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The long and short of hedge funds
An introduction to the hedge fund world

The wild market swings witnessed over the past couple of years, not to mention the past eight weeks, have given rise to the popularity of a different kind of investment fund - the hedge fund. But if you think picking good mutual funds is hard; multiply that by ten and you've got a sense of how tough it is to pick a good hedge fund. In this, the first part in a series, I'll go over some basics of hedge funds. The remaining articles will cover their unique structures; some caveats of historical hedge fund performance; and finally some tips on how to incorporate them into portfolios.

Risks of stock investing

Without getting too technical, investing in stocks entails two types of risk.

Company-specific risk has to do with the happenings of specific companies - i.e. that the stock price of a company will fall due to factors specific to that company, such as falling market share, rising debt levels, etc. On the other hand, stock market risk is really just the risk that the stock market, as a whole, will fall in price.

If you put all of your money into the stock of one company, you leave yourself wide open to both stock market risk and company-specific risk (because all is riding on one firm's fate). Spreading the same money among, say, twenty different stocks will go a long way toward reducing your portfolio's dependence on any one of the companies purchased. In other words, simply owning many companies can dramatically reduce company-specific risk.

However, even buying shares in all companies listed on a stock exchange can' t eliminate stock market risk. Think about it. Even if you invest in "the market", you still have exposure to the risk that "the market" will fall. The only way to reduce stock market risk is to invest outside of the stock market. For instance, buying bonds is a good way to reduce your vulnerability to a falling stock market.

I don't mean to equate investing to gambling, but think of buying stocks as placing a bet (i.e. that stocks will rise in value). Buying bonds could be seen as an offsetting bet to cover yourself in case your bet on stocks is wrong.

Hedge funds 101

When tackling such a daunting topic, a dictionary definition is a good starting point. For the verb, to hedge, it would read something like this: "to protect oneself from losing or failing by a counterbalancing action". This captures the essence of what hedge funds, in general, aim to do.

In an investment context, hedge funds make very specific bets, but then hold some offsetting position so that they are protected in case their bet is wrong. The goal is to generate high, positive returns while minimizing the downside risk. Let's look at hedge funds pursuing a "market neutral" strategy to illustrate the point.

As we saw above, buying stocks always exposes investors to stock market risk. Market neutral strategies use somewhat complex strategies to achieve the simple goal of eliminating market risk so that company-specific risk can be isolated. Reason: A hedge fund manager might think the market, as a whole, is very unattractive, but at the same time find some individual companies quite appealing.

By using vehicles that allow investors to benefit from falling stock markets (i.e. short selling, put options, etc.), the hedge fund manager removes the potential damage a falling stock market would cause - i.e. stock market risk is eliminated. However, company-specific risk remains; but that's the whole idea.

Individual stocks can sometimes fall in value for no good reason. Remember the technology boom of 1999-2000? It seemed like any company with a "techy" ring to its name saw its stock price soar. In the meantime, businesses in the so-called old economy were considered passi or boring; and were seeing their stocks fall in value despite booming top- and bottom- line growth.

In 2000, many market neutral managers began buying an interest (i.e. going long) in these old economy stocks; while simultaneously betting that the euphoric stock prices built into the overall market would come crashing down (i.e. going short - by short selling, buying put options, etc.).

As we now know, they were bang on.

Hence, contrary to popular belief (and despite their success in profiting from the burst tech bubble), hedge fund managers simply cannot eliminate all risks and expect to make much money in the process. Instead, hedge fund managers isolate the risks they're prepared to take, and buy a type of insurance (i.e. put options) to eliminate types of risk they don't want to take.

Other hedging strategies

Hedge fund strategies are numerous. A couple of the other more common hedging strategies include:

Long/Short: Managers go long stocks about which they are bullish; while shorting those they view as very unattractive.

Merger Arbitrage: This really involves anticipating a merger before it happens. In mergers/acquisitions, the buyer often pays a hefty premium (over current market prices) to gain control of the target company. That, combined with the fact that many mergers are unsuccessful, is the motivation behind this strategy. To benefit, hedge managers may go long the target company, while going short the buyer.

Fund of Funds: The manager of this type of hedge fund is like a consultant who specializes in hedge manager selection. Managers are monitored (both for risk and return) and 'hired' and 'fired' as necessary. Typically, these funds incorporate the strategies of 15 or 20 different hedge fund managers.

If you've understood much of this article, consider yourself pretty savvy. Hedge funds, and the strategies they employ can be intimidating. However, I' ve really just scratched the surface of the hedge fund world, so stay tuned for more.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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