Hedge Funds For Dummies, 2nd Edition
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Hedge funds use pooled funds to focus on high-risk, high-return investments, often with a focus on shorting — so you can earn profit even when stocks fall.

The power of diversification

The easiest and most powerful way to hedge a portfolio is through diversification. Hedge funds often seek out exotic assets to increase their variety of holdings. It works because asset performance is volatile; no asset consistently beats the market.

The table below shows the top five performance asset classes over five years. Note how much the rankings change.

2017 2018 2019 2020 2021
Emerging Markets Equity Cash and Equivalents Large Cap US Equity Small Cap US Equity Large Cap US Equity
Developed Markets (ex US) Equity US Fixed Income Small Cap US Equity Large Cap US Equity Real Estate
Large Cap US Equity High Yield Bonds Developed Markets (ex US) Equity Emerging Markets Equity Small Cap US Equity
Small Cap US Equity Global Markets (ex US) Bonds Real Estate Global Markets (ex US) Bonds Developed Markets (ex US) Equity
Global Markets (ex US) Bonds Large Cap US Equity Emerging Markets Equity Developed Markets (ex US) Equity High Yield Bonds

Tools for hedging

Hedge fund managers have many techniques to maximize return for a given level of risk. Most fund managers use a combination of the tools I present in the following list,  so keep the list handy when interviewing a potential fund manager:

  • Derivatives — options, futures, and other investments that can help a fund decrease or increase its exposure to certain parts of the economy like interest rates, commodity prices, or stock market index values
  • Diversification investing in a wide range of assets so that if one part of a portfolio isn’t doing well, another part can pick up the slack, and the overall return of the portfolio will be more consistent
  • Leverage — borrowing money to make an investment. This increases the potential return but also boosts the risk. The loan has to be repaid regardless of what happens.
  • Macro investing betting on global trends, usually in interest rates, currencies, and economic changes
  • Short-selling — selling a security (often something that you don’t own) because you expect the price to go down. You borrow the security, sell it, and then buy it back (hopefully at a lower price) to repay the loan.

Questions to ask a hedge fund manager

Below are a few important questions to ask a hedge fund manager when researching a particular fund to help you understand what it does and how its managers work:

  • What’s your investment strategy? How do you plan to achieve alpha?
  • Who works on the fund? What is their education and experience? How much money do they have invested in the fund?
  • Who’s your prime broker? Your administrative services firm? Your auditor?
  • What’s your value at risk? How much of your borrowing is overnight? What are your fund’s sources of risk?

Knowing the modern Greeks

Mathematical explanations for the world mark modern finance, and wherever math is, you’re bound to see symbols and variables.

You don’t need to know all of the equations that shape financial theory, but you’ll have a leg up if you know the Greek letters used to describe different sources of risk and return. Keep this list handy when investigating hedge funds:

Alpha: Investment return that’s different than you’d expect, given an investment’s beta, which is its exposure to market risk and return. In the hedge-fund world, alpha is used to describe the value that the fund manager adds and the extra return generated for the amount of risk that the fund takes.

But remember, alpha can be negative, meaning that the fund manager subtracts value from the fund. Some researchers aren’t sure that alpha exists at all.

Beta: The amount of risk in the overall market portfolio. The market beta is 1, so an investment with a beta of more than 1 is riskier than the market as a whole. You’d expect the investment to return more than the market in an up year and less than the market in a down year.

If beta is less than 1, the investment is less risky than the market, and if beta is negative, the investment moves in the opposite direction.

Delta: The percentage change in an investment. Delta is often used to describe how much an option changes in price when its underlying security changes in price.

Gamma: The rate of change in delta. Gamma is exposure to any change in price, positive or negative.

Sigma: Represents standard deviation, or the likelihood that any one number in a series — like a series of investment returns — will be different from the return that you expect. The higher the standard deviation, the greater the investment risk.

About This Article

This article is from the book:

About the book author:

Ann C. Logue is a freelance writer and consulting analyst. She has written for Barron’s, the New York Times, Newsweek Japan, Compliance Week, and the International Monetary Fund. She’s a lecturer at the Liautaud Graduate School of Business at the University of Illinois at Chicago. Her current career follows 12 years of experience as an investment analyst. She has a BA from Northwestern University, an MBA from the University of Chicago, and she holds the Chartered Financial Analyst designation.

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