Hedge Funds - 10 Step Guide
Hedge funds, they're in the news, and all over media.
But what really are they?
In this article I'll breakdown everything there is to know about hedge funds, equipping you with knowledge you can definitely show off to your friends about.
Ergo, within this blog we will be discussing the 10 step guide for all things Hedge Fund:
What is a hedge fund in simple terms?
Hedge funds, in the simplest way possible, are like the hulk of the investing world, they are pooled investment funds which trade with relatively liquid assets in order to supplement their extensive use of more complex trading, portfolio selection and risk management techniques.
These points must be considered in an attempt to better their performance. What distinguishes a hedge fund from other funds such as ETF’s and mutual funds are the techniques that they implement.
These include; their ability to make use of their wide-ranging ability to leverage, short sell and their use of derivatives.
Leveraging is a technique which involves using “borrowed funds” instead of actual equity when purchasing an asset. We have previously spoken about what leveraging is and how it can be used in forex. Here is a link to the video.
In the investing world being “short” an asset means that an investor will profit from an asset if the price was to fall. This is the polar opposite to a long position, which is where an investor will profit if the value of the asset was to rise.
A derivative is a contract between two or more parties that develops its actual value from the performance of an underlying entity. Some expected underlying entities to look out for are bonds, currencies and stocks to name a few. - Syndicate Room
Why is it called a hedge fund?
Hedge Funds get their name from the fact they originally existed to have a negative correlation to the market. It allowed investors to protect and make money when the markets go down.
For example, a hedge fund in the United States would allow investors to make money when the S&P500 benchmark was going down (or so that's the idea).
Why do hedge funds exist?
The primary purpose of hedge funds is akin to many other funds. This is to maximize investors returns, whilst simultaneously trying to eliminate risk.
However, as I have stated previously, hedge funds are considered to be much more aggressive than other funds.
The reason hedge funds are capable to partake in these more aggressive and risky methodologies is due to their key investment strategies which are not available to other asset management services.
What do hedge funds invest in:
A hedge fund is able to invest in any asset related to stocks, currencies, real estate, land and derivatives.
Contrariwise, other funds such as mutual funds have only the freedom to invest into stocks and bonds. This is due to the fact that hedge funds face very little regulation from the Securities and Exchange Commission (SEC).
The SEC is an independent federal regulator agency that is responsible for keeping the markets fair, in order as well as protecting investors when it comes to the trading of securities in the market market.
"The SEC promotes full public disclosure, protects investors against fraudulent and manipulative practices in the market, and monitors corporate takeover actions in the United States. It also approves registration statements for bookrunners among underwriting firms."
Therefore, any financial service, whether it is brokers, advisory firms and asset managers such as Hedge funds, must be registered with the SEC before they are able to conduct any sort of business.
Even though I have stated that to trade a business must be registered with the SEC. It is not always the case, this is where hedge funds gain an advantage.
A hedge fund can avoid having to register with the SEC if they are able to qualify for the private fund advisor legislation which is in the Dodd -Frank Act and communicated in Section 203(m) (1) of the Investment Advisers Act of 1940.
This exemption is stated as seen below:
"This exemption is applicable to an advisor of a hedge fund who has principal offices located in the United States, has regulatory assets under management below $150 million, and only has private fund clients. If a hedge fund advisor has at least one non-private fund client, he is not eligible for the private fund advisor exemption. Also, all assets count towards the $150 million threshold, including assets managed outside of the United States."
So, The reason hedge funds are able to get away with certain regulations which are enforced on other investment vehicles is down to the fact that, hedge funds take most of their money from qualified investors and high net worth individuals who meet the requirements. As well as some hedge funds meeting the requirements of not having to register for the SEC.
How hedge funds make money:
In this section I'll discuss how hedge funds actually make their money. Hedge funds make money via:
Management fees and performance fees. People in the investing world like to call this the 2 and 20. You’re probably asking yourself what this is right?
Well it’s pretty simple, the two and twenty is a fee arrangement which is fairly common in the hedge fund industry. Some funds may charge more or some less, but typically they are always around the 2 and 20% mark.
Management fees:
The 2% is typically the fees that hedge funds charge their investors for managing their funds (Assets under management) or AUM for short.
These fees are customarily paid monthly or quarterly subject on the firm itself. Hedge funds use the 2% to pay for their overhead costs and the daily expenses for running the firm. Here is a link going into further depth on management fees.
Performance fees:
This is regarded as more of an incentive fee for funds, this is down to the fact this fee is calculated solely as a percentage of the funds profits. In simpler words, the more money the fund make, the more they get paid and vice versa.
These performance fees give the firm an incentive to want to grow in size and in the amount of money it makes. This is because performance fees are normally used to pay employees their bonuses as well as reward the hard workers within the firm itself.
Leverage:
We have spoken about leverage in videos on our website logikfx. Leverage is when an investor basically borrows the brokers money to make a larger investments.
Hedge funds are no different. They use lines of credit in hope that their returns will outpace the interest that they have to pay back on the money they have borrowed.
They do this to maximise their return on investment. However, even though leverage can look great, the complete opposite can be said for leverage when losing.
This is because, the same way in which leverage magnifies your wins, it can amplify your losses.
In reality, leverage is used to increase the brokers revenue. Let's use an example to show you an example on how leverage actually works for the individual investor (you and I).
Lets say that we are trading an EUR/GBP for example. The bid price is 1.3288 (price at which you can sell an asset) and the ask price is 1.3289 (the price you can buy an asset).
Now let's imagine that this currency trades only twice a day. Once at 1.3288 and once at 1.3289 and it does this everyday, forever.
Do you still think it's possible to make money on this asset in one day? or even in a year? The answer is no.
How can you make money if the assets price does not move. So in short, just because you leverage and borrow more money, it doesn't mean the opportunity in the market has increased.
What you are basically doing here is leveraging volatility that doesn't exist, but instead giving it the illusion that it does exist. So what leveraging does is simply increase the volatility of your own profit and loss.
Leverage limits on the opening of positions by a retail clients have ranged from 30:1 all the way down to 2:1 as per the FCA's handbook. These vary according to the volatility of the underlying asset.
30:1 for major currencies;
20:1 for non major currencies;
10:1 for commodities other than gold and non major equity indices;
5:1 for individual equities and other reference values;
2:1 for cryptocurrencies.
Let's say your broker has a 1% margin requirement
This means you only have to put up £1,000 'initial margin'
This allows you to borrow £100,000 from the broker (meaning that you are 100x leveraged)
Allowing you to trade 1 lot of GBP/USD for example.
So if the GBP/USD exchange rate goes up by 1% how much will you make? Well you'll make £1,000 because that's 1% of the position size that you opened. Easy right?
What happens if the GBP/USD exchange rate goes down however? Well, quite easy again, you go BUST!
So, what to gain from this section is that leverage is all good and well when your trades are going in your favour, but if you do not use the correct risk management techniques, you can very easily be wiped out, the same goes for hedge funds.
Derivative Trading:
I have spoken about what a derivative is in the first section of this article. However, how hedge funds make money and minimise their losses using derivatives is what I will review in this section.
Let’s say that a hedge fund manager expects a stock to rise, instead of purchasing the stock outright, he can purchase a call option, this allows the hedge fund manager to purchase the stock at the current days market price.
He can then use this option to purchase the stock in future at that exact same price, as long as it is within the timeframe of the specified date enforced by the call option contract.
So if his intuition was correct and the stock price does rise, he is still able to purchase it for the price that the stock was when he decided to make the call option.
By doing this the hedge funds can maximise their profits and minimise their losses.
What if the stock price drops though? Well, what happens is that if the stock stays constant or falls, the hedge fund managers can limit their losses as they will only have to pay the price of the initial call option that they purchased.
Who is the wealthiest hedge fund manager?
James Harris Simons, otherwise known as 'Jim Simons' or the 'Quant King' is an American mathematician, billionaire hedge fund manager and philanthropist.
He is regarded to be one of the most successful investors in recent history with the net worth of $29.4 billion.
Simons was born in 1938, where at the age of 14 he found his love for mathematics. This would be the career path that he would then go on to pursue.
Simons' dream was to work for the Massachusetts Institute of Technology (MIT) as a mathematician, his dreams soon became reality as in 1955 Simons was accepted into the MIT and would then go on to be majored in mathematics.
Fast forward to 1961, this is when he received his doctorate in mathematics from the University of California at Berkeley. Simons would the go on to work on many mathematical theories which proved vital later on down the line.
This includes theories such as the 'Chern-Simons form' which played a major role in the topological quantum field theory. These quant theories proved to be what was used by Renaissance Technologies (Rentech).
Come 1964, Simons decides he wants to work for the The Institute for Defence Analyses (IDA). At his time in the IDA, Simons would help play a key role for the USA to break codes during the Vietnam War.
Post IDA, Simons would go to teach mathematics at MIT and Harvard University. After his long career in mathematics, Simons came to the conclusion that he wants to delve into the financing world.
In 1978 he started a hedge fund named Monometrics which would go on to be the predecessor of Renaissance Technologies (Rentech). Renaissance Technologies was founded by Simons in 1982 at the age of 44.
Simons took 6 years to come to the realisation that he wanted to solely use quantitative analysis to help his fund decide which trades will return optimal results and profits.
Since the introduction of quantitative analysis, Rentech's flagship fund 'The Medallion hedge fund' has generated over $100 billion in trading profits between 1994 and 2014. The fund had an average annual return of 71.8%.
I hear yourself asking, why doesn't every investor just invest in the Medallion fund if the return on investment is so high?
Well, the answer is simple. Unfortunately, the Medallion fund is only available for employees and family members.
Simons retired from his CEO role at Renaissance Technologies in 2010, but he still remains a non executive chairman.
Are hedge funds high risk?
From research concluded, I personally would say that hedge funds are considered high risk in comparison to other investment funds out there. By nature they're designed to take on higher risk, to give their clients much higher returns.
And as our old friend Warren Buffett always says, "risk only comes from not knowing what you're doing".
Some of the risks that I have found that have been associated with hedge funds are as stated below:
Risky Investment Strategies:
Hedge funds will often use some speculative investment and trading strategies. The way that hedge funds are managed means that there is a balance between high risk of
capital loss, and a high potential for capital growth.
However, the risks that hedge funds take are very large and they have the ability to wipe out your entire investment. Therefore, if you cannot afford to do this, hedge funds are something that you should avoid investing your money in.
Unregistered Investments:
The funds of hedge funds often invest in other private hedge funds who are not registered with the SEC. We have spoke about this in more detail in a previous section. Here is a link to that section.
As we have discussed previously, a lot of the individual investors protections and safety from the potential fraudulent and manipulative practices are taken away when a hedge fund is not registered to the SEC.
This makes it difficult for you and your hedge fund manager to assess the performance of the hedge funds in question. This is because some information may be hard to verify, meaning that it makes it easier for a hedge fund to potentially take part in fraud.
Tax and Lack of Liquidity:
When it comes to hedge funds, the tax structure may be very complex, this could lead into delays in receiving important tax information. This could force your hand into having to apply for an extension to your income tax return report.
In terms of liquidity, hedge funds are very illiquid. Therefore, both the registered and unregistered hedge funds are subject to restrictions on transferability and resale.
So to put it in simpler terms, you may not be able to get the money you invested in the hedge fund back when you want out of the investment.
The most popular hedge fund strategies:
Within this section I will discuss the most popular strategies that are used by hedge funds and how they can relate to forex:
Global macro strategy:
The first strategy we will examine is the global macro strategy. This strategy involves hedge fund managers taking into consideration major macroeconomic trends. These involves topics such as; interest rates, GDP and strength of a country’s currency.
Macro funds do not always hedge their bets, instead they take directional bets, but there is always a risk of the market going the opposite way, that is why the global macro approach is one of the most volatile hedge fund strategies.
Furthermore, macro hedge fund managers must be willing to invest across multiple sectors and trading instruments, they must be able to monetise every attractive opportunity, trend and strategy, this is essential for them to see the entire globe as their playing field.
These are very crucial things that macro economic based hedge funds have to take into consideration, mainly being because even events that take place in countries on the other side of the globe, it can still have a domino effect across the global markets.
The unhedged bets that are placed with large amounts of derivatives and leverage is the greatest threat to the performance of the global macro hedge fund, this again is due to the volatility that they will face in the market.
For more in depth information on how the global macro strategy works, please click this link to my colleagues article whose primary focus is the 3 step guide to Global Macro Trading.
Long/Short strategy:
The hypothesis for this method of trading is quite simple. Once the research on which currency pairs a hedge fund wants to trade, they will be able to single out winners and losers.
Once they have done this, hedge funds will take long positions for the winners and at the same time open a short position for the losers.
To put this into perspective, if we wanted to long GBP/USD, we would also short the GBP/USD pair to try and “hedge” our losses. This in turn reduces the market risks as the shorts counterbalance the long market exposure.
In comparison to long only strategists, the long short method is designed to have lower sensitivity to market movements which is measured once again by beta and volatility.
The reason that strategies like this are used to provide an element of protection for the hedge fund when the markets decline, this is because the gains on the short positions will dampen losses on the long positions that the hedge funds have taken.
I have extracted some information on how Investment banks such as Morgan Stanley take a variety of steps to reduce risk and protect capital. These are:
Market Neutral:
The main aim for a market neutral strategy is to generate investment returns which are independent to that of the market environment.
So, to eliminate the impact that the market fluctuations have on the currency market, the hedge fund manager will once again hedge by opening both a long and short investment.
These sort of funds will use leverage to try and increase their performance returns, this is because they are trying to neutralise the effects of the market instead of trying to beat it.
To give you an example, a hedge fund may take a 50% long position and a 50% short position on a chosen currency pair, this is so that they can remain market neutral.
Therefore, if the market moves down, the losses due to the long positions are offset by the profits made by the short investments.
The key for hedge funds who use the market neutral strategy is not the direction in which the markets move, this is because regardless of the direction the markets move, the profits and losses offset by each other.
Instead, the key for a hedge fund to be successful when it comes to using the market neutral strategy is the way and the reasons it picks the currencies or stocks, Otherwise known as stock picking.
There are many forms of employing a MNS (market neutral strategy). The most popular ones are:
"To provide the company with a potential trajectory of a trade based of predictions, the hedge fund manager uses fundamental analysis instead of quantitative algorithms." Visit Logikfx. Here you can find the exact fundamental strategy used by hedge funds prior to entering a long or short position.
"When a manager places trades on currencies based on quantitative methods, they use sophisticated algorithms to analyse historical data and expose price discrepancies in the given data. They then place their bets on currencies and stocks that are most likely to revert to their historical mean."
Long Only and Short Only Strategies:
Long Only strategies are adopted by hedge fund managers who are looking to take a longer term approach to the markets. In comparison to other strategies this one is relatively risk averse. But, it does also tend to generate lower returns in contrast to other strategies.
However, there is a lot of competition when it comes to hedge funds using this strategy. Therefore, hedge fund managers who decide to adopt this method must work very hard in order to produce great results to rationalise the fees that they charge people to invest in them.
Short Only approaches aims to return profits from “short selling” currency pairs whose prices are expected to fall in the long term.
This is where hedge fund managers skills are truly tested, reason being is because managers will have to identify currencies that are showing signs of weakness but are being overlooked by other investors.
The key point for this strategy to be successful is that there must be a bear market. These short only hedge fund strategies can also be called “event driven”.
An example of this is the coronavirus and the impact it had on certain currencies such as the GBP which lost its purchasing power immensely.
This is evident in the price charts, in this example we will be using GBP/USD. Here you can see the negative affect Covid-19 had on the U:K's economy when the first lockdown was announced in March 2020.
Advantages and Disadvantages of Hedge Funds:
People in the investing world have a variety of opinions when it comes to hedge funds, in this section we will discuss what the advantages and disadvantages of hedge funds actually are.
Advantages:
Diversifying Investments:
The first advantage of using hedge funds is the option to Diversify your investments. By adding hedge funds to your portfolio you can achieve higher risk adjusted returns.
The different strategies that hedge funds use allow for the ability to generate positive returns through both favourable and unfavourable market conditions.
Alpha:
Ability to produce Alpha. The difference between beta and alpha results are that if you invest in funds such as Index funds, your returns will likely resemble that of the performance of the index that you have chosen. For example the S&P500.
Alpha is the chance to "out-perform" the market in a sense. The more alpha, the more return in comparison to the relative market benchmark.
However, on the flip side if you chose to invest your money with a skilled hedge fund manager who can pin point stocks that can outperform the market, your potential returns will be higher than that of the market.
This might seem like a no brainer but it is very rare for someone to consistently outperform the market, that is why alpha is regarded very highly in the investment world.
Potential for new opportunities:
Another advantage of investing in hedge funds is the potential for new opportunities. This is because hedge funds have the ability to invest in assets and other trading strategies that other funds may not be able to.
The reason for this, is the fact that they are more freely regulated than other traditional funds, meaning they have more freedom in terms of what they want to trade and what they can trade. For example, derivatives and highly illiquid securities.
Disadvantages:
Who can Invest:
They only trade with “qualified investors” this is due to their risky strategies. These risky strategies, as we have stated previously can work in your favour.
However, the reason that hedge funds can only trade with qualified investors’ money is because they will be able to endure the large losses which can be experienced via these risky strategies of hedge funds, in comparison to the average investor who may not be able to withstand the losses if taken.
High Minimum Amount Required:
Unlike other funds, such as mutual funds where you might be able to get away with depositing a few hundred pounds or dollars, you will not be able to do that with hedge funds.
A hedge fund will require a much higher minimum which could translate into tens and even hundreds of thousands, sometimes even more!
Doing this as an independent trader can be very difficult, as this will narrow your ability to diversify your portfolio which every great trader should do.
Additionally, by investing most your capital into one hedge fund is not a good idea, this again relates to the fact that because the hedge funds use such aggressive and risky strategies.
So, if they make a trade which does not go in your favour, it could potentially wipe out your entire investment portfolio.
Costly Fees:
We have already spoken about the 2 and 20 fee arrangement that hedge funds impose on investors. These costs for investing in a hedge fund will be a lot higher than investing in mutual funds for example.
To put this into perspective, mutual funds charge an annual rate generally between 0.5% and 2.5% of the assets that you have invested with them.
Locks up funds:
When you invest in a hedge fund you will most likely experience a lock up period, meaning that there might be a long time between when you invest and when you actually start making money.
The reason that hedge funds implement these lock up periods is so that they can get rid of any investments which aren’t making any profitable returns for them.
The length of time that these lock up periods vary from one to three months, in some cases people have even stated that their money has been locked up for over a year.
Ergo, if you are someone who wants to see quicker returns on investment, investing in a hedge fund might not be for you. You will have to be very patient.
Can anyone invest in a hedge fund?
We have mentioned in previous parts of the article why it is so hard for an individual investor to invest in hedge funds. However, the major investors in hedge funds are the institutional investors.
They are typically pension funds, government workers and labour unions. The reason it is easier for these larger corporations to invest in hedge funds is because they have large amounts of cash.
The above are classified as 'accredited investors' this is a person or business who is allowed to deal with securities which might not be registered with the SEC, but they must have a defined net worth.
Therefore, due to the risky and aggressive strategies hedge funds use, if they lose large amounts of cash these large corporations have more than enough money to compensate for the losses.
In comparison to an individual investor who may not have the funds to compensate for these large losses which could be inflicted by hedge funds via their preferred strategies.
How you can trade like a hedge fund:
To trade like a hedge fund when it comes to forex, there is one main method of trading that is used, this is the global macro strategy.
As spoken about previously in the article, the global macro strategy predominantly focuses on the overall economic and political views of a country and how they will affect the exchange rate of a country. This method of hedge fund trading is the style of trading that is principally taught here at the Logikfx trading academy.
To give you an insight on the way hedge funds operate, we have created a short video on how to integrate their trading strategies into a strategy even the individual investor can use.
Conclusion:
To conclude, I can tell you that a hedge fund is not something you want to invest in yourself if you are an independent trader. They come in with a large degree of risk which your portfolios may not be able to compensate for if results do not go your way.
However, hedge funds are a great example to use when wanting to trade forex, this is because they do actually run the market due to their sheer size and power.
So using the COT tool which comes with the Logikfx membership you can actually see what positions the hedge funds have taken on a currency, which will be able to support you when coming to the conclusion of either shorting or longing a specific currency.
Learn to trade with Logikfx Academy
Take the first steps into growing your value as a trader with our free online courses, webinars, seminars. All from a small team of highly skilled traders with over 15 years’ experience in the financial markets.
Learn how to use powerful tools such as the macro currency strength meter alongside market positioning through a step-by-step COT tutorial - all at your own pace, including interactive exercises, engaging examples, and full support to help you develop your understanding. Here is a link to the COT report and how it can be used effectively.
