Understanding Their Strategies, Structures, and Role in a Portfolio
Hedge funds are private investment funds that use a wide variety of complex strategies to generate returns. Unlike traditional mutual funds, they are lightly regulated, open only to accredited (wealthy and sophisticated) investors, and have the flexibility to use tools like leverage, short selling, and derivatives. Their primary goal is often to generate alpha (absolute, market-beating returns) regardless of market direction.
Generate alpha (absolute returns) that are uncorrelated with market movements through sophisticated investment strategies.
Limited to accredited investors - wealthy individuals, institutions, and sophisticated investors who meet specific criteria.
Hedge fund strategies are diverse and are typically grouped into broad categories.
Long/Short Equity
Takes long and short positions in equity securities. This is the original and most common hedge fund strategy.
Sub-Strategies:
Fundamental Long/Short, Market Neutral, Short Biased
Corporate Events
Seeks to profit from specific corporate events, such as mergers, acquisitions, bankruptcies, or restructurings.
Sub-Strategies:
Merger Arbitrage, Distressed/Restructuring, Activist
Price Discrepancies
Exploits small pricing discrepancies between related securities. This strategy often uses significant leverage.
Sub-Strategies:
Convertible Bond Arbitrage, Fixed-Income Arbitrage
Macro Trends
Makes bets on the direction of broad markets (e.g., interest rates, currencies, commodities) based on macroeconomic trends.
Sub-Strategies:
Global Macro, Managed Futures
Hedge funds are typically structured as limited partnerships, with the fund manager acting as the General Partner (GP) and investors as Limited Partners (LPs).
A common structure for global funds is the Master-Feeder Structure, which combines capital from both U.S. (onshore) and non-U.S. (offshore) investors into a central master fund.
Hedge fund returns can be broken down into three components:
Return from exposure to broad market risk.
Return from the specific risk factors of the fund's strategy.
The excess return generated by the manager's skill, independent of market and strategy betas. This is what hedge funds are paid to deliver.
Failed funds are excluded from databases, artificially inflating average returns of surviving funds.
New funds add strong past performance to databases, inflating historical averages.
Impact: Measuring true hedge fund performance is difficult due to several reporting biases in hedge fund databases.
To protect against mass withdrawals during periods of poor performance, hedge funds use several tools to manage liquidity:
A period after the initial investment during which investors cannot withdraw their capital.
Require investors to give advance notice (e.g., 30-90 days) before a withdrawal.
Limit the amount of capital that can be withdrawn from the fund during any given redemption period.
A key attraction of hedge funds is their potential to provide diversification. Many strategies have low correlation to traditional stock and bond markets. Adding a carefully selected allocation of hedge funds to a traditional portfolio can potentially reduce overall portfolio volatility and increase risk-adjusted returns (as measured by the Sharpe ratio), especially during market downturns.
Low correlation with traditional assets can improve risk-adjusted returns
Many strategies designed to perform well during market stress