Understanding hedge funds

What is a hedge fund?

The goal of a hedge fund is to hedge risks that are not part of the managers' views (often market beta) and to provide solid risk-adjusted returns (often by targeting absolute returns).

Hedge funds tend to be actively managed. They are also typically not regulated as strictly when compared to mutual funds (SFC authorized funds in Hong Kong), and have more leeway to use higher-risk investment strategies and invest in non-traditional asset classes. Hedge funds generally invest in different types of underlying instruments, such as shorts, derivatives, FX, and rates.

There is no single definition in the investment management industry of what a hedge fund is, given that such pooled vehicles can employ very diverse strategies suited for a large variety of portfolio needs.

For instance, some refer to hedge funds as an asset class within the alternative investment umbrella, while others describe it as a business model and governance structure.

The first hedge fund strategy was started in 1949. The thesis from Alfred Winslow was meant to separate two risks that come from investing in stocks — market risk and risk embedded in specific stocks. The aim was to create a market-neutral portfolio, such that it was “hedged” against market movements. 

With the evolution of the hedge fund market, not all hedge funds today are designed to hedge exposures or employ hedging techniques, though the label has stuck.

How are hedge funds structured?

Traditionally, most hedge funds are open-end, similar to mutual funds or unit trusts, as opposed to closed-end.

That means the shares of a hedge fund can be continuously issued to investors, and it accepts a constant flow of fresh capital. New shares in an open-ended fund are created whenever an investor buys them, and there is no limit to the number of shares it can offer. 

Investors can also make periodic redemptions, by selling the shares back to the fund at the net asset value, although the amount of capital that can be withdrawn at a given time may be capped.

In contrast, a closed-end fund issues only a fixed number of shares once, through an initial offering, and does not issue new shares subsequently even if there is more demand from investors. Most closed-end funds also do not allow redemptions.

Hedge funds usually require investors to contribute their capital at the start of the investment relationship. Thereafter, investors can choose to make additional contributions from time to time. 

The different ways a hedge fund may invest capital

Today, there is a broad variety of hedge funds using different methods of portfolio construction and risk management techniques. Their investment strategies can be complex and proprietary.

Some funds are diversified across many strategies, asset classes, and managers. Others use a single strategy, or take highly concentrated positions.

The strategies commonly employed by hedge funds include long/short equity, credit, event-driven, and macro.

• With an equity strategy, the fund essentially takes long positions in stocks it sees as undervalued, expecting the prices to rise, and takes short positions in stocks that it thinks are overvalued and anticipates a price drop. Long/short equity funds usually lean towards having net long market exposure. Market-neutral funds will hedge bullish stock picks with bearish bets that have an equivalent market value.
• If a hedge fund uses an event-driven strategy, it invests with the aim of profiting when an expected corporate event — such as an earnings call, merger, reorganisation, or spin-off — takes place. For example, it may buy the deeply discounted debt of a company facing bankruptcy, or try to profit from sudden changes in a stock price caused by a hostile takeover bid.

Essentially, a hedge fund can invest in anything, depending on its mandate — be it stocks, bonds, real estate, currencies, derivatives such as futures and options, or even collectibles like wine and fine art. These may include highly illiquid investments that are difficult to value, as compared to traditional assets. 

Hedge funds also frequently use leverage. That’s when the manager uses borrowed money to buy more of an asset to amplify the potential returns — though this also means it will increase the potential loss from the investment. Leverage allows hedge funds to take aggressive short positions.

Why consider allocating to hedge funds?

Hedge funds as an asset class can be attractive to investors because of the potential high absolute returns it offers, the diversification benefits, the reputation of its manager, its investment strategy, or the assets it invests in.

Hedge funds have also done better than other broad investment classes. The HFRI Fund Weighted Index lost just 4% from the start of 2022 to end-August 2022. That outshone the near 18% drop in the MSCI World Index and a 15.6% fall in the Bloomberg Global Aggregate Total Return Index.

Other motivations for investing in hedge funds may be to reduce portfolio volatility, lower the portfolio’s correlation to public markets, and improve risk-adjusted returns. Some hedge funds are able to generate positive returns despite unfavourable market conditions.

The benefits of hedge fund investing will depend on the manager’s selected strategy. A macro strategy, for instance, can help diversify portfolios because it has exposure to multiple markets. With an equity strategy, high returns are likely if the manager is experienced in selecting the right stocks.

One way to approach hedge fund investing is through the core-satellite investment strategy. The smaller, satellite allocations of your portfolio can include hedge funds and other alternative investments. These will then complement your portfolio’s largest, core component, which should be globally diversified, have a strategic passive asset allocation, and come at a low cost.

Things to note before investing in a hedge fund

Hedge funds often cater to institutional investors and affluent individuals, specifically sophisticated or Professional Investors. This is because such investors are able to afford the larger initial minimum investment, and should have the expertise to understand and manage the risks associated with such investments.

If you’re thinking of buying shares in a hedge fund, make sure to read its prospectus, product highlights sheet, and other related documents. Understand the level of risk involved in its strategies — it should be suitable for your risk tolerance, investing goals, and time horizons. In terms of investing in Hong Kong, if the hedge fund is unauthorised by SFC, the offering document may not be as transparent or easy to understand as those retail authorised funds. Investors are expected to  to have complex product investment experience and may consult with their independent financial advisors before decide to invest.

To understand risk, an investor can look at the Sharpe ratio of the hedge fund of interest, which indicates a fund’s returns relative to its level of risk. If a fund delivers a Sharpe ratio of more than 1, it has earned more than one unit of return for each unit of risk taken. 

Another indicator to evaluate is the drawdown — this tells investors the bigger decline in a hedge fund’s performance from its peak to its trough.

When it comes to redeeming (or cashing in) your shares in the hedge fund, there may be restrictions such as a lock-up period, a maximum amount of capital you can withdraw at any given time, or a cap on the number of times you can redeem each year. Such limitations will affect liquidity, as your money will need to be kept in the fund for a certain duration, and also give rise to the possibility that the value of your shares might fall during the time taken to redeem them.

Fees are another important factor to consider, as they impact your return on investment. Fund managers will charge a fund-level fee for their services in managing and investing the funds you purchase. 

Start your hedge fund investing journey with Endowus Private Wealth

Endowus has a private wealth arm that provides access to more investment products, including alternative investments such as absolute return multi-strategy hedge fund solutions and other alternative investment products to Professional Investors.

Making access to private and illiquid assets easier for individual investors is an important part of our mission to democratise wealth management for everyone. Most recently, a part of the industry we have been looking to revolutionise through better access, advice, and lower cost is absolute return multi-strategy hedge funds. These strategies have traditionally been difficult to access and often exclusively available to institutional investors.

"Absolute return" strategies focus on generating a positive return over any period through cycles, which is different from the more common relative return strategies that focus on returns relative to a specific benchmark.

Well-known asset managers that implement these strategies include: Millennium, Point72, Balyasny, Brevan Howard, Eisler, Hudson Bay, LMR, and Schonfeld.

With Endowus Private Wealth (EPW), clients looking to invest a minimum of US$1 million in assets across our services can gain exclusive access to more personalised solutions and products.

Endowus keeps fund-level fees as low as possible by working with fund managers to access their lower-fee share classes and with our industry-first practice of rebating 100% Cashback on trailer fees to our clients. For more information on our transparent fees, click here.

Let us introduce you to a better way to manage your wealth. For more information on EPW and hedge fund investing, please contact us for a consultation.

Read more: Your guide to different hedge fund strategies

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Investment involves risk. Past performance is not an indicator nor a guarantee of future performance. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. 

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