What Are Hedge Funds and How Do They Work? Strategies Explained
Chapter 1 gave us the history. Now in Chapter 2, Travers answers the big question: what actually is a hedge fund, and why would anyone put money into one?
So What Is a Hedge Fund?
Here’s the thing. The name “hedge fund” is misleading. Many hedge funds don’t actually hedge anything. Some hedge only part of the time. Sebastian Mallaby (author of More Money Than God) joked they should drop the “h” and just call themselves “edge funds,” because what they really claim is having an edge on the rest of the market.
Travers defines a hedge fund as a private investment vehicle where the manager has some unique edge, whether that’s a quantitative model, a special process, or just really good stock-picking skills.
More formally, it’s an investment structure for managing a private pool of money that can invest in securities and derivatives, use leverage, and aim for absolute returns. Legally it can be a limited partnership, corporation, trust, or mutual fund depending on where it’s set up.
What Makes Hedge Funds Different
Travers lists several characteristics that separate hedge funds from your regular mutual fund:
- Absolute return objective. Traditional funds benchmark against indexes like the S&P 500. Hedge funds aim for positive returns no matter what the market does.
- Flexible mandates. Hedge fund managers can shift their portfolio around based on where they see opportunities.
- Leverage. They can borrow money to amplify returns. Sounds scary, but with good risk management it can actually improve risk-adjusted returns.
- Long and short positions. They can bet on stocks going up AND down. Some can even go net short, which helps when markets are falling.
- Skin in the game. Managers typically invest a big chunk of their own money alongside investors. Your interests are aligned.
- Two layers of fees. A management fee (to keep the lights on) plus a performance fee (incentive to do well).
- Limited liquidity. You can’t just pull your money out whenever you want. There are lock-up periods, notice periods, and sometimes gates that limit redemptions.
- Low correlation. Hedge funds tend to move differently from stocks and bonds, which makes them useful for diversification.
The Master-Feeder Structure
Most hedge funds use something called a master-feeder structure. The master fund is usually set up in a tax-friendly offshore location like the Cayman Islands. Then separate feeder funds (one for U.S. taxable investors, one for tax-exempt and non-U.S. investors) feed into the master fund. This way everyone’s money gets pooled together for efficiency, but nobody’s tax situation messes up anyone else’s.
Hedge Fund Strategies
This is where the chapter gets really interesting. Travers breaks down the major strategy categories.
Equity-Oriented Strategies
Long/Short Equity is the classic hedge fund strategy, going back to Alfred Winslow Jones (from Chapter 1). The manager buys stocks they think will go up (long) and sells stocks they think will go down (short). They can focus on value, growth, or a mix. They can specialize in small-cap, large-cap, specific regions, whatever. Historically, the HFRI Equity Hedge Index returned 13% annualized with 9.3% standard deviation from 1990 to 2011. Positive in 19 out of 22 years.
Long Biased funds carry net exposure above 50%, sometimes above 100% with leverage. More volatile because they’re more exposed to the market. They returned 10.1% annualized with 10.4% standard deviation.
Short Biased funds are the opposite. They’re basically betting against the market most of the time. These managers are highly contrarian. Here’s the problem, markets generally go up over time, so these funds struggle in the long run. They returned only 0.3% annualized with a painful 19% standard deviation. But they can be useful during crashes as portfolio insurance.
Relative Value Strategies
These funds exploit pricing mismatches between related securities.
Convertible Bond Arbitrage managers buy convertible bonds (bonds that can be converted to stock) and short the underlying stock. They profit from the pricing relationship between the two. Returned 8.7% with 6.7% standard deviation.
Fixed Income Arbitrage finds price anomalies between related bonds, like buying government bonds at the short end of the yield curve and selling at the long end. Returned 7.9% with 6.7% standard deviation.
Equity Market Neutral runs equal dollar amounts of long and short positions, trying to eliminate market risk entirely. These are usually quant-driven funds. Returned 7% with only 3.3% standard deviation, positive in 20 out of 22 years. Steady but not spectacular.
Event-Driven Strategies
These depend on corporate events like mergers, bankruptcies, or restructurings.
Activist funds buy enough shares to influence a company’s management. They push for changes they believe will increase shareholder value, sometimes by taking board seats, sometimes just by writing strongly-worded letters.
Merger Arbitrage funds buy shares of companies being acquired and short the acquirer, locking in the “spread” between the current price and the deal price. The risk is that the deal falls apart. Returned 8.9% with only 4.1% standard deviation.
Distressed/High-Yield managers buy the debt of companies in financial trouble, betting on a recovery. Sometimes they start with debt and end up holding equity through a bankruptcy restructuring. Returned 12% with 6.7% standard deviation, one of the better risk-adjusted strategies.
Directional Strategies
Global Macro is the strategy made famous by George Soros. These managers make big bets on entire economies, currencies, interest rates, and commodity markets. They might be long Asian equities one quarter and short the next. It’s top-down, big picture stuff. Returned 12.8% with 7.7% standard deviation.
CTAs (Commodity Trading Advisors) use quantitative models to find over- or undervalued securities across markets. They returned 11.6% with 7.5% standard deviation.
Multi-Strategy
Multi-strategy funds run several of these strategies at once, either in fixed allocations or shifting money to wherever the best opportunities are. Returned 11.3% with 5.9% standard deviation.
Why Invest in Hedge Funds?
Travers gives several reasons:
Better Returns with Less Risk
From 1990 to 2011, the HFRI Composite returned 11.3% annualized with 7.3% standard deviation. Compare that to the S&P 500: 8.2% return with 15.2% standard deviation. Hedge funds returned more and bounced around less. Even a simple 60/40 stock/bond portfolio only returned 8% with 9.5% standard deviation.
But here’s the problem. Performance was much better in the 1990s than the 2000s. Average hedge fund returns dropped from 13.6% in the 90s to 5.9% in the 2000s. Still, they beat the S&P 500, which basically went nowhere (0.5% return) during the 2000s.
Diversification
The average hedge fund correlation to the S&P 500 was only 0.43, and to bonds just 0.08. Adding uncorrelated assets to a portfolio improves the overall risk/return profile, that’s basic portfolio theory. However, correlations have been creeping up over time, which is worth keeping in mind.
Protection in Down Markets
In 2008, the HFRI Composite fell 19%. Bad, right? Well, the S&P 500 fell 37%. Hedge funds generally underperform in bull markets but lose much less in bear markets. Because of how compounding works (losing less matters more than gaining more), hedge funds came out ahead over the full period.
Size and Age Matter
Here’s an interesting finding from a Pertrac study: smaller hedge funds (under $100 million) and younger funds (under 2 years) historically outperformed larger, older funds. Why? Smaller funds are more nimble. They can invest in opportunities that are too small for big funds. And young managers are hungry, they need to build their reputation. More established managers sometimes play it safe to protect what they already have.
Key Takeaways
Chapter 2 is basically the “what are we dealing with” chapter. Before you can evaluate hedge funds (which is coming in Part Two of the book), you need to understand the landscape. The main points:
- Hedge funds aim for absolute returns using flexible strategies
- There’s a wide range of strategies, from boring market-neutral to wild global macro
- Historically they’ve offered better risk-adjusted returns than traditional investments
- They provide diversification, though correlations are increasing
- Smaller and younger funds tend to outperform
Now that we know what hedge funds are and how they work, the next chapter moves into the real purpose of this book: how to actually evaluate them.
Previous: Chapter 1: Hedge Fund History (Part 2) Next: Chapter 3: The Due Diligence Process