Education • 9 min read
When the first hedge funds were introduced to the markets, the intended strategy behind them was to buy shares and hedge the positions by short selling. The name of the investment vehicle derives from the verb "to hedge", which can be translated as "to secure". Today however, the focus of hedge funds is on increasing returns rather than minimising risks.
CAUTION: Hedge funds are high-risk products and are only suitable for experienced and advanced investors who have sound knowledge of financial and capital markets. Depending on the jurisdiction, specific restrictions apply to investors.
Hedge funds are actively managed funds that focus on high-risk, high-return investments. As you may remember, mutual funds contain different securities that are assembled to achieve the goals of a mutual fund. To do this, fund managers invest money from investors into different companies and industries with the basic goal of reducing risk and maximising returns using high levels of diversification. Hedge funds, on the other hand, invest very aggressively by using different strategies to increase their returns.
In essence, hedge funds can invest in a far greater variety of financial products than most other mutual funds thanks to aggressive strategies, drawing on a wide range of techniques and financial instruments, including some that other mutual funds are prohibited from using by law.
These include instruments such as short selling, derivatives, certain methods of arbitrage and leverage based on borrowing. Hedge funds are able to enter into these high-risk investments because they are subject to far fewer regulations than mutual funds or exchange-traded funds (ETFs).
In a short sale, an investor speculates on the price drop of a security in order to profit. They borrow a large number of securities, which is where the term "short sale" comes from as the investor does not own these securities themselves but borrows them from the owner instead. This type of speculation when prices are falling is also called "going short" or "to short".
The investor now sells the securities they borrowed and hopes/speculates that the falling price will continue to fall even more, not least because other investors are also selling as a result of the price drop. As soon as the price has reached a level where an end seems to be in sight, the investor buys the securities back at the now lower price and returns them to the owner, including a lending premium with interest.
The same procedure is also used when an increase in price is anticipated, in which case this strategy is called "going long" or "to go long". The investor borrows securities in order to sell them at the highest possible price and thereby make a profit. They then return the securities for a premium.
When using a long-short equity investment strategy for example, long positions are taken with stocks with expected price increases and short positions in stocks whose prices are expected to fall. The strategy of long-short funds is to achieve profits thanks to a type of market neutrality.
Based on their broadly diversified portfolio, an investor is looking to benefit from price gains of stocks in the long positions and price declines in the short positions simultaneously. This is intended to maximise the upside potential of the markets while limiting downside risks. This way, undervalued stocks can be held in anticipation of rising prices, while at the same time, overvalued stocks are "shorted" to minimise losses. It is the attempt to achieve equilibrium through such intra-fund "hedging" that gave hedge funds their name.
*Despite such risk balancing however, at least some of the fund's assets are always exposed to high financial risks and possible defaults due to uncertain future market developments.
Derivatives are financial contracts whose value is based on other underlying assets such as commodities, precious metals, currencies, stocks, stock indices, bonds and more. Well-known examples of derivative instruments are futures, options, forwards and swaps.
An option is a contractual instrument. It is a conditional forward contract that gives the buyer special rights to purchase. If an investor invests in an option, they receive the right to buy an asset at a certain price, but are not obliged to make the purchase.
In any given situation, a risk will (usually) result in either a gain or a loss. Thus, a possible positive risk (like a chance of profit) is symmetrically opposed to a possible negative risk (such as a possibility of loss).
In the case of asymmetric risk, on the other hand, return on an investment depends on the direction of change in a variable and/or external influencing factors. Thus, the risk here is unequally distributed. Since an option gives the buyer the right to choose (the option) of a purchase or withdraw from the contract, while the seller enters into an obligation to execute the contract, the risk profile of this transaction is asymmetric.
It is precisely for this reason why most hedge funds trade in derivatives: because they offer asymmetric risk. On the other hand, derivatives users have, in some cases, been proven to have lower fund price risks as well as lower market risks.
In our example, a stock is trading at a price of €100 and the expected price increase is significant. However, to avoid the risk of making a loss on a direct purchase of a large quantity such as 2,000 shares (in case the expected strong price increase does not occur after all) the hedge fund manager buys a call option on 2,000 shares for a comparatively small premium.
This gives them the right to buy the share at the current price before a certain date in the future. If the share price rises sharply as expected, they exercise the option and make a profit. If the price does not rise or even sees a drop, the loss incurred is limited to the premium paid.
Another strategy of hedge funds is attempting to achieve a higher return on equity thanks to debt financing by utilising what is called “the leverage effect”. This strategy involves raising capital in the form of a loan in order to maximise returns.
In our example, we have €100,000 of equity capital which we are looking to invest to achieve returns of 10%. Therefore, an additional loan (borrowed capital) is taken out in the same amount at an interest rate of 5% in order to invest even more, assuming that a return of 10% can also be achieved with the invested amount. If things go as planned, the total return on capital is increased to 15% and a positive leverage effect is seen. The loan amount and 5% interest must be repaid.
Still, of course there is no guarantee whatsoever that the planned return will actually be achieved. In the event of negative leverage, the loan amount plus interest must be repaid, which, in the worst case, may mean bankruptcy for both a fund and its investors. CAUTION: This type of investment entails high-risk speculation with possible total loss if the projected return is not achieved.
Finally, there is a strategy known as volatility arbitrage. The volatility of a price or rate is the speed of price movement/fluctuation or the upwards/downwards movement of a market.
Volatility arbitrage is about arbitrage techniques related to the phenomenon of volatility. When there are rapid and large price movements of an asset, this is referred to as “high volatility”. Arbitrage is an attempt to profit from the simultaneous buying and selling of the same asset while profiting from price differences and price movements of an asset in different markets or marketplaces.
In this case, it is volatility and not the price of an asset that is the relative measure. The primary objective is to speculate on the volatility (price fluctuations) of the underlying (commodities, precious metals, etc.), rather than directly on the price of the underlying. In the broadest sense, the goal is to "buy volatility" when it is low and to "sell" when it is high.
An example of volatility arbitrage is trading an option and its corresponding underlying in a "delta-neutral" portfolio. Such a portfolio consists of related securities (mostly options and corresponding underlyings). Since positive and negative delta components usually offset each other, the portfolio value remains virtually unchanged even if the value of an underlying security changes slightly.
The pricing of options is complex and influenced by various factors such as volatility, interest rate, maturity, possible dividends and others. Price fluctuations of an option’s underlying influence the pricing of the option. For this reason, the expected price of an option may differ from the actual price.
The price development of a security expected during the term of the option is referred to as "implied volatility". Investors use this key figure to estimate future fluctuation (volatility) of the security’s price based on certain factors. Fluctuation is directly influenced by supply and demand for options and their expected price development. High volatility of the underlying security results in higher option value.
This explains the difference between the implied (expected) volatility of the option and the predicted volatility of the underlying, which leads to a difference between the expected price and the (current) market price of the option. Accordingly, an investor is interested in options with implied volatility that is significantly higher or lower than the predicted price volatility of the underlying.
Now our long positions and short positions come into play again. For example, if the investor believes that an option is undervalued, they can buy this long call option and open a short position with the underlying at the same time. In doing so, they speculate on an arbitrage position that keeps the portfolio delta neutral. If, with the price of the underlying remaining unchanged, the implied volatility later increases and the option rises to the fair value (agreed upon by writer/seller and buyer), so the buyer makes a profit.
Not all investors can simply invest in hedge funds as they please, as hedge funds are financial products which usually don’t provide investor protection provisions required by law. Therefore, laws mandate that only special types of hedge funds are accessible to everyone.
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This blog article is not intended to be used as a general guide to investing and does not constitute investment advice or an offer or solicitation to purchase any assets.
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