Contrary to what its name might suggest, a hedge fund or alternative fund is not a mutual fund or an investment strategy but an organization that manages the fund. It is set up by a fund manager or investment advisor.
Hedge funds use client capital to generate profits in the market using different investment or trading strategies. In other words, investors deposit their money in hedge funds for the funds to invest on their behalf to collect management or performance fees.
How does hedge fund work?
Hedge fund operate on the basis of a partnership between investors and fund managers. These funds convince potential clients of the reliability of their investment methods. When investors deposit their money in a hedge fund, they typically pay two types of fees: a management fee and a performance fee. We will discuss this topic later.
Features of hedge funds
Some hedge funds only accept capital from certified investors.
Depending on their purpose, they will participate in all markets and derivatives. They can use complex strategies.
They use leverage, borrowing more capital to create a positive alpha.(Read more :Leverage in Financial Trading)
Most hedge funds adopt a “2 and 20” fee structure. That is 2% management fee and 20% implementation fee.
Hedge funds use leverage to increase their returns in the market in different ways:
Margin trading: margin trading involves borrowing capital to be able to open larger positions. Hedge funds can borrow these funds from investment banks.
For example, with a margin of € 500 (VND 13,500,000), one can borrow an additional € 500 (VND 13,500,000) from an investment bank to buy a share for € 1000 (27,000,000 VND) copper). If the stock goes up to €2,000 (VND 54,000,000), the person will gain € 1,000 (VND 27,000,000) instead of € 500 (VND 13,500,000) if only € 500 (VND 13,500,000) is used. dong) its starting point.
Line of credit: the hedge fund can borrow money from the bank to get more transferable capital. Its principle is similar to margin trading.
As we have seen, the industry standard for commission fees is “2 and 20”. The hedge fund will bill 2% annual fees from assets under management regardless of performance and market conditions. In addition to these management fees, an investor will have to pay a performance fee when the hedge fund generates a return on its invested capital. The usual implementation fee is 20%.
For example, if a fund manager sets up his hedge fund and an investor entrusts the fund with 1 million euros ($27,000,000,000), the manager will receive 2% of the 1 million, or 20,000 euros. (540,000,000 VND) regardless of the fund’s performance. Then suppose that he earns 200,000 euros ($5,400,000,000) by applying his investment strategy. At that time, he still receives 20% of this amount, or 40,000 € (1,080,000,000 VND).
Hedge fund strategy
Many investment strategies have been developed since the first hedge fund was founded. Some strategies are as simple as buy and hold, others are more complex and use derivatives.(Read more : copy trading)
A macro strategy is relatively simple and is based primarily on economic indicators such as GDP or interest rates as well as political events.
For example, suppose that the United States decides to lift sanctions on Iran, then the country will be able to produce and export more oil and thereby increase world oil production. From there, the hedge fund can speculate on a drop in the price of oil.
Hedge funds with a multi-strategy approach use a variety of financial instruments to beat the market. They do not specialize in a particular method. Their goal is to make a profit regardless of the market situation. These hedge funds tend to be very cautious and take risk management seriously.(Read more : Day Trading for Beginners)
With an event-driven approach, a fund manager often tries to capitalize on microeconomic events related to a company or sector. It is essentially a news trading strategy.
For example, profit warnings are often accompanied by a decline in a company’s market share. Hedge funds can take advantage of this phenomenon by shorting securities. This event-driven approach makes it possible to take advantage of short-term fluctuations.
Short buy-sell strategy
This is the simplest strategy in the stock market. This strategy involves buying undervalued stocks and selling overvalued stocks. Hedge funds can be either buyers or sellers in this market. The advantage here is that they can take advantage of both rising and falling markets.
Hedge funds can take three approaches to a short-buying strategy:
Long-term bias strategy: the hedge fund will make more purchases than short, in other words, its long positions will outnumber its short positions.
Dedicated short-term bias strategy: the hedge fund will make more selling.
Neutral market: buy and sell positions are fairly balanced.
Relative value difference
This is a strategy that hedge funds use to capitalize on the price difference between two assets of the same class. The arbitrage strategy is to simultaneously buy and sell two assets that are said to be unlisted at their actual value.
As a result, the trader would sell the overvalued asset and buy the undervalued asset. When the price level returns to equilibrium, they will liquidate these positions. Judgment can be applied to two stocks, two commodities, two bonds, and so on.
(Vulture Fund Strategy) Vulture Fund Strategy
This strategy involves buying debt from troubled companies at low prices. The purpose of this strategy is to take advantage of this debt during the debt restructuring period when the company recovers its financial viability.(Read more : forex broker)
Hedge funds with a quantitative approach are increasingly appearing in the market, and traditional hedge funds are starting to adopt quantitative strategies. Quantitative analysis includes the development of algorithms that underlie automated trading in the markets.
Quantitative trading is based on a systematic and non-arbitrary approach. The trading robot is responsible for making investment decisions on behalf of the manager, who is always there to monitor the development of the math.
Controversy and Controversy
Although hedge funds are major players in the financial markets, they have suffered a lot of bad reputation. These funds are often accused of profiting from social collapses and financial crises.
History has shown that hedge funds are important players in the financial sector and even the economy. After the collapse of Long Term Capital Management (LTCM) in 1998, the world recognized that they represented a systemic risk. LTCM is a well known hedge fund in the US but it is 25 times more indebted than its capital (leverage 1:25).
Systematic risk describes the likelihood of a series of correlated failures among financial institutions. This failure often comes from a particular institution or sector: a bank or a hedge fund. The collapse of LTCM caused a liquidity crisis in the United States.
The systemic risk that hedge funds present is partly due to the fact that the large banks whose trading branches often act like hedge funds and the fact that investment banks trade derivative products has a certain leverage. That shows that hedge funds expose banks to risks associated with their trading activities. The bankruptcy of a large hedge fund can upset financial markets and the entire economy.
Hedge funds have often been left out due to excessive speculation in the market since the crash of LTCM in 1998. Also, most funds have rarely been able to beat the market.
CEM Benchmarking, a Toronto-based investment advisory firm, compares the returns of 382 large hedge funds to equity and bond indexes. CEM then found that hedge funds could not, on average, beat the market year over year from 2000 to 2016. In other words, traditional funds outperformed hedge funds. household.
Lack of transparency
You may have noticed that hedge funds are not the most transparent financial institutions. Investors often don’t know what managers are investing in because they are often very complex. Therefore, you should work with a financial advisor before making an investment decision in a hedge fund.
Hedge funds are complex and controversial investments. They accept a higher level of risk in order to outperform the market. To do that, hedge funds employ complex strategies that use derivatives and leverage.
Studies have shown that “beating the market” is not always easy even when hedge funds have invested a lot of resources. However, they are still an attractive solution for investors looking for absolute growth and give you diversification options over traditional investments.