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Hedge funds, sometimes called ‘alternative instruments’ are a specialised type of professionally managed portfolio that makes extensive use of derivatives. To hedge means to reduce investment risk by acquiring a new risk to offset the unwanted risk. Ideally, these two risks should cancel each other out, but in practice it is rare to find an opportunity to make a completely safe hedge.
Many investors hedge occasionally. For instance, suppose an investor in equities does not want the risk that the market may drop for a period. The investor could sell an index future short, or buy a put on an index to protect against a decline in the value of the equity portfolio. All kinds of risks can be hedged against, including :
Currency risk
Interest rate risk
Equity sector risk
Hedge funds generally seek to make above-average returns by using very complex strategies. Although most hedge funds do attempt to hedge against certain risks, they are willing to assume high risks of other kinds, in line with their investment objectives. Typical hedge fund strategies include :
Market neutral – aims to reduce market risk by buying undervalued securities and selling overvalued securities in equal amounts. The strategy relies heavily on stock-picking, and the returns are likely to have a low correlation with market performance.
Classic hedge – also relies heavily on securities selection to construct complex combinations of short and long positions in equities, bonds, and options. The strategy is principally to profit from good stock selection while hedging against market volatility.
Event-driven – seeks out special situations such as mergers and acquisitions. The fund may buy the stock of the target company while short-selling the stock of the acquiring company. Leverage may be used in the hope of a better return.
The strategies mentioned so far generally have medium risk. There are also hedge funds that use highly risky strategies, such as :
Macro-management – the fund managers seek to exploit changes in value caused by political and economic events. Some managers are willing to take positions in virtually any security or market in the world, often with very heavy leverage. The term ‘hedge fund’ is therefore a little misleading, especially for the funds that adopt very high-risk approaches. If you are interested in investing in a hedge fund, you should examine its strategy very closely. Hedge funds often require you to ‘lock-up’ your investment for a period and may not open for transactions on a daily basis. In general, you should expect to hold a hedge fund investment for at least 3 years. (Martin)
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