What Investment Bankers Should Know about Hedge Funds - dummies

What Investment Bankers Should Know about Hedge Funds

By Matt Krantz, Robert R. Johnson

The term hedge fund is misleading to investment bankers. The term hedge is defined as “a means of protection or defense.” The act of hedging in finance involves risk reduction or protection against adverse outcomes. Companies producing goods or providing services that rely on certain commodities will hedge against price increases on those commodities by contracting in the futures markets to purchase inputs well in advance of production.

For example, airlines will often hedge against rising jet fuel prices by contracting in advance to purchase oil in the futures markets (markets that allow investors and traders to bet on the price of commodities months or years from now). If fuel prices go up, the airline is unaffected because the cost has been agreed to in advance. This allows airlines to better manage costs, plan, and reduce risk.

So, a hedge fund must be some sort of vehicle that allows investors to reduce risk, right? Not hardly. A hedge fund is simply a professionally managed pool of money that is largely unregulated and can only be accessed by sophisticated (accredited) investors (see the nearby sidebar).

Whoever came up with the name hedge fund was a pure marketing genius, because the goal of most hedge funds is not to reduce or limit risk, but to seek high returns by taking positions in a wide variety of asset classes. Hedge funds typically take positions in complex derivative securities and strategies involving derivatives securities and often leverage highly concentrated positions.

There are a wide variety of hedge funds that pursue many distinctly different investment strategies and styles. Although some people refer to hedge funds as an asset class, they’re more accurately defined by their strategies. The most common types of hedge-fund strategies include the following:

  • Long-only: These funds are most like stock mutual funds. They buy stocks they believe are going to go up in value.

  • Equity long-short: In these funds, managers purchase the securities of stocks they expect to go up in value while short-selling stocks they expect to fall in value. Often, these types of funds choose to specialize in particular sectors or geographical regions of the stock markets.

  • Event-driven funds: These funds invest in securities of corporations involved in special situations such as bankruptcy, spinoffs, mergers and acquisitions, and other restructuring events. As an example, these funds buy or sell the stocks and bonds of firms involved in mergers and acquisitions — betting that some securities are overvalued while others are undervalued.

  • Relative value and arbitrage funds: These funds seek to identify securities and positions that have the same risk and return characteristics and purchase the underpriced securities and sell the overpriced securities. One of the most common types of relative value funds is convertible arbitrage, which typically purchase convertible bonds and sell the common stock of the issuer.

  • Global macro funds: These funds have the broadest investment style of all hedge-fund categories. They have no limitations on the asset classes, security types, or geographical locations of investments. They invest in whatever investments strike the fancy of the asset manager. They often take highly leveraged and large positions.

  • Fund of funds: A fund of funds invests in many different hedge funds. This strategy can help reduce the risk of a single manager achieving poor performance or running off with investors’ funds, because the investor’s holdings are spread across many different hedge-fund managers. The downside is that it introduces another layer of fees — those of the manager of the fund of funds.

Managers of hedge funds are the new titans of business — the Rockefellers and Mellons of the 21st century. These new-age billionaires include John Paulson, Stephen Cohen, and James Simons, men who have amassed fortunes by achieving investment returns that often exceed market averages by wide margins.

Successful hedge funds get the headlines, but there are some major risks to investors. First of all, not all hedge funds do well, in fact, most do not. And if a hedge fund is on a hot streak, the managers know it and demand to be paid accordingly.

Running a hedge fund is a lucrative business — fees paid to managers are typically 2 percent of assets under management annually, as well as a cumulative payout of 20 percent of the profits of the fund. This fee structure is often referred to as “two and twenty” and means that considering these fees, hedge-fund managers must really bring home the bacon to earn their keep. And some certainly do.

For instance, James Simons’ Medallion Fund at Renaissance Technologies has returned an average annual compound return in excess of 35 percent since it was established in 1988. (Before you go running out and try to invest some money in Medallion, realize that the fund has been closed to new investors for many years.)