Hedge Fund: A Short Introduction
We all love the hedge fund lifestyle. The private jets, the mansions, the publicity, the yachts, and the charitable giving they do. Managers are known to make a lot of money and spend it for all to see. For instance, Ken Griffin recently paid $500 million to three art collections. Steven Cohen, a legendary hedge fund manager is known to own more than an art collection worth a billion dollars. In 2014 when his hedge fund was flying high, William Ackman bought a penthouse for $90 million. Who wouldn’t want that lifestyle? I know I do.
As an industry, hedge fund is relatively old with pioneers being people like Benjamin Franklin. The sector was created for the wealthy individuals in search of alpha. Alpha is a financial jargon which means extraordinary returns that are not correlated to the market performance. The opposite is Beta which refers to a return that is correlated to the market. This is common with mutual funds and index funds.
What we don’t see from the managers is the amount of stress and pressures that comes from managing other people’s money. These people charge high fees to their clients with the industry standard being a 2% management fee and a further 20% of the profits generated. Sadly, the performance of a hedge fund can be tracked on a daily basis. Therefore, if a fund fails to perform, investors can redeem their funds.
As an individual, it is possible to trade your $10,000 using the same strategies that hedge fund managers use. The benefit of this is that you will not be in the public eye. In addition, you will not be under pressure to perform. If you fail, you will quietly stop trading and focus on other things. Below are some of the key strategies used by hedge fund managers that you can replicate.
Hedge Fund: Arbitrage
Most hedge fund managers use this strategy to hedge against a downside. Arbitrage is a term that simply means pairs trading where you buy a certain ‘asset’ while shorting a related ‘asset’. For instance, generally, if the price of oil is falling, we expect that BP and Exxon will both fall. Using arbitrage, you can buy BP (LSE) while shorting Exxon (NYSE). You will therefore gain from the spread if your theory becomes true. This is known as statistical arbitrage. Alternatively, if company A is being bought by company B, then you can short company B while going long A. This is known as merger arbiptrage. It is also possible to do arbitrage in one company where you short its shares while going long its bonds. This is known as convertible arbitrage.
Hedge Fund: Event driven
This is a strategy that hedge funds love. There are so many financial or economic events that you can use to gain alpha. For instance, many investors love IPOs. In many cases, when a hot Silicon Valley startup lists, chances are that it goes up. For instance, BOX went up by more than 10% on its inaugural day. Many hedge fund managers shorted the company because they knew that the company would later go down. Other events such as mergers and acquisition and the earnings season is also ideal for hedge fund managers to maximize their returns.
Hedge Fund: Global Macro
A global macro hedge fund is one that looks at the global economic and financial world and then makes decision based on this. If for instance a hedge fund manager believes that the Mexican economy will lose ground, then they will short the Mexican Real. In addition, if the economies of the emerging markets are not stable as a result of the weakened commodity prices, then the manager might short the emerging markets. The benefits of all these is that as a trader, you have the data with you and so you can replicate the strategy.
Hedge Fund: Multi-strategy
Other hedge fund managers follow a multi-strategy approach where they use different strategies and target various sectors. A good example of such a hedge fund is one that combines arbitrage with quantitative techniques. Also, another example is one which uses various asset classes such as currencies, commodities, and equities to trade.
There are other strategies used by hedge funds that you can apply to your trading. These are: directional (which bases investment on long or short positions only), sector (bases investment on single sectors), long/short equity (buying and shorting stocks), and activism among others.