By: Vanmeet Talwar
Hedge funds have evolved from the primitive investing techniques and revolutionalized the way fund managers utilize their resources to invest, manage and strive for superior returns on investments. Hedge funds implement many different techniques and tactics to efficiently allocate their resources mostly based on in-house research and valuable contacts. Common practices for hedge fund managers include one or a combination of short selling, leverage, hedging, arbitrage, futures and options, specific markets, position limits buy and sell targets stop-loss restrictions.
Before getting into the crux of the matter, we need to expand on the basic practices which are mentioned above. These practices are employed to foster wealth accumulation for the fund and ultimately its investors. Let us take the example of short selling, where the brokerage firm borrows shares and posts some form of collateral as per the margin account requirement. Hedge fund managers short sell either to reduce exposure to a single investment, or use it to profit from securities whose current prices are higher than their intrinsic value.
On the other hand, the practice of leveraging increases the exposure to investment for the investors in a hedge fund than the investors unilaterally would be exposed to, given the assets the individual investors hold. This is used by managers to magnify their returns; however, the same practice can turn out to be the inverse where the managers’ losses are more than the original investment if the returns are immensely in the negative territory.
This brings us to the topic of hedging, where the manager believes that a certain investment offers profit opportunity but does not want to be exposed to other inherent threats such as market risk. For example, the fund manager believes that a certain stock on the NASDAQ is significantly overpriced. Therefore, the hedge fund manager short sells the stock and simultaneously buys a NASDAQ index fund. This would only expose the fund manger to the specific security risk. This practice can be implemented even when the stock is undervalued by inversing the dependent factors.
Yet another practice hedge fund managers take pride in is the use of futures and options. Both of these are considered derivative products. A futures contract sets up a future price for a specific investment and both parties are bound by the contract. Options on the other hand give the buyer the right to buy or sell the underlying assets at a predetermined price like a futures contract. However, this does not place an obligation on the buyer to exercise a buy or sell. Consequently, due to the nature of a futures contract since it has an in-built fixed lag, it offers symmetrical risk exposure. Contrary to that, options are speculative in nature and so they offer asymmetrical risk exposure.
Hedge fund managers also indulge in arbitrage, which is defined as “riskless investment”, in the academic genre. The essence of arbitrage is to profit from discrepancies in value of the underlying asset. The underlying asset could range from stocks, bonds or even world currencies. For example, if a company has convertible bonds which currently have a market value of $1050 and its stocks have a market value of $15 each. If each bond converts into 60 common stocks, then the total value of the conversion would be $900 for the investor – a loss of $150. For the fund manager to take advantage of this price discrepancy they would short sell the bonds at $1050 and with the cash raised they would buy the stocks of the same company – making a profit of $150 (1050-1000). The fund manager would continue this cycle which would eventually lower the bond price to its par value at $1000 and increase the stock price narrowing the spread.
To diversify their portfolios and to reduce risk by some extent, hedge fund managers often target specific markets, sectors and/or asset classes that they perceive as advantageous. This practice would be in line with investors who agree with the modern portfolio theory. Hedge funds achieve this often by differentiating between geographical locations, such as European and Asian markets; asset types such as equities and fixed income; and sectors, such as pharmaceuticals or Information Technology. Targeting specific markets, hedge funds can gain exposure to opportunities which otherwise would not be available in the overall market.
Lastly position limits, buy/sell targets along with stop-loss restrictions are practices hedge fund managers implement to limit losses to bare minimum and on the contrary to maximize profits. Positions limits restrict the size of an investment in any single investment to a certain percentage of the total fund’s allocation. Position limits can also trigger liquidation of certain holdings in the event of losses becoming too large. The end result is that position limits protect hedge funds from large swings in value if the price of investment begins to depreciate significantly.
Similarly buy/sell targets will either sell a current investment being held by the hedge fund given that it is fairly valued or buy into an investment which is perceived to be undervalued. When these investments hit one of those targets, it triggers a buy or sell transaction. Stop loss restrictions are exactly what the name suggests. Stop loss restrictions are predetermined points that hedge fund managers’ maximum loss he or she is willing to incur on any one particular investment. Stop loss restriction in effect protects the fund from additional downside pressure.
These are basic principles hedge fund managers implement in order to strive for profit maximization. These principles are also used by hedge fund managers to woo investors by posting returns higher than the benchmark returns. Hedge funds are a powerful way for accredited investors to build wealth. The practices mentioned above when employed effectively can limit losses to bare minimum or provide investors exponentially high returns. Moreover, due to limited governmental regulations hedge funds have more leeway to slide through in order to achieve their bottom lines. Hedge fund managers are revolutionizing the way they utilize their resources to invest, manage and strive for superior returns on a day to day basis. These have evolved significantly from the primitive investing techniques.
Hedge funds have evolved from the primitive investing techniques and revolutionalized the way fund managers utilize their resources to invest, manage and strive for superior returns on investments. Hedge funds implement many different techniques and tactics to efficiently allocate their resources mostly based on in-house research and valuable contacts. Common practices for hedge fund managers include one or a combination of short selling, leverage, hedging, arbitrage, futures and options, specific markets, position limits buy and sell targets stop-loss restrictions.
Before getting into the crux of the matter, we need to expand on the basic practices which are mentioned above. These practices are employed to foster wealth accumulation for the fund and ultimately its investors. Let us take the example of short selling, where the brokerage firm borrows shares and posts some form of collateral as per the margin account requirement. Hedge fund managers short sell either to reduce exposure to a single investment, or use it to profit from securities whose current prices are higher than their intrinsic value.
On the other hand, the practice of leveraging increases the exposure to investment for the investors in a hedge fund than the investors unilaterally would be exposed to, given the assets the individual investors hold. This is used by managers to magnify their returns; however, the same practice can turn out to be the inverse where the managers’ losses are more than the original investment if the returns are immensely in the negative territory.
This brings us to the topic of hedging, where the manager believes that a certain investment offers profit opportunity but does not want to be exposed to other inherent threats such as market risk. For example, the fund manager believes that a certain stock on the NASDAQ is significantly overpriced. Therefore, the hedge fund manager short sells the stock and simultaneously buys a NASDAQ index fund. This would only expose the fund manger to the specific security risk. This practice can be implemented even when the stock is undervalued by inversing the dependent factors.
Yet another practice hedge fund managers take pride in is the use of futures and options. Both of these are considered derivative products. A futures contract sets up a future price for a specific investment and both parties are bound by the contract. Options on the other hand give the buyer the right to buy or sell the underlying assets at a predetermined price like a futures contract. However, this does not place an obligation on the buyer to exercise a buy or sell. Consequently, due to the nature of a futures contract since it has an in-built fixed lag, it offers symmetrical risk exposure. Contrary to that, options are speculative in nature and so they offer asymmetrical risk exposure.
Hedge fund managers also indulge in arbitrage, which is defined as “riskless investment”, in the academic genre. The essence of arbitrage is to profit from discrepancies in value of the underlying asset. The underlying asset could range from stocks, bonds or even world currencies. For example, if a company has convertible bonds which currently have a market value of $1050 and its stocks have a market value of $15 each. If each bond converts into 60 common stocks, then the total value of the conversion would be $900 for the investor – a loss of $150. For the fund manager to take advantage of this price discrepancy they would short sell the bonds at $1050 and with the cash raised they would buy the stocks of the same company – making a profit of $150 (1050-1000). The fund manager would continue this cycle which would eventually lower the bond price to its par value at $1000 and increase the stock price narrowing the spread.
To diversify their portfolios and to reduce risk by some extent, hedge fund managers often target specific markets, sectors and/or asset classes that they perceive as advantageous. This practice would be in line with investors who agree with the modern portfolio theory. Hedge funds achieve this often by differentiating between geographical locations, such as European and Asian markets; asset types such as equities and fixed income; and sectors, such as pharmaceuticals or Information Technology. Targeting specific markets, hedge funds can gain exposure to opportunities which otherwise would not be available in the overall market.
Lastly position limits, buy/sell targets along with stop-loss restrictions are practices hedge fund managers implement to limit losses to bare minimum and on the contrary to maximize profits. Positions limits restrict the size of an investment in any single investment to a certain percentage of the total fund’s allocation. Position limits can also trigger liquidation of certain holdings in the event of losses becoming too large. The end result is that position limits protect hedge funds from large swings in value if the price of investment begins to depreciate significantly.
Similarly buy/sell targets will either sell a current investment being held by the hedge fund given that it is fairly valued or buy into an investment which is perceived to be undervalued. When these investments hit one of those targets, it triggers a buy or sell transaction. Stop loss restrictions are exactly what the name suggests. Stop loss restrictions are predetermined points that hedge fund managers’ maximum loss he or she is willing to incur on any one particular investment. Stop loss restriction in effect protects the fund from additional downside pressure.
These are basic principles hedge fund managers implement in order to strive for profit maximization. These principles are also used by hedge fund managers to woo investors by posting returns higher than the benchmark returns. Hedge funds are a powerful way for accredited investors to build wealth. The practices mentioned above when employed effectively can limit losses to bare minimum or provide investors exponentially high returns. Moreover, due to limited governmental regulations hedge funds have more leeway to slide through in order to achieve their bottom lines. Hedge fund managers are revolutionizing the way they utilize their resources to invest, manage and strive for superior returns on a day to day basis. These have evolved significantly from the primitive investing techniques.
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