The techniques and strategies used within various hedge funds are as wide-ranging as that of mutual funds. Most involve more sophisticated investment processes than simply owning a particular basket of investments. In order to provide an idea of how they work, here are four general examples of “hedging” techniques.
Leverage - Seeking to increase returns by borrowing funds. Leverage can involve debt, such as when an investor borrows money from a broker “on margin” and is therefore able to purchase more stock than could otherwise be possible. If the stock goes up, the investor may sell the stock, repay the broker the loan amount plus interest for the loan, and keep the profit. Although an investor assumes greater risk, borrowing money permits an investor to seek returns on an investment without having to commit their own proceeds.
Example: A portfolio manager buys 1,000 shares of ABC at $50 per share, and only pays for 500 shares out of pocket, or $25,000. The manager borrows the amount needed for 500 additional shares, or $25,000. If ABC stock increases in value to $55 per share, the manager may decide to sell the 1,000 shares for $55,000. After repaying the $25,000 borrowed (plus interest charged), the portfolio makes a profit of $5,000 on the transaction.
Likewise, should the price decline to $45, the investor would now own stock worth only $45,000, and would still owe $25,000 plus interest. The portfolio would have lost $5,000.
Short Selling - The process of selling shares of a security that the seller does not own. Such sales are made in anticipation of a decline in the price of the security to enable the seller to cover the sale with the purchase at a later date, at a lower price, and thus at a profit. Short sales are allowed only when a stock price is moving upward, forestalling strategies designed to profit from driving down a stock price through heavy short-selling, then repurchasing the shares.
Example: A portfolio manager believes that XYZ stock is overpriced at $75 per share. The manager borrows the stock from another investor and sells it. Assuming the price of the stock declines to $60 a week later, the manager repurchases the stock and returns it to its lender. The manager’s profit is $15 less whatever was paid to borrow the stock.
Should the stock price rise to $90, the manager would lose $15 plus whatever was paid to borrow the stock.
Arbitrage - The simultaneous purchase of a derivative product in another market to profit from the price differentials between the two markets.
Example: A basket of stocks sells for $100,000 in the futures markets, but the individual stocks that make up the basket are priced (in the aggregate) for $102,000. An arbitrageur purchases the futures contract and short sells the individual stocks. If the prices of these two positions converge, the arbitrageur makes $2,000.
Derivative - A generic term often applied to a wide variety of financial instruments that derive their cash flows, and therefore their value, by reference to an underlying asset, reference rate, or index. An example of a derivative is a call option – a contract that gives its owner the right to buy a certain amount of stock at a specified price for a specified period of time.
Example: QRS stock trades at $37 per share. Investors buy three-month call options on 100 shares of QRS stock at $40 per share for $100. Assuming QRS’s stock price rises to $45 per share two months later, these investors exercise their option to buy 100 shares for $40 per share. Then they immediately sell the shares for $45, earning a $500 profit, less the $100 they had to initially pay for the options. On the other hand, should the share fail to rise in value, the options would expire and the investor would lose $100.
The above snapshots explain some of the basics of hedging techniques. In a broader sense, though, hedge funds can also be characterized by their general strategies or philosophies. The following is a list of five different hedging strategies with a brief explanation of each one.
Relative Value hedge fund strategies attempt to take advantage of relative changes in the price of individual securities instead of broad changes within a particular market. They identify individual securities that are undervalued relative to other securities, invest in the undervalued ones and take offsetting short positions in the overvalued ones. If their relative values converge, the portfolios can potentially profit.
The combination of offsetting long and short positions seeks to “hedge,” or reduce, the impact of broad market changes on the portfolio’s overall return – the long position can profit in a rising market, and the short position can profit in a declining market. It also makes the returns of the strategy more closely tied to the manager’s ability to pick pairs of stocks than to whether a particular market is going up or down.
Event-Driven hedge fund strategies strive to capitalize on corporate events such as mergers, takeovers, spin-offs, bankruptcies and reorganizations. Managers of these funds seek to profit by correctly anticipating a resolution to a corporate event. For example, one type of event driven strategy is merger arbitrage, which involves investing in announced corporate takeover transactions for which the ultimate outcome is uncertain. A merger arbitrageur analyzes an announced transaction to predict its likely outcome and to determine whether the acquirer’s and the takeover target’s stocks are correctly priced relative to one another. If the arbitrageur believes the stocks are relatively mispriced, it sells short the overvalued stock and purchases the undervalued one, expecting them to converge once the merger is consummated. The success of hedge funds that employ an event-driven strategy depends upon the ability of the manager(s) to predict the likely effect of a corporate event on stock prices.
Distressed hedge fund strategies seek to buy securities at a low price when a company is near or at bankruptcy and expect the price to then rise in the future. A hedge fund manager who employs this strategy identifies companies that are financially distressed, but fundamentally sound and expected to recover.
Convertible Arbitrage hedge fund strategies seek to exploit undervalued securities relative to other securities of the same company. The managers will buy different securities of the same issuer (common shares and “convertibles” - usually preferred shares or bonds) and then “work the spread.” For example, within the same company the manager buys one form of security he believes is undervalued and sells short another security type of the same company.
“Global” or “Macro” hedge fund strategies refer to the ability to exploit differences between the markets of different countries, whether that difference is revealed in commodities, interest rates, currencies, etc. For example, if the price of gold is cheaper in Japan than in the United States, a hedge fund manager could buy gold in Japan and sell short gold in the United States and make a profit through this price discrepancy.