Hedging means managing risk. A fund manager employs a particular hedging technique in order to mitigate a particular type of risk. For example, a market risk can be hedged against by selling a broad collection of securities short, in equal proportion to one’s long exposure or by buying put options on an index. You can hedge against interest rate, inflation, currency etc. Tools for hedging include raising cash, selling short, buying or selling options, futures, commodity and currency futures etc.
A hedge fund is a private investment partnership. Hedge funds tend to be skill-based investment strategies that attempt to obtain returns based on a unique skill or strategy. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions. It designs a strategy to reduce investment risks using call options, put options, short selling or futures contracts.
The hedge insures against the possibility of a future loss. These funds have the potential to deliver positive returns under all market conditions. Further, they have access to highly specialised strategies. The hedge fund managers adopt different strategies to multiply returns on investments. They invest both long and short, in the securities of companies which are expected to change in price over a short period of time due to an unusual event.
By pairing individual long positions with related short positions, the market-level risk is reduced significantly. Investments are made in securities that have the potential for significant future growth. The portfolio is made after considering factors like interest rates, economic policies, inflation etc. The fund provides an investment portfolio with lower levels of risk and can deliver returns not correlated with the performance of the stock markets. Hedge funds have historically offered higher returns than stocks and bond markets.
There are different investment strategies used by hedge funds, each offering different degrees of risk and return. A macro hedge fund invests in stocks and bond markets and other investment opportunities, like currencies, in the hope of profiting on significant shifts in global interest rates and countries’ economic policies. A macro hedge fund is more volatile but potentially faster-growing.
An equity hedge fund may be global or country-specific, hedging against downturns in equity markets by shorting overvalued stocks or stock indices. Hedge funds invest using different strategies. These strategies include investing in asset classes such as stocks, bonds, commodities, currencies, and returns-enhancing tools such as leverage, derivatives, and arbitrage.
Some hedging strategies used by these funds: Selling short: Selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their prices will drop. Discounted securities: Investing in deeply discounted securities of companies about to enter or exit financial distress or bankruptcy, often below liquidation value. Derivatives: Trading options or derivatives – contracts whose values are based on the performance of any underlying financial asset, index or other investment.
Arbitrage: Seeking to exploit pricing inefficiencies between related securities. For example, can be long convertible bonds and short the underlying issuer’s equity. Investing: Investing in anticipation of a specific event – merger etc. All hedge funds are not the same. Returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets can deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds.