What Are Hedge Funds And Why Are They Relevant?

  • Nov 20, 2019 GMT
  • Team Kalkine
What Are Hedge Funds And Why Are They Relevant?

The most appropriate of definitions of a Hedge Fund is a fund that has been created by a consortium of private individuals, having minimum regulatory oversight and flexibility to invest in any kind of asset class. Most of the other types of funds have some kind of regulatory control over them as they raise funds from the general public. Doing away with most of these regulations gives hedge funds the flexibility to adopt strategies that cannot be adopted by other such investment vehicles, with the result that they offer a return potential that cannot be matched by others.

The entire fund administration part of the Investment industry can be placed in a hierarchy of the least regulated to the most regulated. These regulations in the industry, in fact, have been enforced to provide a cushion of safety to the investors and restrict fund managers to venture into asset classes with more than permitted risk levels. These regulations and the institutional bodies who control and monitor them determine what is the general level of acceptable risk for the industry and constantly appraise the movements in the markets and the activities of all participants to ensure that the interests of the investors are always protected. There are, however, a lot many investment avenues, both conventional and unconventional that fall beyond the boundaries of these regulations and provide risk return profiles that cannot be compared to any other investment avenue. It is these opportunities that attract many a venturer and risk taker to explore ways and means to best exploit these opportunities.

Hedge Funds have been there for more than fifty years now, the first reference to which comes from the investment strategies followed by Alfred Winslow Jones, an Australian Investor and fund manager, who was the first one to employ speculative strategies to neutralize the risks of a portfolio and was able to deliver returns that were superior to that of a conventional fund. The strategies followed by him further got evolved and became the basis for the hedge fund industry. Alfred Winslow Jones is widely regarded as the father of the Hedge fund industry and is the one credited with coining the term Hedge Fund and was one of the most successful fund managers of his time.

However, the essential component of least possible regulation became associated with the Hedge fund industry much later, and over a period of time so did the many different strategies and themes which are now followed. In fact, the term hedging as an instrument to mitigate risk has today become just a misnomer and finds minimum use in the industry today. The Hedge fund industry of today in-fact revolves more around lowest regulation, employment of unconventional strategies and investment in unconventional asset classes rather than mitigation of risks as the principal objective of investment.

Given these characteristics one might imagine, what roles do these funds play in today’s capital markets and is at all significant for them to be taken seriously at all when considering equity markets. Well for one, these funds control a large volume of assets and can be a considerable force as far as exerting an influence in the capital markets is concerned. Second, the management styles they deploy can be very aggressive and most of all the returns that they generate are far superior than other investment vehicles. In fact, in many of the debt markets, these funds are almost the exclusive players providing the required liquidity and volume for the sustainable running of the markets.

The most important role played by Hedge Funds is that of providing the risk capital for investment when every other investment fund class would shy away. Needless to say, the returns generated by these funds would be superior to others. Other than that, these funds attract the best and the brightest of talents from the fund management industry and employ some of the most sophisticated tools to aid portfolio managers in their decision-making process. The administration of these funds is also in the hands of some of the largest and well know investment management firms of the industry which gives them the edge as far as the quality of fund management and procedure of fund administration are concerned.

One of the hallmarks of the Hedge fund industry is its willingness to invest in unconventional asset classes, which offer risk and reward characteristics very uncommon with other asset classes. The strategies and investment themes followed by these funds can also be very unconventional. Some of the well know hedge fund strategies are, Global Macro- where the fund manager is guided by the forecast and interpretation of global politico-economic events and takes his investment decisions accordingly, prime example being a fund manager taking a medium to long term position on Pound Sterling based on his understanding of the Brexit situation and its unfolding. Directional- a strategy that capitalizes on inconsistencies and inefficiencies in the market in order to make gains and not focusing on the fundamentals of a stock, sector or economy at large.  Event Driven- These types of hedge fund strategies capitalize on the understanding and forecast of anticipated corporate events like consolidations, recapitalizations, acquisitions, liquidations and  bankruptcies; This strategy is however, highly risky as the success or failure of this strategy is highly corelated to the happening or non-happening of a corporate event. Relative Value- This type of strategy focuses more on the pricing inefficiencies of securities among different asset classes and tries to take advantage of the same to profit from it. Also known as arbitrage pricing strategy, styles within this strategy include fixed income arbitrage, conventional arbitrage, statistical arbitrage, volatility arbitrage and risk arbitrage among others. Other strategies- other than the above four other strategies in the category include, funds of hedge funds strategy, a strategy which is amalgamation of multiple strategies; a multi manager hedge fund strategy; a 130-30 strategy where fund invests 130 per cent of the assets on long positions and 30 per cent on short positions leaving a net 100 per cent net long position and an AI driven strategy where sophisticated AI tools like Big Data Analytics and predictive tools like Machine Learning are used to create models in order to make investment decisions.

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