Evdokia Pitsillidou, Risk Associate, easyMarkets
Hedge Funds gained a great deal of traction back in the nineteen eighties when investors sought out new opportunities outside of the securities and bond markets. Most investors should be concerned with asset allocation which is paramount as part of their investment strategy.
Investors realize that by utilizing hedge funds they can diversify their portfolios and in addition can leverage the strategies used by hedge funds. Hedge funds utilize numerous strategies to increase their returns. Some of these strategies include leverage, relative value arbitrage, short only, distressed debt etc.
Many hedge funds utilize leverage as part of their trading strategies. The option of using leverage allows the fund to maximize returns by utilizing additional dollars that are put to work. The use of leverage can be looked at in both a positive as well as negative light. Again, from a positive position strong trading and or investment returns are maximized by the additional dollars that are put to work. There is also a downside to using leverage. When a hedge fund uses leverage as a trading strategy it can increase a sell off if/when the fund receives margin calls and in turn is forced to sell off positions to meet those margin calls. There are times when a hedge fund will leverage as much as one hundred to one. What this means is that for every dollar the fund manages they borrow one hundred dollars. This can be extremely dangerous if the market turns against the fund.
Another strategy used by fund managers is relative value arbitrage. Relative value arbitrage is a strategy which allows managers to trade debt within their portfolios. When utilizing relative value arbitrage the hedge fund manager typically purchases two different bonds with identical maturity along with credit quality. When using this strategy the bonds purchased have a different coupon value (let’s say five and seven percent). The seven percent bond should trade at a premium to par value while the five percent bond will remain at or below par with a smaller coupon. If all goes as planned, the premium bond will mature at or near par along with the lower coupon bond.
Short only is an additional strategy used by hedge fund managers and is deemed a difficult strategy to utilize. When utilizing a short strategy the hedge fund only sells stock short. When utilizing a short only strategy the hedge fund manager walks a tight-rope. Hedge fund managers using short only strategies have gotten crushed over the last several years as the overall markets have risen.
Hedge fund managers utilize distressed debt as another form of hedge fund strategy. When utilizing distressed debt the fund manager will purchase bonds which have lost a large portion of their value due to the company’s financial outlook and instability. There are other instances where a company is emerging out of bankruptcy and the fund would purchase the lower priced bonds with the idea that the value of the bonds will increase in value. Using a distressed debt strategy may also be very risky. If a company does not improve its situation you can have a situation where the funds have to get involved and actually run the company.
In closing, hedge funds use numerous strategies to increase their returns. Investors who are looking at other options in increasing their opportunities for greater returns should be aware of the strategies used by hedge funds and the risks as well as the rewards.