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Hedge Funds: Navigating the Maze of Risk and Reward

hedge maze featured photo

Is there another phrase in the finance sector with more mystique surrounding it than the term “Hedge Fund?”  Despite the allure of tossing the phrase around at cocktail parties, many people are not sure what a hedge fund is. This column is part two of  a three-part series  about Hedge Funds, what they are, the risks, rewards and the why.  Read part one Hedge Funds:Not Your Mother’s Garden Club Treasury here.

How do hedge funds make money? With over 7,000 hedge funds, there are lots of different strategies, but most are some variation of the following:

Equity market neutral – the manager buys stock in a company he thinks will outperform, and at the same time, sells short a company he thinks will drop in value. In so doing, the manager seeks returns based on his ability to pick stocks, rather than on how well the overall market performs. Selling short means the manager sells shares he borrows (but does not own) hoping that the price will drop, and he then can purchase them at the lower price to close out the position.

Long/short – a variation on market neutral, only the ratio of longs to shorts gives the fund exposure to the general market, and can include use of leverage, with obvious implications for added risk and, you hope, return.

Arbitrage – in this strategy, the manager makes bets on related securities that may reflect a price differential. For example, a bond that is convertible to stock has a particular value based on the price of the stock. The manager capitalizes on what he perceives to be temporary mispricing between the two, hoping that the securities will revert to their true value and then he can liquidate the positions at a profit. There are several variations of this strategy, one being merger arbitrage, in which a manager bets on the price of the company to be acquired, hoping it will be different from what the marketplace anticipates it will be.

Event Driven – this strategy bases its investment on a particular event, a common example of which is investing in a “distressed” READ: bankrupt company. A manager identifies a company in which the underlying business, properly realigned, again can become profitable. Sometimes, activist investors enter the fray who not only invest in the company but also force a change in management, or require board seats as part of the deal. The risk, of course, is that the company cannot right itself, but oftentimes, the securities (either the equity or bonds) are so deeply discounted that a solid risk-adjusted return is possible anyway.

Global macro – this strategy seeks to exploit opportunities in world events, like the current debacle in the Eurozone. Macro means the manager looks at macroeconomic factors to find opportunities to rack up returns. Most of us remember Long Term Capital Management – a global macro bond manager that blew up when it bet that Russian bonds would behave in a certain way. Unfortunately, the bonds had a mind of their own, and the Federal Reserve was forced to organize a consortium of banks to come up with capital to save the financial system. Sound familiar?

Multi-strategy – as this eponymously named strategy suggests, the manager uses several strategies in a fund, with the idea that through investing in several strategies, rather than just a single one, he will diversify and thus minimize the risk.

These are some of the more common ways that hedge fund managers make money. How can you be sure to, as well? First, do your homework, or due diligence, as we say in the trade. Who is the manager? What is his reputation? Has he been in prison? Don’t laugh – many have, and just as many are on their way for defrauding investors. Also, does he have sufficient assets under management? If he is scrounging for investors, can he be paying attention to managing your money? How does he make his money? No one who asked Bernie Madoff to explain how he did ever got a good answer. Demand that 1) he explain it and that 2) you understand it.

Once the manager passes muster, you need to evaluate the fund’s risk. Comparing hedge funds with an index is a good place to start. The standard index for most hedge funds is the HFRI, produced by Hedge Fund Research, Inc. which maintains over 100 different hedge fund indices. If the fund you are contemplating investing in outperforms the index, that’s good. Make sure to measure the fund’s performance for at least 5 years. Yes, you may miss out on a new, hot fund that has a shorter track record. But, if it’s a good fund, it should last at least 5 years, and you’ll have the opportunity then to pile up profits. Let someone else take the short-term risk.

Another measure of risk is something called Value at Risk, which measures, with 95% confidence, just how much a portfolio could lose over a specific time period. It relies on a bunch of statistics, assumptions about returns and economic models. But like anything in life, and investments in particular, we can’t necessarily predict the future with 100% accuracy. What worked historically has no bearing on what could happen. In 2008, the analysts at Bear Stearns calculated acceptable value at risk figures for its portfolios and still managed to implode. Such is the nature of estimating how markets will behave, particularly when a crisis raises its ugly head.

Downside capture is another important aspect of risk measurement. When the market is in freefall, some hedge funds manage not to fall as far. Those are the funds worth further investigation for investment. After all, anyone can make money when the markets are exploding on the upside. It takes real talent not to lose as much when markets are plummeting.

We’ve mentioned leverage, but it bears re-emphasizing, since it is the most common reason that hedge funds go out of business and lose money for their clients. All managers make mistakes, because markets are unpredictable. But careful, judicious use of leverage can mean the difference between total loss and living to fight another day. What is an acceptable level of leverage? Somewhere south of the 90% or so that Long Term Capital used in the late 90s, or that Lehman Brothers employed just three years ago.

This article is for entertainment purposes only. It is not to be considered investment advice.   Everyone’s financial situation is different and before investing in any hedge fund, it is important that you consult your tax and investment advisor to see if these types of investments are right for you.

Read part one of Merry Sheils’ article Hedge Funds: Not Your Mother’s Garden Club Treasury. Tomorrow in part three of her series, Sheils discusses how to invest in hedge funds.

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