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Readers' Request: Hedge Funds Part II

 

We received a lot of feedback on our recent post – Hedge Funds, Alpha and The Holy Grail. Thank you very much to all our avid readers and please do keep reaching out to us with any topics you would like us to explore. In the interest of popular demand, here are more of our thoughts on those wonderful creations we call “Hedge Funds”.

 

In the beginning, things either go up or they go down – in that we buy an asset at a price of x, and we make money when we sell at x+1. But then in the 80’s, we discovered a way that allowed us to do other things than just speculating on asset prices going up. We are of course talking about the notorious concepts of “shorting” or using “derivatives” to benefit from the other direction of travel. To most laymen, these terms must appear like the horsemen of the apocalypse. As it happens, what these wonderful creations of financial engineering were foremost designed to do, is to allow us to take away (hedge) certain risks such as market, sector or commodity exposure.

 

Think of the farmer who has a wheat field and needs money before the harvest is due. He can hedge his risk by entering into so-called forward contracts. On the other side of that trade are other investors, who believe that the price of wheat is headed in the opposite direction. Nothing wrong with that, and that’s what makes a market. So, if you can speculate on things going down, as well as going up, why not play them relative to one another? Say you buy (long) a stock such as Vodafone, then your risk is that the price falls. If, however, you sell (short) another asset such as British Telecom in the same amount and at the same time, then your risk is the difference of the share price between the two. The risk is not that they both fall when the market goes down. That risk has been hedged away by the nature of the position (long and short), and that is a beautiful thing.

 

And so the games began. All of sudden, people started playing all kinds of things against each other, Apple versus Nokia, FTSE versus DAX, Treasuries versus Bunds, orange juice futures versus pork bellies. Then we started using leverage to exploit ever tinier margins of risk and we used technical analysis, fundamental valuations and structural or quantitative arbitrage models to exploit so called “alpha” (akin to risk free returns). And of course, there are the fees, because unlike in traditional asset management where one typically pays less than 1%, hedge funds sell their magic at 2% and charge 20% performance fees.

 

It became complicated, people got rich and of course, alpha started to disappear. That’s because an arbitrage only exists for so long as everybody else has not taken notice. Once you have trillions of dollars and machine algorithms scanning the known universe for every clue or trace of alpha, it becomes very difficult to find the golden nuggets. But for so long as markets don’t move up and down in straight lines, there will be alpha. And having strategies that are not correlated to the markets is an essential building block of any diversified investment portfolio.

 

But beware of the pretenders. Not surprisingly, attracted by the lure of easy money (read: high fees), some rather unscrupulous characters have entered the fray, and they have given hedge funds their bad name. Managers taking long positions (and charging performance fees), using cash to time the market (and charging management fees), or making grand predictions that never come true (no one knows the future). As long as you don’t do that, then welcome to the most fascinating area of finance and enjoy yourself as you discover what all the fuss is about.

 

Please see past blog posts: Hedge Funds, Alpha and The Holy Grail, The Price of Orange Juice, Leverage and Arbitrage, What Actually is Alpha?, What Actually is Alpha? Revisited.

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