WHAT IS HEDGING?
Simplistic definition to get started:
An investment made in order to
reduce the risk, of adverse price movements in a security,
by taking an offsetting position in a related security, such as
an option or a short sale.
The use of the term "hedge" in the US originally
was coined by the agriculture industry.
Farmers were the first "hedgers" by selling crops or cattle
yet to be harvested at a price for future delivery.
In doing so, they locked in a price today and were "not
exposed" to future market fluctuations.
In essence, they "hedged" their market exposure for the
period of time it took them to harvest and deliver their
GOAL OF THE FUND
The primary aim of most hedge funds is to
Reduce volatility and risk
while attempting to preserve capital, and
deliver positive returns under all market conditions.
Historically the hedging strategy centered around
Equities on the "long side" outperformed up markets. At
the same time, the equities on the "short side" did not
create a drag on performance, and possibly even added to
the portfolio’s return since there are always stocks that
lose value, even in a bull market.
In a market correction, the short portfolio would
outperform the long portfolio, or at least "hedge" or
reduce the slide in the long portfolio’s value.
TYPES OF HEDGE FUNDS
Long-Short Funds: Take both long and short positions in securities
in hopes of using superior stock picking strategies to outperform the
Market-Neutral Funds: A sub-type of a long-short fund, however
fund managers attempt to hedge against general market movements
(thus the name "market neutral").
Event-Driven Funds: An attempt to capture gains from market
events, such as mergers, natural disasters or political turmoil.
Macro Funds: Take directional bets on the market as a whole, either
long or short, based upon research and/or the fund's philosophy.
HOW IS HEDGE FUND DIFFERENT FROM
Hedge funds traditionally reserved for clients with
initial minimum investment of $1 million. Mutual
fund companies beginning to offer hedge fund
products to wider client base
There are 5 key differences between them based
1. Performance Evaluation
2. Level of regulatory control
3. Basis for Remuneration of Management
4. Portfolio Protection
5. Dependence on Markets
Mutual funds are measured on relative performance
compared to a relevant index or to other mutual funds in
Hedge funds are expected to deliver absolute returns under
all circumstances, even when the relative indices are down
Level of Regulation:
Unlike hedge funds, mutual funds are highly
regulated, restricting the use of short selling and
derivatives. Makes it difficult to outperform market, or
protect assets in downturn.
Remuneration for Management
Mutual Fund managers are paid based on a % of
AUM. Hedge funds pay managers performance-
related incentive fees plus a fixed fee
Mutual funds are not able to effectively protect
portfolios against declining markets other than by
going into cash or by shorting a limited amount of
stock index futures
Hedge funds are often able to protect against
declining markets by using various hedging strategies,
and can generate positive returns even in declining
Dependence on Markets
The future performance of mutual funds depends on the
direction of the equity markets.
The future performance of many hedge fund strategies
tends to be highly predictable and not dependent on the
direction of the equity markets.
FACTS ABOUT HEDGE FUND INDUSTRY
Estimated to be a $2 trillion dollar industry, with about 10,000
active hedge funds.
Includes a variety of investment strategies, some of which use
leverage and derivatives while others are more conservative and
employ little or no leverage.
Most hedge funds are highly specialized, relying on the specific
expertise of the manager or management team.
not dependent on the direction of the bond or equity markets unlike
conventional equity or mutual funds (unit trusts).
Hedge fund managers are generally highly professional, disciplined
Hedge funds have a definite place in portfolios for
both return enhancement and diversification. They
do have some drawbacks that should be seriously
considered during the portfolio construction process,
but carefully selected hedge funds, or even hedge-
fund-like strategies, are a great addition to any