HEDGING YOUR BET- PART 1

What makes a hedge fund tick?

Dealing with any investor can be a winning or a losing situation, and if you want to be successful, ‘hedging’ your bet by increasing your knowledge is a good start. In Hedging Your Bet - Part 1, we look at the somewhat secretive hedge fund industry to figure out what makes the players tick. In Part 2, we will continue the discussion, providing tips for the IR community when interacting with hedge fund investors.

What is a Hedge Fund?

Hedge funds are pooled investment vehicles with professional management, similar to mutual funds. But that’s where the similarities end. Unlike mutual funds, hedge funds are not restricted as to strategies or types of investments – a hedge fund can invest in just about anything. To offset risk and maximize returns, hedge funds can use leverage (borrowing money to add to an investment position), arbitrage (taking simultaneous long and short positions in different securities to profit from market inefficiencies), or hedging (using derivatives to offset risk). However, hedge funds don’t always hedge – the term refers more to their status as private pools of investment capital. And the same laws (exemptions) that afford hedge funds the flexibility to invest in just about anything, also make them virtually unknown, as securities laws do not allow hedge funds to advertise or solicit the public.

Hedge Fund Versus Mutual Fund – Key Differences

Adapted from AIMA Canada Hedge Fund Primer

Putting Hedge Funds in Perspective

In Canada, there are about 250 hedge funds, managing approximately $25 billion. That’s a big number, but a drop in the bucket compared to the $2.2 trillion managed by hedge funds globally. And hedge funds, as a category, are tiny relative to other pools of assets under management.

Hedge funds used to cater almost exclusively to private money but are seeing a shift in investor base. Today, investors in hedge funds are much more likely to be institutions, including public and private sector pension funds, insurance companies, university endowments and charitable foundations.

In aggregate, hedge funds lost about 25% of their value during the financial crisis of 2008-2009, but the broader markets fell about 40%. Some argue that hedge funds actually helped to stabilize financial markets by providing liquidity, reducing market volatility, taking contrarian positions, and serving as ready counterparties.

Investment Strategies

Hedge funds can employ multiple strategies to protect capital while maximizing investment returns. (Hedge fund-type strategies can also be used in-house by institutional investors.) Grasping these strategies is key to understanding what makes the funds tick.

Relative-value strategies employ a variety of fundamental and quantitative techniques to identify and profit from a perceived valuation discrepancy (mispricing) in an asset or security, including equity, fixed income, and derivatives. These strategies rely heavily on determining whether a stock is overvalued or undervalued. A hedge fund may buy one company’s stock and sell short the stock of a sector peer, looking to profit from differences in performance. Conversely, an arbitrageur who believes a company’s debt is overpriced relative to its equity might short the company’s debt and buy the company’s stock. These pair trades reflect an equity market-neutral strategy, designed to exploit market inefficiencies without exposure to directional movements (i.e. gains and losses will offset each other). This strategy usually involves both long and short positions and often involves leverage.

Or a hedge fund manager, believing a convertible bond is undervalued relative to the underlying stock, will buy the bond (receiving the yield) and sell short the common stock of the same company (receiving interest on the cash proceeds while eliminating the stock price risk embedded in the convertible bond). This convertible arbitrage strategy is designed to profit from differences in pricing while protecting principal from market moves.

Some hedge funds seek to exploit pricing differentials between debt instruments, employing complex fixed income arbitrage strategies, including interest swaps, forward yield curve trades, futures contracts, and mortgage-backed securities. They might trade globally and use leverage.

Event-driven or situational strategies are designed to capitalize on sudden prices changes caused by earnings disappointments or announcements of corporate transactions, including mergers, restructurings, tender offers, shareholder buybacks, debt exchanges, security issuances, or financial distress. Hedge funds may also target underperforming stocks and agitate for spinoffs, share buybacks, increased leverage, special dividends, or outright sale. Such activism often involves a proxy battle and a sophisticated public relations campaign, with the hedge fund using stock loans, options, derivatives and other devices to increase its voting power.

In merger arbitrage, the hedge fund makes a bet on the probable success or failure of the deal, considering factors such as bid price, timing, and regulatory risk. A hedge fund manager who believes the takeover will be completed and the stock prices of the two companies will converge may buy the stock of the target and short the stock of the acquirer – assuming the bid is at premium to market price. Short and long positions may change rapidly based on developments, such as another suitor making a bid at a higher price (the hedge fund might switch its short position to the new bidder).

Strategies focused on distressed securities depend on the likelihood of a debt default resulting in a corporate restructuring or bankruptcy. Distressed or high-yield securities are typically below investment grade and therefore illiquid. Hedge funds might buy distressed securities at a deep discount hoping to sell them at a higher price – but must be willing to wait for an extended period. They might take on an activist role, becoming involved in negotiating the terms of the restructuring, seeking a seat on the company’s board, or initiating legal action.

Equity hedge managers with a net long or a net short exposure may have similar strategies, but remain net long or net short depending on their market outlook. A manager with a net long bias seeks to identify undervalued companies, whereas a manager with a net short bias looks to identify overvalued companies. Other managers have a variable bias, switching between net long and net short equity exposures.

Global macro strategies typically employ a top-down analysis of economic variables based on the outlook for global trends and market movements. A global hedge fund that anticipates an interest rate increase in the U.S. might buy the U.S. dollar and sell the Canadian dollar, expecting the Canadian dollar to depreciate against the U.S. dollar when U.S. interest rates rise.

Hedge funds with an emerging markets strategy typically invest long-only in equities or bonds in emerging markets, with exposure to currency movements.

A managed futures strategy speculates on the direction in market prices of currencies, commodities, equities and fixed-income securities, investing in currency futures, forwards, options and warrants (both exchange traded and over the counter).

Key Terms

2/20 refers to the hedge fund industry’s typical compensation structure, which consists of a 2% annual management fee plus 20% of the profits above a certain threshold.

ACCREDITED INVESTOR refers to an individual or institutional investor with high net worth or high net income (see definition in National Instrument 45-106) deemed to be financially sophisticated and therefore not requiring protection under prospectus and registration requirements. Only accredited investors may invest in hedge funds.

ALPHA refers to the excess return (the return above the expected return) on an investment that is attributed to a fund manager’s skill in investing; the return in excess of a benchmark risk-free investment.

ARBITRAGE means to take advantage of disparate pricing between two similar instruments in the same or different markets. In the hedge fund world, arbitrage typically involves the simultaneous purchase and sale of two similar securities whose prices, in the opinion of the trader, are not in sync with their true value. Assuming that prices will revert to true value over time, the trader will sell short the overpriced security and buy the underpriced security. Once prices revert to true value, the trade can be liquidated at a profit.

ASSET SWAPS are complex financial instruments (derivatives) similar to insurance contracts; they provide the buyer with protection against specific risks. However, the trader does not have to own the asset to insure it. Swaps are traded over-the-counter by sophisticated investors.

DERIVATIVES are financial instruments whose value is derived from the value of an underlying security, asset, or variable. Examples include options, warrants, futures, forwards, and swaps.

HEDGING is taking a position that offsets other risks; transactions that protect against adverse price movements and limit exposure to a specific risk. These are usually opposite transactions within the same asset class or market.

LEVERAGE is the practice of borrowing money to add to an investment position when one believes that the return from the position will exceed the costs of borrowing. Hedge fund managers use leverage in order to increase returns. Leverage can magnify returns as well as losses.

LONG POSITION is holding (buying) a positive amount of an asset.

MARKET NEUTRAL STRATEGY is taking long and short positions in related assets in order to offset directional market risk.

SHORT POSITION is holding a negative amount of an asset, where assets are sold without owning them (selling short).

SHORT SELLING is borrowing a security the trader doesn’t own, selling it, then hoping it declines in value, at which time the trader can buy it back at a lower price than he/she paid and return the borrowed securities.

Where To Get More Information