What are Hedge Funds?
In the world of finance today, hedge funds are in the public spotlight for a myriad of reasons. Several hedge funds, managed by 'financial rockstars' like George Soros and David Einhorn, have consistently earned investors yearly returns north of 20 percent. Conversely, some of the greatest financial follies have also occurred in the hedge fund industry, whether it be the collapse of Long Term Capital Management or the Ponzi-scheme fallout of Bernie Madoff's Ascot Partners.
Usually perceived as unregulated, risky investment vehicles for the most affluent investors, the truth is a little more complicated. A hedge fund is a type of investment fund that is actively managed, in the hope that higher than market returns can be realized. Usually open to a limited number of investors, these funds typically have net worth requirements greater than $1 million for investors. In the United States, hedge funds are less regulated than other types of investment funds, allowing greater strategic flexibility. Ultimately, this increased flexibility allows hedge fund managers to employ the use of a variety of exotic investment tactics including short sales, swaps, options and arbitrage. Even if the everyday investor can't afford the typical minimum level of investment for hedge funds, it is sometimes possible to use similar techniques to invest in the same manner as a hedge fund.
As early as the 1920's, hedge fund style investment vehicles were in existence in the United States. Perhaps the most prominent during this time period was a partnership between the iconic economist and mentor to Warren Buffett, Benjamin Graham, and Jerry Newman. The Graham-Newman Partnership, as their fund was called, focused on purchasing undervalued equity securities. This approach, known as value investing, became Graham's most significant contribution to the field of investing. Graham and Newman's fund achieved extraordinary returns during the latter half of the Great Depression - between 1936 and 1941, the fund averaged 11.8 percent growth each year. During this same period, the ninety largest American equities averaged a yearly loss of -0.6 percent.
The father of the term 'hedge fund', Alfred Jones, developed another model for hedge fund investing in the late 1940s. In an attempt to curtail the riskiness of his long-term stock holdings, he began to short sell related stocks. The phrase 'to hedge one's bets,' perfectly applies to this investment strategy. For example, if Jones was bullish on Union Pacific Railroad, he would purchase that company's stock. Using what became known as the 'long/short approach,' he would choose another firm in the North American rail industry that he expected to perform worse than Union Pacific, and short that stock. Let's suppose the stock he chose to underperform was Canadian National Railways. In order for this strategy to yield a positive return, Union Pacific must simply outperform Canadian National. Excluding transaction fees, if Union Pacific's yearly return is 10 percent and Canadian National's is 9 percent, Jones would see a positive return of 1 percent. A positive profit would also be ensured even if both stocks have negative returns, as long as Union Pacific outperforms Canadian National.
By the turn of the century, the hedge fund industry had grown to comprise over 12,000 operations. Most recent estimates place its total size to be between $1.4 and $1.9 trillion. In an attempt to earn greater returns, several funds employed riskier techniques using instruments like swaps or options. Subsequently, many active hedge funds began to adapt strategies based on the anticipation of future company-specific or macroeconomic events.
For example, suppose that in 2012, a hedge fund has a focus on macroeconomic analysis and is expecting the imminent collapse of the European Monetary Union. In order to profit off of this potential geopolitical event, this hedge fund could pursue a variety of investment actions. First, they might sell large quantities of Euros in the foreign exchange market, expecting the chief currency of the European Monetary Union to fall in value in the future. Additionally, they may also purchase credit default swaps on sovereign debt throughout the Eurozone, as insurance against any possible debt defaults. Finally, it could be a decent idea to purchase put options on some major European firms expected to be affected the worst. Although these three actions are slightly simplified, it is important to understand that many hedge funds employ this type of directional strategy in anticipation of a future macroeconomic event. If the expected event does not occur and the hedge fund's position is significant enough, it is possible that it may fail and become insolvent.
Another strategy employed by more contemporary hedge funds is known as arbitrage. In economics, arbitrage is the application of taking advantage of price or interest rate differentials between two markets or related assets. In theory, the most certain form of arbitrage is known as price arbitrage, where identical assets are priced differently in separate markets. In an efficient global market, an asset is priced the same everywhere. For example, if one share of Apple Inc.'s (AAPL) stock currently costs $419.81 in a U.S. stock exchange, it should cost the exact same amount in a stock exchange in Europe. If this is not the case, say it costs $419.91 in Europe; a hedge fund could make a profit by short selling the stock obtained from Europe and purchasing the stock obtained from the U.S. Eventually, the inevitable price convergence would yield a positive profit. It should be noted that since the inception of computerized trading, pricing arbitrage opportunities have all but disappeared.
A more complex type of arbitrage can be done with interest rate differentials on fixed income securities or bonds. A good example of this kind of arbitrage gone wrong can be seen with the case of the aforementioned Long Term Capital Management. In the mid 1990's, LTCM was the world's most well known hedge fund, achieving an annual average return of over 30 percent between 1995 and 1997. One of the premier strategies employed by the hedge fund came to be known as 'fixed-income arbitrage.' With this tactic, LTCM made bets in the fixed-income or bond markets concerning the interest rate spread between two different bonds.
For example, if the spread or difference between the interest rate on a 10-year U.S. Treasury bill and German Bond was typically 2 percent, any increase in this difference presented a possible arbitrage opportunity. If the spread between these two assets was temporarily 3 percent, hedge funds would have a profit opportunity. In this example, the bond with the higher interest rate would be purchased and the bond with the lower interest rate would be short sold. With the case of LTCM, a Russian default in 1998 spooked investors into turning away from European bonds, drastically increasing their interest rate over U.S. Treasuries. In this play however, the difference between the two interest rates did not converge, causing LTCM to experience heavy losses and had to liquidate their fund just two years later.
Strategies for the Everyday Investor
As is now evident, hedge funds use a variety of investment strategies. Based on the methods discussed above, the everyday investor can make profitable investments even if they do not have the capital of a typical hedge fund. Due to the fact that it is not always possible for individuals to short sell stocks or use credit default swaps, the two strategies listed below are the best types of hedge fund strategies most suitable for the everyday investor.
Using Graham's Value Investing Strategy - The most central strategy that individual investors can take from hedge funds is known as value investing. Conceived by Benjamin Graham, this technique focus on picking undervalued stocks. The term 'undervalued' simply means that the market is valuing a stock at a price that is lower than analysis suggests it to be worth. One way to determine a stocks value can be done by looking at its Price-to-Earnings ratio. Also known as P/E ratio, this indicator measures the price that investors are willing to pay for every $1.00 of company earnings. Historically, stocks with a P/E below the market P/E have on average outperformed stocks with higher P/E ratios.. As of early January 2012, the P/E ratio of the S&P 500 is 21.21. Of course, this is only one of many indicators and factors one should look at when looking for undervalued companies, but it can be an excellent place to start.
Using a Macroeconomic Event Strategy - This strategy can be used for investors who follow macroeconomic trends closely. For example, many analysts note that the People's Republic of China is expected to experience slower economic growth in 2012. Additionally, it is also reported that the Chinese inflation rate has begun to decline, reiterating the prospect of slower GDP growth. If an investor believed these growth concerns to be overstated, and Chinese stocks therefore undervalued by the market, they could invest in a number of Chinese ETFs like the Global X China Consumer ETF (CHIQ) and the Global X China Financials ETF (CHIX).
The tactics used by hedge fund managers are not out of the reach of individual investors - in fact, many can use the strategies of innovative funds to their advantage. While at first, people may declare that hedge funds achieve their profits through 'revolving door' strategies, it is truly the research done by these types of institutions that help to make a profitable return. If enough research is done on both the company-specific and macroeconomic level, an individual investor can achieve similar returns. After all, the success of the everyday investor depends on discipline, dedication and hard work.