yet when the markets collapsed through 2008–09, it was these hedge funds that tore up their clients’ money.

Clients couldn’t redeem their money fast enough. Some funds simply refused to refund any money, in case their fund collapsed.

Post the sub-prime disaster, working at a hedge fund more likely attracts ridicule. As the benchmark indices went on a decade-long tear, passive index funds left hedge funds in their dust.

What really got up investors’ noses, though, was that the bonuses kept flowing. Hedge funds continued to pay their staff handsomely, despite their sub-par results.

Plus, what some of the hedge funds did cut against the grain. Some were just big-game hunters, punting gold or oil, currencies, or whatever took their fancy. They were anything but ‘hedged’.

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Backing a strategy

What is often lost, though, is that a pure hedge fund should underperform in a bull market. When the market rallies for a decade, any hedged product will by definition, underperform.

However, the reason hedge funds exist is to generate returns irrespective of what the market is doing. And that is what hedge funds are starting to return to today.

There are any number of strategies hedge funds employ to achieve their goal. They can buy shares and hedge them through options or index futures.

Conversely, short sell shares, and hedge them with call options. For example, they could short sell each of the stocks in the ASX20, but hedge them with a call option on each of the shares, or index.

Another way hedge funds aim to generate returns (and remain hedged) is by trading a basket of stocks.

To construct that basket, they might choose stocks from one particular sector. For example, banking stocks on the ASX. Or, they might use larger-cap stocks that can trend a similar way.

The underlying theme they are looking for are the stocks that are strongly correlated. In other words, stocks that often track closely, and/or mirror each other.

We saw this throughout 2017–18 (and prior), when bank stocks collectively fell in anticipation of the royal commission.

You can also see it when a commodity is on a run. For example, when lithium stocks rallied, as investors bought into the story of their use in electric vehicle battery storage.

Many, though not all, lithium stocks rallied simultaneously. But not all of them rallied by the same amount.

It’s about stock picking

And that is where hedge funds look to apply an edge. Their skill is in picking these stocks, and how they rate against each other.

Once they have done that, they buy the stocks they believe to be the strongest. At the same time, they short sell stocks they think are the weakest in the bunch.

There are endless ways to construct these hedged portfolios. You could, for example, trade the Big Four banks, buying the strongest two, whilst selling the weaker two. Or, buy all the Big Four banks, and short the regional banks, if you think the cost of funding will harm the smaller banks more.

The style of hedge fund will determine how they manage this basket of stocks. For example, some might have a perfectly equal weighting in each stock. As one stock rallies — and thereby increases its weighting in the basket — the fund re-balances its holdings daily.

Some hedge funds might let positions run, a bit like a long-short fund. The difference being that the market neutral hedge funds will pick stocks that have a strong correlation.

This style of market neutral investing might sometimes only produce negligible results. But that is exactly why investors pick them.

They know that while returns can be slim, it is a strategy that should have a lot less risk. Particularly when the markets get more volatile, or roll over, and start heading down.

All the best,

Matt Hibbard,
Editor, Options Trader

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Money Morning Australia