Hedge fund investing

Investing in hedge funds

Unusual investment strategies and the resulting high rate of return are the shortest characteristics of hedge funds.

Hedge funds have been present on the financial markets since the middle of the 20th century. The first fund of this type was set up by Alfred Jones in 1949. Its uniqueness was to reduce market risk by selling and buying shares at the same time.

The essence of hedge funds are very diverse and unusual ways of investing

The low correlation with traditional asset classes (shares, bonds) allowing for better diversification of the investment portfolio means that hedge funds are classified as alternative investments.

Hedge funds  investment strategies are based on:

• arbitrary transactions (transactions guaranteeing profit without risk resulting from the difference in the price of a given instrument on different markets);
• the use of sophisticated derivative instruments;
• purchase/sale of raw materials and merchandise;
• expansion into a global marketplace, including emerging markets, and participation in mergers and acquisitions, - participation in mergers and acquisitions;
• the use of short selling (sales of securities redeemed).

Due to the low degree of regulation of the hedge funds sector, managers are not bound by investment limits and restrictions on the investment techniques used.

This freedom allows us to achieve absolute profits, i. e. profits independent of market conditions. Dynamic investment strategies are conducive to achieving high rates of return, regardless of the situation in the financial markets.

They contradict the buy and hold strategy. The dynamic management method assumes constant adaptation to current market trends and the use of short-term price changes.

The composition of the hedge fund portfolio does not reflect the benchmark (corresponding portfolio) and it can be continuously revised to maximise profit.

Fees in hedge funds

Managers are motivated to achieve good investment performance by the structure of fees charged to investors. In addition to the management fee that exists in most mutual investment institutions, hedge funds also charge a performance fee.

It is at the average level of 20% of the profit generated. Often, to increase investment efficiency, a fund sets a minimum rate of return that must be achieved in order for the manager to receive a performance premium.

Another way to motivate hedge fund managers is to assume that they pay commission only when the rate of return exceeds the level achieved in previous periods. This protects the investor from paying commissions if the investment performance of the fund deteriorates.

Return rates achieved by hedge funds

Rates of return achieved by hedge funds in recent years have shown the effectiveness of their operations to be highly effective. In the years 1990-2003, the average annual rate of return for the whole sector was at the level of 14% and was higher than the rate of return obtained from investments in shares (S&P 500 index), and bonds (Lehman Global Bond index).

Risks measured by the standard deviation could suggest a relative security of this type of capital investment due to the fact that its level did not differ much from the risk for the Lehman Global Bond.

However, hedge funds should not be analysed only in respect of these indicators. In order to have a complete picture of the risks involved in investing in such funds, it is necessary to take into account the shape of the distribution of return rates. Their tendency to reach extreme values more frequently than in the case of traditional asset classes increases the overall level of risk.

When analysing the return rates obtained by hedge funds, it is worth noting that they are highly resilient to falls in the value of equity indices. This is mainly due to the use of low correlation strategies with the equities market, the use of spreads based on opposite transactions and short selling.

In addition, hedge funds aim to maintain a stable rate of return, i. e. in periods of the boom, they achieve a lower profit than the stock market, but in times of the bessa they lose less than shares. This is the result of proper portfolio management and setting minimum return rates, the achievement of which guarantees a bonus for the manager.

If a hedge fund using high watermark had shown a rate of return during t0 years, it would have achieved 5 percentage points higher rates. From the equity index, this would mean that in the period t1, regardless of market conditions, it would have had to beat the result of the previous period. However, this involves too much risk for managers.

Hedge funds are attracting an increasing number of investors....

Hedge funds attracts an increasing number of investors interested in high returns and diversification of the investment portfolio. Institutional investors are increasingly becoming clients of hedge funds, including American and UK pension funds, which treat funds as a specific investment alternative at low interest rates and low returns on the financial markets.

The diversity of investment strategies allows us to tailor the appropriate type of fund to the investor's needs. Funds with the greatest exposure to market risk are funds applying a strategy of following:

• market trend, in particular:
• macro,
• long/short,
• short sellers,
• emerging markets.

The above mentioned funds are characterized by high volatility of return rates, but at the same time they achieve very high investment results. They have a market share of over 50% and are known worldwide due to their significant impact on financial markets.

It was the macro hedge funds that largely contributed to the UK currency crisis in 1992, including in particular the Quantum fund managed by George Soros. The speculative attack of selling pounds of bank loans led to a devaluation of the British currency.

Moderate exposure to risk is a domain of event-driven funds, including distressed securities and risk arbitrage strategies. Event-driven funds make their investment success dependent on factors such as acquisitions, reorganisations, liquidation or bankruptcy. They choose companies that are experiencing financial difficulties, hoping for an increase in the prices of their assets.

Funds belonging to the arbitrage strategies category avoid taking market risk. Market inefficiency is a key source of profit for them. They do not follow the market trend, but try to minimize the correlation of results with return rates achieved on financial markets.

Within the category of arbitrage strategies it is possible to distinguish: convertible arbitrage, equity market neutral, fixed income arbitrage. The latter strategy was pursued by one of the most famous hedge funds, Long Term Capital Management, founded by two Nobel Prize winners in the field of economics: Myron Scholes and Robert Merton. The Russian crisis of 1998 contributed to the loud collapse of the LTCM fund.

For whom do hedge funds?

Because of the high capital requirements, hedge funds are targeted at rich retail investors and institutions. The minimum amount required to start investing in hedge funds is 250 000. USD. Funds of the funds make it possible to invest also less wealthy clients, reducing the amount of the first contribution to 25 thousand USD.

Hedge funds provide liquidity to financial markets by using strategies based on inefficiencies in the valuation of financial instruments. However, there is a threat to the stability of the financial system that results from the way funds are invested.

As a result of the expanding hedge fund industry, the number of favourable transactions they can enter into is decreasing. Therefore, in order to achieve profit, they invest in similar financial instruments. With a large volume of transactions, the possibilities of profitable closing of a position on a given market may be limited. Moreover, in a situation of rapid changes in market conditions, by closing their exposure they may influence the price of securities and thus the stability of the market.

It should be noted that the lack of supervisory control does not allow for a complete characterisation of the sector. Since hedge funds are not obliged to publish their financial statements, any sector-wide data is only estimates.