First up, what are hedge funds and how are they different from other forms of investment funds? The main clue is in the name. While usual investment funds will mainly derive their gains or losses from the overall movement of the markets they invest in, hedge funds try to reduce their dependence on the overall market and generate their returns from the selection of individual securities.
For example, the most obvious model of a hedge fund is an investment strategy that buys put options to protect itself from any losses in the overall market or short sells a number of securities.
Therefore, the fund’s overall performance becomes less correlated to the performance of the market and more reliant on the selection criteria of the investment manager.
To become a successful trader, you need to have a strategy that you can clearly articulate.
No one in the hedge fund arena is able to get large institutions to invest with them if their strategy comes down to a shrug of the shoulders and the statement: “We just look for stocks that are going up”.
The race for hedge fund money is extremely competitive and the key decision-makers are looking for hedge funds
to have strategies that are relatively easy to communicate to investors.
But this isn’t just to make the marketing easier. When institutions are looking to invest, they need to ensure that the hedge fund complements their many other investments. To do this, they need to know how the hedge fund will invest their money.
So, successful hedge funds, like successful traders, must have a strategy. You have probably heard the experts discuss how important it is to have a trading plan. This is the same as a hedge fund’s strategy. Your strategy or plan needs to be clear, not open to interpretation and easily replicable over and over again.
The strategy we outlined earlier, in which a hedge fund takes both long and short positions, is the most common type of hedge-fund strategy.
One common form of this strategy involves the investment manager investing the majority of their cash into stocks they believe are likely to outperform the market. The manager then also takes a number of short positions in stocks they believe are likely to underperform the market.
In a perfect world, the best performing stocks rise as the market moves higher, while the weaker stocks that the manager has as short positions struggle lower. This allows the manager to produce a return well ahead of the market.
However, if the market falls, while the manager loses on their long positions, the short positions, assuming they fall in line or more than the market, produces a positive return for the market. While the manager is still likely to see losses on their portfolio, these losses should be less than the market (or regular, long-only funds).
Retail traders can apply this strategy to their own trading. Rather than having only long positions, a number of short positions can also be taken, providing the trader with a level of protection should the market fall sharply.
Hedge funds will often use a set of criteria to calculate how much short exposure they should have.
For example, one common tool is to measure the overall market index, such as the S&P/ASX 200, against a long-term trend-following indicator such as the 200-day moving average. While the index is above the moving average, fewer shorts are needed than when the index is below the moving average.
One of the advantages that hedge funds have over more common investment strategies is their ability to look offshore for opportunities.
This style of investment management, known as ‘global macro’, attempts first to identify countries that are likely to generate above average economic growth.
For example, at the moment, most global macro managers would probably avoid taking positions in economies in the US or Europe. These countries have clearly been the hardest hit by the global financial crisis and may take some years before their economic growth recovers.
Another way of identifying economies that are likely to outperform is by performing demographic analysis.
In this example, the hedge fund manager might take short positions in Japanese stocks, due to the fact that the population of Japan is ageing and this will result in a greater share of economic growth needing to be diverted to social welfare. By the same token, a country such as Vietnam, with a greater proportion of young workers, is likely to experience economic growth that is above the globe’s average.
These funds don’t necessarily have to invest in stocks and shares. Many of these funds will take positions in currencies that they believe will appreciate because of global factors.
For example, a hedge fund could buy the Australian dollar in the expectation that as the global economy improves, this will result in greater demand for commodities. The Australian dollar’s performance is closely tied to the global demand for commodities and this would allow the hedge fund to benefit from its view on the world’s economic growth.
By the same token, global macro funds that are concerned about economic growth, especially in large developing nations such as China or India, might look to short sell industrial commodities such as copper.
Event driven strategies look to benefit from situations that occur – or might occur in the future – in the market, rather than looking for stocks or securities that are over or undervalued.
The most obvious example is those hedge funds that look for companies that are likely to be taken over in the near term.
There are a number of ways of identifying stocks that have the potential to be taken over. One way is to look for companies in which competitors have started to buy up stock in the company. Any shareholder that owns more than 5% of a company needs to disclose this to the ASX and therefore this information is fairly easily available.
Another way of identifying companies ripe for takeover is by looking for sectors in which takeovers have already occurred. For example, BHP’s recent failed takeover of Canadian fertiliser company Potash might mean that other fertiliser stocks will be next in the firing line.
Quantitative strategies, often known just as ‘quant’, are the domain of the eggheads. These strategies are extremely system-based and look to identify certain characteristics that have in the past delivered strong returns.
For example, one simple strategy might look for stocks that have recently announced better-than-expected earnings. The investment manager would invest in these stocks in the expectation that the company could continue on this path and make further positive announcements.
In reality, quant managers will have very many different characteristics that they might look at.
In addition to looking for companies that are constantly upgrading their earnings, they might also look for stocks that are consistently outperforming the market in terms of their share price performance. They might then look for industry sectors that are also beating the market. The stocks that meet all three of those criteria are then included in the hedge fund’s portfolio.
We’ve left the arbitrage sector of the industry to last – and with good reason. This is an extremely difficult strategy for the smaller trader to try and use.
Arbitrage opportunities occur when two similar securities become mispriced. The trick is to buy the cheaper security and sell the more expensive security in the expectation that they will eventually move back in line.
Why is it so hard for smaller traders? In the first instance, looking for arbitrage opportunities is a full-time job. With so many large financial institutions looking for these kinds of trades, they typically come and go in the blink of an eye.
Additionally, very often the mispricing is extremely small. This means that the transaction costs are often more than the benefit of taking the arbitrage. Larger institutions can often negotiate very low transaction costs, but retail traders are usually stuck with much higher costs.
Lessons to be learnt
All of the strategies used by hedge funds can be applied to individual traders in one way or another. Even arbitrage, which is notoriously difficult for smaller traders to implement, can help individuals in their understanding of the market.
The most important lesson from hedge funds is for smaller trader to have a clear strategy when approaching the market. All of these types hedge funds are successful in the industry to one extent or another because they maintain their faith in their investment ‘world view’.
Individual traders will find themselves far more successful if they look to hedge funds, identify how they want to look at the market – and stick to it.