Though a poster child for exclusivity, hedge funds are no strangers to the limelight. Rarely a week goes by when they’re not in headlines for their stance on specific asset groups, commodities, or even entire industries.
As an alternative to the traditional stocks and bonds market, hedge funds offer a different way to invest. Investors looking to diversify their portfolios with hedge funds usually begin by evaluating the fund’s operational strategy, which differ on a variety of parameters, like scale, risk tolerance and asset group focus.
Hedge funds aim to reduce risk on an investment. They do this through hedging, or the act of buying/ selling an asset to help reduce the risk of losses in another asset.
Though hedge funds perform this in very sophisticated ways, the concept of hedging can be compared to the ways people mitigate risk in their everyday lives. By paying for insurance for example, we hedge against the potential loss, be it financial or physical, in the event of an unprecedented event.
Hedge funds – which are funded with subscriptions from qualified purchasers or institutional asset allocators – aim to achieve outsized returns by employing advanced strategies to compensate for potential loss. Though no two hedge funds are exactly the same, they share some common characteristics, such as lower liquidity (they’re hard to pull out of), less regulation due to higher subscription minimums and higher risk-return profile.
Backed by strong performance over the last few years, the market’s been bullish on hedge funds.
Hedge fund strategies are in essence a give and take, with the crucial, added element of “for how long?” The goal of the funds is to balance the wins against the losses, and to time the market correctly to earn returns in excess of their benchmark.
One of the most common strategies employed by hedge funds is the long/short equity strategy, which aims to minimize market risk by taking both long and short positions on stocks. In theory, this means that if the market declines and the longs take losses, the shorts can potentially provide gains and keep the portfolio profitable.
In contrast, market-neutral hedge funds assign shorts and longs equal market value. The entire return of the fund is driven by the quality of the stocks selected by the manager, irrespective of the movement of the market.This strategy is lower risk but expected returns are lower, too.
Arbitrage strategies involve exploiting differences in price (pricing inefficiency) across different markets for identical assets. For example, if stock of company X can be found on the New York Stock Exchange (NYSE) for $10 but is trading for $10.05 on the London Stock Exchange (LSE), the arbiteur (trader) in the case can earn a profit of 5 cents per share.
Similar, event-driven hedge funds also bank on momentary fluctuations, but are more associated with special situations. Pricing inefficiencies that occur right after a major corporate event like a bankruptcy, a merger (merger arbitrage), a spinoff or even an earnings call mean that these funds can buy the security or equity at a lower price, in hopes of reselling it in the future at a higher price, or its assumed true value.
Global macro hedge funds are also event-driven but on a larger scale. Managers of these funds attempt to profit from broad market swings caused by political or economic events. These types of hedge funds were particularly active before the Brexit vote in 2016 when the United Kingdom voted to exit the European Union (EU). Hedge funds that were confident that Britain would vote to leave the EU took long positions in safe assets like gold, and shorted against European stocks and the British pound.
Other types of hedge funds include credit hedge funds (primarily invested in debt), quantitative and FX. While multi strategy hedge funds exist, due to the high level of risk and operational effort required to maintain these types of funds, single strategy funds are far more common.
One of the biggest drawbacks to hedge funds is that they’ve historically been limited to institutional investors and qualified purchasers. Yieldstreet does not yet offer access to hedge funds, but is a leading platform in the alternatives space as it allows investors to allocate to a large variety of private market assets, including real estate, private equity, private credit and digital currencies.
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.