A Hedge Fund Primer, Part 1

October 21, 2014

Hedge Funds – The Musical

“[General relativity] occurred to me by intuition, and music was the driving force behind that intuition. My discovery was a result of musical perception.” – Albert Einstein

Welcome to the first part of our module demystifying hedge funds. Just for kicks, let’s start on a slightly mystical note from Albert Einstein.

Einstein viewed the process of scientific discovery as having two stages. 

Stage 1: Inspired, intuitive leap into the ineffable area normally claimed by art; creative play dominates and leads to innovative ideas. 

Stage 2: Grounding these ideas, translating them into the language of math, logic and physics. 

“Conventional words or other [mathematical] signs have to be sought for laboriously only in a secondary stage,” he wrote, “when the associative play already referred to is sufficiently established and can be reproduced at will.” 

Physics teachers focus on the second stage, but without the first there is no greatness and no discovery. And of course, what applies to physics must apply to hedge funds…

An important distinction between a mutual fund and a hedge fund (and a key reason why sophisticated institutional and ultra high net worth investors have invested significantly in the latter) is hedge funds’ freedom to be flexible in how ideas and convictions are expressed. 

The soul of a hedge fund lives in this creative space. So, as we slice the hedge fund universe up into various strategies, characteristics, styles and results, please keep in mind this analysis is a heuristic applied after the fact to something that is still more open art than hardened science. 

So, what is a hedge fund? 

The name “hedge fund” comes from “hedged fund,” and as the name implies, many (but not all) of them use a variety of financial instruments and strategies to hedge against downturns in the markets in order to reduce risk and improve returns. They do so by hedging out their exposure to risks such as the stock or bond markets. Relative to their mutual fund brethren, they have more flexibility to use derivatives and to employ leverage to take long and short positions. Unlike mutual funds, hedge funds are usually run less than 100% net long, often considerably less. (See the chart below for a refresher on gross and net exposure.) As a result, hedge funds are not always as exposed to the vagaries of the stock market and even have the ability to to profit from downward moves in the markets. 

How are hedge funds different from mutual funds?

Hedge funds use a wider variety of financial instruments than mutual funds, and therefore are held to a different performance standard. Specifically, they seek absolute returns, while mutual funds focus on relative returns.

What does this mean? A relative return framework is one where the investor’s point of reference for measuring performance is a moving target, with the most common example being an index benchmark like the S&P 500. Practically speaking, this means that if the S&P index is down 30% on the year, and the mutual fund is “only” down 20%, during the same year, it is considered a success.

Absolute returns, on the other hand, are measured in reference to something fixed — or absolute. That absolute number can be 0% (i.e. the only acceptable return is a positive return) or it can reflect what the typical investor needs or considers sufficient, perhaps 3% to exceed inflation, or 5% to satisfy a specific liability. Thus, hedge funds are expected to make a profit even when the market is down. 

Investors in hedge funds can also expect to have less liquidity than investors in mutual funds. Mutual funds have daily liquidity, which means that if you suddenly become very nervous about markets in general or just about the competence of the portfolio manager, you can get your money out by the next day. That said, depending on which share class you have purchased, you may be charged a fee for withdrawing before a designated period has elapsed. 

Redeeming (i.e. withdrawing your money) from a hedge fund takes more doing. First, most hedge funds allow redemption only on a monthly, quarterly or annual basis. Also, many hedge funds require that you give notice, sometimes as much as 90 days, before redeeming. Not a very responsive panic button.

This longer notice period for redeeming money from hedge funds is not an arbitrary way to keep you from your money. It’s because hedge funds may hold underlying investments that are less liquid than the more standard stuff (like stocks and bonds) that mutual funds hold. Longer redemption periods allow the hedge fund manager to exit positions more slowly in efforts to minimize the negative impact on their portfolio. Because the last thing you want the portfolio manager to do is hit the panic button. 

How big is the world of hedge fund investing?

Hedge funds in aggregate continue to break their own fundraising and total asset records, hitting a ninth consecutive quarterly record total AUM of $2.82 trillion as of Q3 2014. Putting the sheer size of the asset class in perspective, it is equivalent to over 16% of the latest (Q2 2014) United States Gross Domestic Product (GDP)1. Just as the economic engine of our country is driven by an incredibly rich layering of businesses and industries, some enduring from the Founding Fathers’ time and others being formed as we speak, hedge funds are immensely varied, ever-evolving and hard to pin down.

One unifying factor across styles and types of hedge funds is the imperative to make money by taking advantage of inefficiencies in a market. Finding those inefficiencies is a creative process similar to Einstein’s description of physics—an intuitive leap made possible by exhaustive knowledge within a particular field. No matter how much analytical firepower is applied to grounding and testing the results of that insight, the initial stage is very much in the realm of listening to the music of the celestial spheres, or markets, as the case may be. Doing it well requires a differential view grounded in deep expertise, seeing patterns or anomalies that others don’t, and then figuring out a repeatable method to exploit that insight.

Because it’s a creative process and there are infinite strategic possibilities, there are a number of different ways to classify hedge funds, and none of them is perfect. There will always be strategies that fall outside the boundaries or defy categorization. Stay tuned for A Hedge Fund Primer, Part 2, where we make a valiant attempt at classification in order to bring the big picture into sharper view.

1 Source: U.S. Bureau of Economic Analysis

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