Hedge Funds Focus on High Returns and Aggressive Growth
A hedge fund is a pool of investments that are part of an aggressively managed portfolio. In general, hedging refers to strategies that are designed to leverage risk.
What Funds Do
They trade undervalued bonds, trade options, and stocks, use arbitrage, take short and long positions, and invest in different assets with the aim of reducing risk and volatility. At the same time, the goal is to deliver returns and preserve the capital of investors. Hedge funds employ different investment strategies that involve varying degrees of return and risk. Equity funds, for example, short overvalued stock indexes and securities while macro funds invest in currencies, bonds, and stocks to profit on economic policies and interest rates. As a rule, these types of investment vehicles use both derivatives and global market strategies. They invest in futures, options, calls, and puts and are run by experienced managers. Some use aggressive investment strategies while others are more conservative. Investors include high net worth individuals, private banks, insurance companies, endowments, pension funds, and others.
Strategies Used
Managers use different strategies such as investing in anticipation of bankruptcy, spinoffs, hostile takeovers, mergers, and other events. Using arbitrage and buying derivatives and options are other strategies. Many funds specialize in emerging markets and distressed securities to achieve aggressive growth. Some are considered opportunistic as their strategies are not consistent. They look for opportunities such as hostile bids, price fluctuations and changes, initial public offerings, and so on. Others use different strategies to diversify their portfolios and achieve long-term or short-term gains. Securities hedging, short selling, and market timing are also strategies that managers use. Some managers focus on events such as leveraged buyouts, reorganizations, and takeovers. They sell and buy stock of the acquirer and acquired company simultaneously. Volatility depends on the choice of strategies. It varies from low and moderate to variable and high.
In general, they invest in currencies, commodities, equity, and other assets and use instruments such as swaps, options, and futures.
Types
Funds can be divided into four main categories – macro, event-driven, market-neutral, and long-short. The latter use stock picking techniques and take short and long positions. Market-neutral funds employ aggressive strategies to realize high profits. They focus on short securities and interest rates. The aim is to deliver returns that are in the range of 200 – 300 percent. This solution is suitable for high-risk investors. Funds focus on groups of stocks categorized by market capitalization, industry, sector, region, or country. The hefty fees are one issue for investors. There are also sector-specific hedge funds that focus on energy, biotechnology, healthcare, and other sectors. Funds of funds are another variety. They specialize in different investment instruments to diversify their portfolios. The fees are higher (double) compared to other options.
Offshore investment vehicles are designed to control risk and are managed under foreign law. The main benefit is that they are not subject to domestic taxation. They are designed for non-residents and non-nationals and raise capital from foreign investors.
Funds can also be divided into directional and absolute-return. The goal of the latter is to generate steady cash flows and returns regardless of market performance. Managers implement different strategies to eliminate market risk and use their skills and experience to generate returns. This solution is a good choice for prudent investors. Directional funds are also run by managers who focus on high returns and maintain a degree of market exposure. The level of risk is higher for investors. This vehicle is not the best option for those looking for a steady income stream.
Advantages and Downsides
The main benefit for investors is the ability to generate high returns in falling and rising bond and equity markets. Their inclusion in an investment portfolio helps reduce volatility and risk. It is an investment solution that facilitates diversification. Lower volatility compared to equities is another benefit. The downsides are the lack of regulation and the risk involved, depending on the fund of choice. In general, they can have a considerable impact on the stock market, oil prices, and the state of the economy.
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