Hedge Funds

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What is a Hedge Fund? A Closer Look at Hedge Funds.

There are plenty of investment vehicles that financially savvy individuals can think about investing in or tracking. The hedge fund is just one of those, but it is also the one that is worth looking at. There’s an air of mystery about this type of investment vehicle, but it is not always a tough nut to crack. What investors need to do is to educate themselves on what hedge funds are and to understand what risks they should expect to expose their investments to.

How Do Hedge Funds Work?

Hedge funds are considered as viable alternatives to the existing forms of investment on the financial markets. However, it is not open to every individual investor. Rather, the funds are more ideal for people and institutions that have significant amount of assets that they want to be managed and grown. Managers typically pool together the assets of their clients to create a unified fund, and then they make their trades and investments using that single fund.

It is theoretically similar to mutual funds, but they differ in the techniques. That’s the reason why it’s not open to individual investors. There are significant risks involved – aside from traditional investment vehicles like the popular mutual funds and stock market options as well as bonds, hedge fund managers lean more towards high risk but sophisticated trading techniques to realize significant profits for their clients’ portfolio.

Adding to the risk exposure is the fact that hedge funds are not as closely regulated as the other financial instruments. Hedge fund managers are not always required to make filings and reports to the Securities and Exchange Commission, but that’s on a case to case basis. If the assets are large enough, the SEC will require reports. Hedge fund managers, however, are bound by law to protect their clients’ investments or face anti-fraud measures.

A Brief History of Hedge Funds

Hedge funds have a very long history. People and institutions began investing in this vehicle at the early 21st century. The funds never lost popularity over time. Before the recession hit, there was a total value of US$1.93 trillion being managed by hedge fund managers worldwide. The industry had a brief hiccup afterwards, because of the sub-prime mortgage crisis, but it eventually recovered. This is a testimony to how popular hedge funds really are, and how much investors are willing to trust their assets to managers.

Hedge fund assets totaled $2 trillion worldwide by April 2011, just three years after the crisis burst. By the third quarter of 2014, the worldwide value of assets under management or AUM is at $2.38 trillion and may continue to grow in the next years.

Hedge Fund Strategies

Hedge fund managers do not subscribe to a single strategy but, rather, they employ a combination of various strategies. It is not uncommon to find hedge fund managers putting some of the money in their management to purchase securities derivatives.

There are, however, some popular strategies that hedge fund managers acknowledge and use. Hedge fund managers will exercise any strategy and option within their discretion in response to several factors in the market.

Here are some of the strategies that hedge fund managers could use, either by itself or in tandem with other techniques in managing assets:

• Global macro

This type of strategy relies on identifying macroeconomic events that take place around the world to make investment decisions. Managers generally look at the big picture globally to identify potential entry points for profitable investments. The Global Macro approach leverages multiple markets, and managers will employ long and short investment strategies to maximize profits from volatile market movements. This approach is very flexible, and very diversified as well because there are many variations of sub-strategy under this umbrella.

• Directional

The directional strategy does not pay too much attention to what is happening to markets on a global basis. Instead, directional strategy dictates that fund managers look at each individual market movement when picking ideal investments. A typical action under this strategy is to invest in equities with an eye for the long term, and to couple that position with short-term buying and selling to hedge against risk.

• Event-driven

Hedge fund managers following this philosophy are focused in following corporate events and leveraging their assets to earn from the market movement influenced by these occurrences. For instance, company consolidations and mergers can make possible upward movements in price. Event-driven hedge fund management will typically take positions before or after such events take place in order to leverage and earn profits from the price movements that occur. Even bankruptcy declarations can also spur action from event-driven hedge fund managers.

• Relative value

Relative event hedge fund management focuses on finding price discrepancies and investing on those. This is the most technical of all the four management strategies discussed so far. Analysis is very comprehensive and somewhat holistic, as there are many types of analysis carried out under this strategy to identify the profitable price discrepancies.

How Do Hedge Fund Managers Approach Risk?

As mentioned above, hedge funds are not advisable for all types of investors because of the amount of risk involved in their operation. That is where risk mitigation comes in. In fact, managers operating in the hedge fund industry are described as being the most meticulous – they use the most stringent and the most precise means of protecting investments against the risks that the volatility of the market brings.

The most common method of reducing the risk exposure of managed assets is to diversify. The entirety of the funds used to set up the hedge funds are split between various investments, and varying investment positions. For instance, some of the funds may be put into long-term positions in low-risk, low-return funds that can steadily gain in the passage of time.

A portion of the funds may be invested in high-risk, high-return investment positions that the hedge fund manager may monitor in the short term, taking into consideration the risk factor and market environment.

In addition, hedge fund companies may employ risk officers. These are not people who are directly involved in trading, but have knowledge in how markets work. These risk officers will focus on identifying long and short-term risks to the assets under management, and will then work on creating a comprehensive risk management strategy that will be applied by the hedge fund managers for their managed assets.

Other techniques for managing risk in hedge funds include using risk management methodologies as well as operational due diligence.

Offshore and Onshore Hedge Funds

Because of their popularity and the global nature of their investment, hedge fund managers can be found all over the world. There are two types of hedge fund management companies, and they are the onshore and offshore hedge fund managers. Their differences lie mainly in the levying of tax on the investors’ earnings.

Offshore hedge fund managers give their investors the advantage of minimal tax consequences. For example, US-based investors who enjoy tax exemptions on their investments, particularly in retirement funds, will turn to offshore hedge funds. This helps them avoid being taxed for their income from the hedge funds.

On the other hand, if offshore hedge funds invest in instruments and securities in the United States, they can expect the US government to slap withholding taxes on their investments. However, there are no capital gains tax involved here – this is to make sure that offshore investors are not double-taxed for any increase on the value of their assets. Only their local jurisdiction has the legal right to levy any taxes on the investors for gains they see from their investments.

The presence of both onshore and offshore hedge management funds make the taxation more flexible and more personalized according to each investor’s personal expectations in taxation. In addition, it encourages global investment because of the measures imposed specifically to avoid the horrors of double-taxation – a common fear among investors who have eyes on diversifying globally.

Prominent Centers of Investment

The United States remains the center of global hedge fund management. 70% of the hedge fund managers that oversee the progress of global funds are based in the United States. The Securities and Exchange Commission has in its registry nearly 4,000 financial experts, as of April 2012, who handled management of hedge funds. These are found across the US, but most of them are based in New York City and Connecticut’s Gold Coast.

As for European hedge funds, London is the home of the managers with over 800 of them found in the city. In 2011, these firms were responsible for managing 85% of the hedge fund assets from continental Europe.

There is a growing market in Asia, particularly in Japan. Growing economic centers Hong Kong and Singapore are also experiencing a growth in hedge fund assets under management, but it will be some time before they achieve the demand in hedge fund managers enjoyed by the US and London in Europe. In fact, most of the hedge funds from Asia are managed by offshore companies based in these two centers.

Hedge Fund Industry - Assets Under Management

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