Hedge funds are pooled investment vehicles, which are commonly set up as limited partnerships in which the manager acts as the general partner while the investors act as the limited partners.
In order to mitigate a particular type of risk, a money manager employs a particular risk management or hedging technique. For example, the market risk can be hedged against by selling a broad collection of securities short in equal proportion to one’s long exposure or by buying put options on an index.
One may hedge against factors like interest rate, inflation, currency, and the tools and techniques of hedging include raising cash, selling short, buying or selling options, futures, commodity and/or currency futures.
Reducing investment risk
A private investment partnership, hedge funds also tend to be skill-based investment strategies that attempt to obtain returns based on a unique skill or strategy.
It can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in any opportunity in any market where it foresees impressive gains at reduced risk.
The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions. It designs strategy to reduce investment risk using call options, put options, short selling, or futures contracts. Thus, the hedge insures against the possibility for a future loss.
Hedge fund managers adopt different strategies to multiply the returns on investment. They invest both long and short, in the securities of companies, which are expected to change in price over a short period of time due to an unusual event. By pairing individual long positions with related short positions, market-level risk is greatly reduced.
There is thus potential for significant future growth as the investments are made in securities. The portfolio is formed after considering factors like interest rates, economic policies, and inflation.
The fund provides an investment portfolio with lower levels of risk and can deliver returns uncorrelated with the performance of the stock market. In fact, hedge funds have historically offered higher returns than the stock and bond markets.
Investment strategies
There are different investment strategies used by hedge funds, each offering different degrees of risk and return. A macro hedge fund for instance, invests in stock and bond markets and other investment opportunities, like currencies, to cash in on significant shifts in global interest rates and countries’ economic policies.
A macro hedge fund is more volatile but potentially faster growing. On the other hand, an equity hedge fund may be global or country specific, hedging against downturns in equity markets by shorting overvalued stocks or stock indexes.
All hedge funds are not the same – investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies, which are not correlated to equity markets, deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. Many hedge funds are flexible in their investment options.
Derivatives can be used for hedging and many use no leverage. A variety of financial instruments can be employed to reduce risk, enhance returns and minimise the correlation with equity and bond markets.
Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimise overall portfolio volatility and enhance returns.
Hedging strategies
Hedge funds invest in any number of strategies, which include asset classes such as stocks, bonds, commodities, currencies, and return enhancing tools such as leverage, derivatives, and arbitrage.
Some strategies
Selling short: Selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop.
Investing in deeply discounted securities
Securities of companies about to enter or exit financial distress or bankruptcy, often below liquidation value.
Trading options or derivatives: Contracts whose values are based on the performance of any underlying financial asset, index or other investment.
Using arbitrage
Seeking to exploit pricing inefficiencies between related securities. It can be long, convertible bonds, and short, the underlying issuer’s equity.
Investing in anticipation of a specific event
Merger transaction, hostile takeover, spin-off, exiting of bankruptcy proceedings etc.
In order to reduce portfolio risk and volatility, and increase returns, it is advisable to include hedge funds. This is because many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets. Due to the variety of hedge fund investment styles, investors are left with numerous strategies to meet their investment objectives.
And the flexibility of the investment options gives hedge funds the ability to manage investment risks best. They provide an ideal long-term investment solution, eliminating the need to correctly time entry and exit from markets.
However, not all hedge funds are hedged – many are simply long stocks, and may even use leverage. In order to evaluate a fund, you must see how much risk produced its return and ascertain whether a fund hedges, how, and how much. All said and done, hedge funds are an attractive option for investors.
By Ashish Gupta
Source: Economic Times – India Times
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