Hedge Funds – what theory says…

Hedge funds have become very popular among very wealthy communities as preferred medium of investment. To our knowledge there is no standard definition of hedge funds but common characteristics of hedge fund are: private investment fund which invest in variety of asset classes and employs a great variety of investment strategies.

Even during 2008 market crash returns reported by top hedge funds were in the range of ~ 20%-30%. Where many mutual funds, stock investments and other forms of investment vehicles went off track, hedge funds proved themselves more immune to market crash.

It is difficult to get insight into strategies what top hedge funds follow in details because of typical trade secret paradigm. Most hedge fund managers keep secrets to themselves like a magic formula. However one can look into theoretical aspects what researchers explored over the period of time and can make their own strategies. In this article we try to highlight some of the theoretical methods published in literature. Let’s have a look at most common hedge fund strategies fund managers tend to follow:

  • Equity long-short
  • Event driven and special situation
  • Merge arbitrage or risk arbitrage
  • Distressed securities
  • Macro investing
  • Fixed-income arbitrage
  • Emerging markets
  • Equity market neutral
  • Sector
  • Growth
  • Value

It depends on fund manager’s taste or preferences what strategies they like to follow. One may think of mixing different strategies based on their risk level. For example a cautious investor would like to take value investing approach which many give low returns but less risky in terms of devaluating asset value. On the other hand aggressive investor may think of investing in growth companies with high P/E and/or emerging markets where there is a good potential to make more than 100% returns.

Since emerging markets tend to be more volatile than developed, it might need a detailed analysis preferable by local analyst before taking investment decisions. On the up side in those markets the potential of growth is very big. Sometimes special situation like mergers & acquisitions (M&A) may lead to good returns in very short time. There may be couple of points worth looking at in case of M&A, e.g. what is probability for merger. If probability is very high, going long in the company which is being acquired may benefit otherwise going short. It totally depends on the assessment of the market news. Companies in distress financial situations often do restructuring or reorganization.

Such news of restructuring often lead to price disparity in the market. Negative news often provoke widespread investor sell-off of the stock when few investors are willing to invest resulting in market devaluations. Often these times, if one focus on fundamental analysis and carefully do reanalysis of the stock, one may think of investing or pull out of investments locking more profits. Macro investing approaches take into consideration macro-economic factors. Macro investors often look for investments in bonds, currencies and hedge to make more profits.

Macro investing is more prone to political-economic situations of a country. Macro investing strategy focus on “big picture” analysis approach with political-economic considerations into analysis. For example price disparity due to geo-political situation can be identified in U.S. 10 years bonds and U.K. 10 years bonds. Some fund managers use tactical strategies which may use variety of investments e.g. commodities, forex, high frequency trading, derivative, options trading etc.

According to theoretical researchers they find empirical evidences for long/short strategy funds that these get benefit from shortening the positioning as compared to long bias funds (W. Fung et. al., 2011).

Goetzmann et. al. finds empirical evidences that Sharpe ratio of funds of funds index ranges from 0.31 to 0.39 in-spite of having too much differences in mean returns, which suggests that reward to the risk ratio for hedge fund investment has remain surprisingly constant. Their data suggests that most of the fund managers used fundamental and directional strategies with least standard deviation in returns for fundamental strategies and most for event driven strategies.

Brooks and Kat (2002) argued that the serial correlation of the hedge funds returns seems inconsistent with the notion of efficient markets.

There is more theoretical research needed in order to understand more about what are better strategies for better returns one can follow.


References:

  • Gregory Connor et. al., An introductions to hedge funds, London School of Economics.
  • William Fung. et. al. The risk in hedge fund strategies: Theory and evidence from long/Short equity hedge funds,  Journal of Finance
  • W. N. Goetzmann and Stephen A. Ross, Hedge Funds: Theory and performance, MIT.
  • Brooks et. al. The statistical properties of hedge fund index returns and their implications for investors, Journal of Alternative Investment.

 

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