What is hedging and how do hedge funds work?

Key takeaways

  • Hedging strives to mitigate investment losses with strategic opposing investments.

  • Hedge funds use a variety of sophisticated strategies to “play both ends of the market against the middle”.

  • Diversification with alternative investments has the potential to serve retail investors better than hedging.

Hedging can help mitigate the potential for losses from other investments — as in “hedging” one’s bet. The idea is to buy into an asset with the potential to go up, in case another one goes down. For example, an investor will buy an out-of-the-money put option as insurance against a decline in the value of the shares in that stock they already own.

This brings us to a larger discussion of risk, hedging, and how hedge funds work.

What is Investment Risk?

Risk and investments go hand in hand. In fact, it can be said that risk is, in part, what makes investing work. Now, with that said, the key factor an investor must consider is whether the risk inherent to an investment is outweighed by the potential for reward. 

Risk can take a variety of forms. Inflation for example, can reduce the buying power of future dollars. Retired investors must face the risk of outliving their resources. Market volatility can erase gains. Interest rates can fall, decreasing the value of assets tied to them. Investors in fixed income products such as bonds face the risk of issuer default, leaving them holding worthless paper.

What is Hedging?

This brings us back to the idea of investing strategically to mitigate as many of those risks as possible. Here, it is important to bear in mind that hedging cannot eliminate risk altogether. Rather, its goal is to minimize the impact of risk by as much as can be accomplished.

As an example, say an investor purchases 1,000 shares of XYZ Corp stock at $44.50 a share. This would represent an investment of $44,500.  Looking at the sector in which XYZ operates, concerns arise about the viability of the investment, so the investor purchases 10 put option contracts, enabling them to liquidate their position at $40 per share within 12 months. They pay an options premium of $1,800 to cover the contracts.

Should shares in XYZ fall to $30 each within the contracted time period, the investor’s position would be worth $30,000—for a loss of $14,500. However, the put options would have a net value of $10,000, less the $1,800 the investor paid to purchase them, for a total of $8,200. This reduces the loss to $6,300, which is far better than the $14,500 hit the investment would have taken without the hedge. 

What is a Hedge Fund?

Hedge funds are composed of groups of investors who band together to attempt to outperform the market. Hedge fund managers employ strategies such as the one described above and several others to accomplish this goal. 

Participation in a hedge fund is limited to entities qualifying for accredited investor status. This means a liquid net worth of at least $1 million, or an annual net income of more than $200,000 for an individual and $300,000 for a married couple.

Accredited investor status is required because the SEC permits hedge funds to invest in lightly regulated securities options. The assumption is investors who have attained that degree of wealth are more likely to be financially sophisticated than the average retail investor. Hedge funds also typically have very steep minimum investments, often of $1 million or more. 

Structured as limited partnerships, investors assume the role of limited partners, while the hedge fund organizer fulfills the role of general partner. 

How Hedge Funds Work

Many hedge funds operate using a long/short equity strategy. First put into practice by Alfred W. Jones in 1949, the approach is rather simple. It essentially plays both ends of the market against the middle. 

Some stocks are expected to go up and others are expected to go down. The long/short approach takes long positions in the anticipated winners and uses them as collateral to finance the acquisition of short positions in the equities expected to decrease in value. 

Combining these into a single portfolio creates the potential for idiosyncratic gains, which minimizes potential losses because the short positions cushion the exposure of the long positions. 

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Hedge Fund Strategies

Hedge funds are allowed to take exceptionally aggressive approaches because their partners are all accredited investors. Because of this, they tend to employ rather sophisticated tactics. Among these are global macro strategies, directional strategies, event-driven strategies, relative value arbitrage, capital structure strategies and of course the long/short approach we described above. 

The global macro strategy is one in which worldwide macroeconomic trends are considered. These include interest rate changes, currency fluctuations, as well as shifts in demographics and economic cycles. This entails investments in currency trading, futures and options contracts, as well as more traditional public equity investments and fixed income products—in the major financial markets around the world.

Directional strategies consider market trends. Investments are made based upon the perceived potential for these trends to continue unabated or reverse. These determinations inform the purchase of long or short equity hedge funds and emerging markets funds.

Event-driven strategies look for opportunities in acquisitions, consolidations, recapitalizations, bankruptcies, and other corporate transactions. Analysis of such events informs purchases of distressed securities and risk arbitrage.

Buy and Hold Investors and Hedging

Generally, buy-and-hold investors may find some hedging strategies less than effective. Their distant time horizon can often serve as a hedge in and of itself. The more time an investment can perform, the more likely it is to recover from market downturns over time.

Commercial Hedging

Airlines and railroads must have fuel to operate. Food manufacturers need staples such as butter, sugar, salt, wheat and the like to produce their products. Electrical component manufacturing concerns need copper. 

Companies such as these will lock in the prices of their raw materials to make their costs more predictable over time. This can make financial planning easier and the likelihood of generating a profit greater, as it eliminates the risk of having to pay more for those commodities during a set fiscal period.

Back in 2007, Southwest Airlines (NYSE:LUV) became a dominant force in the U.S. domestic carrier industry, largely because it had bought long-term contracts in the 1990s to purchase fuel at what was equal to roughly $51 a barrel through 2009. As the price of oil surged past $90 per barrel in 2007, Southwest’s costs stayed low, while those of its competitors increased significantly. 

In other words, the company hedged its fuel costs and benefited greatly.

Inconveniences of Hedging

We have discussed the positive aspect of hedging, however it is also important to look at the other side of the practice. The most obvious one is what happens when it turns out the hedge was not needed. 

The capital employed to fund the hedge purchase is lost. Yes, the other side of it is the primary investment performed well, which rendered the hedge moot. However, the money invested in the hedge also diminished the profit realized by the primary investment. 

What is De-Hedging?

Liquidating a position originally put in place to serve as a hedge is referred to as de-hedging. This can happen in one transaction, or it can be accomplished in increments, which leaves the main position partially hedged.

Going back to our investor in XYZ Corp and their 10 put option contracts, let us assume that after purchasing the put options, the price of XYZ shares surged so far beyond the original purchase price that the likelihood of losing money was no longer a concern. 

A decision could be made to de-hedge the position, which would entail taking a loss on the hedge. However, that loss would be offset by the gains derived from the investment on the other side of the transaction.

Hedging vs Diversification

Now that we have an understanding of how hedging works, we can consider the value of hedging vs diversifying a portfolio. 

The underlying idea behind diversifying a portfolio is to ensure it is composed of largely uncorrelated assets. This way, a downturn in one segment of the market will not necessarily infect the entire portfolio.   

Hedging, on the other hand, is predicated upon one asset losing value while another gains. With diversification, there is the possibility both investments will increase in value. Overall, a diversified portfolio, particularly one incorporating alternative investments, will likely serve the average buy-and-hold retail investor better than hedging. 

Alternative Investments

Real estate, private equity, venture capital, digital assets and collectibles are among the asset classes deemed “alternative investments.” While they are hard to define, broadly speaking, they tend to be less correlated with public equity, and thus offer potential for diversification – instead of hedging. These assets were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums – often between $500,000 and $1 million.  

Yieldstreet was founded with the goal of dramatically improving access to alternative assets by making them available to a wider range of investors. While traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation, a more balanced 60/20/20 or 50/30/20 split incorporating alternatives may make a portfolio less sensitive to public market short-term swings. 

Summary

Hedge funds and hedging in general aim to profit by playing both ends of the market against the middle. While there are many instances in which this can prove useful, mainstream long-term buy-and-hold investors may find they are better served by pursuing a diversification strategy incorporating alternative investments.

Learn more about the ways Yieldstreet can help diversify and grow your portfolio.

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