How do you understand hedge funds? What are the strategies in practice?

December. 29,2020
How do you understand hedge funds? What are the strategies in practice?

There is a description of hedge funds that stands out to me: hedge funds are a bootleg model disguised as an asset class. I think this statement is key to understanding the nature of hedge funds.

Hedge funds invest in a variety of instruments, markets, and styles, but the only thing that remains the same is the way hedge fund managers make their money - the 2 and 20, which has been popular in the U.S. for years. 2 means that hedge funds take 2% of the principal each year as a management fee, and 20 means that 20% of the annual investment profits go to the hedge fund manager. The former allows the hedge fund manager to keep the fund afloat and not be unable to pay his employees if he loses money on his investments. The latter allows the hedge fund manager to receive a large bonus in years when the investment is successful.

This division of the spoils is naturally lucrative for hedge fund managers, but it is not investor-friendly. Keep in mind that the 2% management fee is a huge amount of money in the asset management world. Large stock/bond funds that are mutual funds have a management fee of less than 0.1% per year, and these funds don't take 20% of the profits.

Since some of the hedge fund's competitors are these very low-fee funds, the hedge fund must differentiate its investment products sufficiently from these mutual funds. If the hedge fund's investment products were as profitable and timely as the mutual funds, and the bulls made money and the bears lost money, the investor would not be able to choose the hedge fund. Therefore, hedge fund strategies will always find ways to keep themselves off the beaten path of the market, especially if they can make a lot of money in a bear market and help their clients hedge against the market risk. Back to the point, that's why hedge funds try to disguise themselves as an asset class that has little correlation to the movements of other assets.

For these objective reasons, a hedge fund's strategy must not be a simple long only, buy and hold, and the hedge fund's alpha (i.e., the reason for making money) is somewhat circumstantial and does not go up with the market. Perhaps the most common hedge fund strategy is pair trading, which involves finding products with similar characteristics, but at different prices, and buying low and selling high. There are also hedge funds that buy convertible bonds and sell stock/option hedges. There are also hedge funds that buy and trade illiquid government bonds and sell and trade liquid government bonds to make a small spread between them.

There are also hedge funds that have the advantage of getting involved in operations that are difficult to do with regular funds. There are hedge funds in the U.S. that specialize in trading sovereign and corporate bankruptcy debt, and their alpha is that they are particularly familiar with the bankruptcy negotiation process, so they can squeeze more return out of bankruptcy debt that they buy at lower prices. There are also hedge funds that are particularly adept at fixing mismanaged companies, buying every stock with the goal of getting on the board of directors, firing management, and then using their philosophy to run the company. In the highly securitized United States, there are even specialized funds that buy and sell art, cab licenses, restaurant chains, farmland, and other alternative investments on a full-time basis. As long as these hedge funds are specialized enough to convince investors that they are willing to spend 2% of their capital on professional investment services, these hedge funds will be able to gain a foothold in the market.

It's important to note that the returns of these strategies are not correlated to the broader market, are highly specialized, and are likely to have outsized returns. That's why hedge funds are successfully masquerading as an asset class on par with stocks, bonds, and real estate. It's also why hedge funds can charge much higher management fees than other asset managers.