You’ll find here our definition of a hedge fund as well as statistical evidence that hedge funds have outperformed both mutual funds and broad market indicators. You’ll also find here definitions of different hedge fund styles and sectors.
We also have included in this section several articles that we hope you’ll find interesting.
What are Hedge Funds?
A hedge fund can be classified as an alternative investment. Alternative investments are investments other than stocks and bonds. A U.S. “hedge fund” usually is a U.S. private investment partnership invested primarily in publicly traded securities or financial derivatives. Because they are private investment partnerships, the SEC limits U.S. hedge funds to 99 investors, at least 65 of whom must be “accredited.” (“Accredited” investors often are defined as investors having a net worth of at least $1 million.) A relatively recent change in the law (section 3(c)7) allows certain funds to accept up to 500 “qualified purchasers.” In order to be able to invest in such a fund, the investor must be an individual with at least $5 million in investments or an entity with at least $25 million in investments. The General Partner of the fund usually receives 20% of the profits, in addition to a fixed management fee, usually 1% of the assets under management. The majority of hedge funds employ some form of hedging — whether shorting stocks, utilizing “puts,” or other devices.
Offshore hedge funds usually are mutual fund companies that are domiciled in tax havens, such as Bermuda, and that can utilize hedging techniques to reduce risk. They have no legal limits on numbers of non-U.S. investors. Many accept U.S. investors, although usually only tax-exempt U.S. investors. For the purposes of U.S. investors, these funds are subject to the same legal guidelines as U.S.-based investment partnerships; i.e., 99 U.S. investors, etc.
Hedge funds are as varied as the animals in the African jungle. Over the years, many investors have assumed that hedge funds were all like the famous Soros or Robertson funds – with high returns, but also with a lot of volatility. In fact, only a small percentage of all hedge funds are “macro” funds of that type. Among the others, there are many that strive for very steady, better-than-market returns. VAN tracks 14 different styles of hedge funds, in addition to a number of sub-styles.
Why You Should Invest in Hedge Funds?
Reward/Risk Characteristics : As you may be aware, an affiliate of Van Hedge Fund Advisors International, Inc. performed the first large-scale research on the reward-risk characteristics of hedge funds. (Van Hedge Fund Advisors International, Inc. and its affiliates hereinafter are referred to as “VAN”). Our current findings include the following:
Hedge funds in aggregate, in most multi-year periods, have provided both superior returns and lower statistical risk than the S&P 500 or mutual funds. In the 15.75 years ended September 30, 2003, both U.S. and offshore hedge funds have achieved higher net compound annual returns, lower standard deviations, lower Van Ratios©, and higher Sharpe Ratios than either the Morgan Stanley Capital International World Equity Index, the S&P 500 Index, or the Morningstar Average Equity Mutual Fund.
Performance in Down Quarters: Hedge funds clearly have demonstrated their ability to protect investors’ money during market downturns, based on VAN research. From January 1, 1988, through September 30, 2003, the S&P 500 had sixteen negative quarters. During these quarters, the S&P 500 lost -69.4% cumulatively. In the same period, the Morningstar Average Equity Mutual Fund lost -70.9% and the Morningstar Average Taxable Bond Fund gained 14.1%. By contrast, the average global hedge fund lost only -10.7%.
Effect of Adding Hedge Funds to a Traditional Portfolio: Hedge funds, when added to a traditional portfolio of stocks and bonds, both improved returns and reduced risk. A traditional portfolio composed of 60% S&P 500 stocks and 40% Lehman Brothers Aggregate Bond Index bonds had hedge funds added to it in increments of 10%. The proxy for hedge funds was the Van Global Hedge Fund Index. As more hedge fund content was added, returns improved and risk (standard deviation) decreased. The benefits of investing in hedge funds would have been even greater if superior hedge funds had been used as opposed to the average hedge fund used in the study.
Comparing Mutual and Hedge Funds: In addition to the average hedge fund outperforming the average mutual fund, the highest returning hedge funds significantly outperformed the highest returning mutual funds.
Performance by Market Sector
Hedge funds can be grouped by investing strategy, as shown in the various index performance pages, or by the industry sector in which the manager may specialize. The database tracks hedge funds specializing in financial services, technology, healthcare, and communications/media/entertainment. U.S. funds have been used because VAN does not currently have sector indices for offshore hedge funds.
Strategy and Sector Definitions
Aggressive Growth: A primarily equity-based strategy whereby the manager invests in companies experiencing or expected to experience strong growth in earnings per share. The manager may consider a company’s business fundamentals when investing and/or may invest in stocks on the basis of technical factors, such as stock price momentum. Companies in which the manager invests tend to be micro, small, or mid-capitalization in size rather than mature large-capitalization companies. These companies are often listed on (but are not limited to) the NASDAQ. Managers employing this strategy generally utilize short selling to some degree, although a substantial long bias is common.
Distressed Securities: The manager invests in the debt and/or equity of companies having financial difficulty. Such companies are generally in bankruptcy reorganization or are emerging from bankruptcy or appear likely to declare bankruptcy in the near future. Because of their distressed situations, the manager can buy such companies’ securities at deeply discounted prices. The manager stands to make money on such a position should the company successfully reorganize and return to profitability. Also, the manager could realize a profit if the company is liquidated, provided that the manager had bought senior debt in the company for less than its liquidation value. “Orphan equity” issued by newly reorganized companies emerging from bankruptcy may be included in the manager’s portfolio. The manager may take short positions in companies whose situations he deems will worsen, rather than improve, in the short term.
Emerging Markets: The manager invests in securities issued by businesses and/or governments of countries with less developed economies (as measured by per capita Gross National Product) that have the potential for significant future growth. Examples include Brazil, China, India, and Russia. Most emerging market countries are located in Latin America, Eastern Europe, Asia, or the Middle East. This strategy is defined purely by geography; the manager may invest in any asset class (e.g., equities, bonds, currencies) and may construct his portfolio on any basis (e.g. value, growth, arbitrage).
Fund of Funds: The manager invests in other hedge funds (or managed accounts programs) rather than directly investing in securities such as stocks, bonds, etc. These underlying hedge funds may follow a variety of investment strategies or may all employ similar approaches. Because investor capital is diversified among a number of different hedge fund managers, funds of funds generally exhibit lower risk than do single-manager hedge funds. Funds of funds are also referred to as multi-manager funds.
Income: The manager invests primarily in yield-producing securities, such as bonds, with a focus on current income. Other strategies (e.g. distressed securities, market neutral arbitrage, macro) may heavily involve fixed-income securities trading as well; this category does not include those managers whose portfolios are best described by one of those other strategies.
Macro: The manager constructs his portfolio based on a top-down view of global economic trends, considering factors such as interest rates, economic policies, inflation, etc. Rather than considering how individual corporate securities may fare, the manager seeks to profit from changes in the value of entire asset classes. For example, the manager may hold long positions in the U.S. dollar and Japanese equity indices while shorting the euro and U.S. treasury bills.
Market Neutral – Arbitrage: The manager seeks to exploit specific inefficiencies in the market by trading a carefully hedged portfolio of offsetting long and short positions. By pairing individual long positions with related short positions, market-level risk is greatly reduced, resulting in a portfolio that bears a low correlation and low beta to the market. The manager may focus on one or several kinds of arbitrage, such as convertible arbitrage, risk (merger) arbitrage and fixed income arbitrage. The paired long and short securities are related in different ways in each of these different kinds of arbitrage but, in each case, the manager attempts to take advantage of pricing discrepancies and/or projected price volatility involving the paired long and short security.
Market Neutral – Securities Hedging: The manager invests similar amounts of capital in securities both long and short, maintaining a portfolio with low net market exposure. Long positions are taken in securities expected to rise in value while short positions are taken in securities expected to fall in value. These securities may be identified on various bases, such as the underlying company’s fundamental value, its rate of growth, or the security’s pattern of price movement. Due to the portfolio’s low net market exposure, performance is insulated from market volatility.
Market Timing: The manager attempts to predict the short-term movements of various markets (or market segments) and, based on those predictions, moves capital from one asset class to another in order to capture market gains and avoid market losses. While a variety of asset classes may be used, the most typical ones are mutual funds and money market funds. Market timing managers focusing on these asset classes are sometimes referred to as mutual fund switchers.
Opportunistic: Rather than consistently selecting securities according to the same strategy, the manager’s investment approach changes over time to better take advantage of current market conditions and investment opportunities. Characteristics of the portfolio, such as asset classes, market capitalization, etc., are likely to vary significantly from time to time. The manager may also employ a combination of different approaches at a given time.
Several Strategies: The manager typically utilizes two or three specific, pre-determined investment strategies, e.g., Value, Aggressive Growth, and Special Situations. Although the relative weighting of the chosen strategies may vary over time, each strategy plays a significant role in portfolio construction. Managers may choose to employ a Several Strategies approach in order to better diversify their portfolio and/or to more fully use their range of portfolio management skills and philosophies.
Short Selling: The manager maintains a consistent net short exposure in his portfolio, meaning that significantly more capital supports short positions than is invested in long positions (if any is invested in long positions at all). Unlike long positions, which one expects to rise in value, short positions are taken in those securities the manager anticipates will decrease in value. In order to short sell, the manager borrows securities from a prime broker and immediately sells them on the market. The manager later repurchases these securities, ideally at a lower price than he sold them for, and returns them to the broker. In this way, the manager is able to profit from a fall in a security’s value. Short selling managers typically target overvalued stocks, characterized by prices they believe are too high given the fundamentals of the underlying companies.
Special Situations: The manager invests, both long and short, in stocks and/or bonds which are expected to change in price over a short period of time due to an unusual event. Such events include corporate restructurings (e.g. spin-offs, acquisitions), stock buybacks, bond upgrades, and earnings surprises. This strategy is also known as event-driven investing.
Value: A primarily equity-based strategy whereby the manager focuses on the price of a security relative to the intrinsic worth of the underlying business. The manager takes long positions in stocks that he believes are undervalued, i.e. the stock price is low given company fundamentals such as high earnings per share, good cash flow, strong management, etc. Possible reasons that a stock may sell at a perceived discount could be that the company is out of favor with investors or that its future prospects are not correctly judged by Wall Street analysts. The manager takes short positions in stocks he believes are overvalued, i.e. the stock price is too high given the level of the company’s fundamentals. As the market comes to better understand the true value of these companies, the manager anticipates, the prices of undervalued stocks in his portfolio will rise while the prices of an overvalued stocks will fall. The manager often selects stocks for which he can identify a potential upcoming event that will result in the stock price changing to more accurately reflect the company’s intrinsic worth.
Sector-Specific Categories: Aside from investment strategy, hedge funds may also be categorized on the basis of the industry sectors in which they invest. While most hedge funds are diversified among several different sectors, some specialize in one sector, devoting 50% or more of their portfolio to such securities. For the purposes of the Van Hedge Fund Indices, domestic hedge funds are identified that specialize in one of the following four industry sectors: Financial Services (banks, thrifts, credit unions, savings and loans, insurance companies), Healthcare (medical services, pharmaceuticals, biomedical products), Media/Communications (telecommunications, publishing, cellular products), and Technology (electronics, hardware, software, semiconductors).