What is a Hedge Fund and How It Works
The history is silent whether it was a cold winter morning or a hot summer evening in late 1940s, when Alfred Winslow Jones, an Australian born and American raised sociologist and publicist, who was working with different social woes (for instance, poverty), hit upon an idea: Why not making money on investments? As a result, he created "A. W. Jones & Со", which is believed to be the first hedge fund ever.
At first, the goal of the fund was to earn enough money for comfortable life without wasting time on “donkey work”. Jones managed his own funds along with money of his friends. As a reward, he received 20% of the profit.
Today, Alfred’s investment strategy looks quite trivial, because it involved buying value stocks, the price of which might, in his opinion, rise and selling stocks of the companies that he expected to depreciate. This approach allowed to diversify risks and receive decent profit. Apart from this, Jones stated that he created the method of tracking and selecting stocks with a high probability of growth. Despite the fact that initial goals of the fund were pretty moderate, the company’s success and investment scheme reshaped the market by mid 1960s and kickstarted the hedge fund industry.
Over the first 10 years of operation, the fund started by Jones raised its investors’ capital by 670%, over the next 5 – by another 325%. However, at those times in the USA and some other countries there were serious legal restrictions, which allowed only big institutional investors with 100 million dollars or more to invest in hedge funds. These restrictions forced hedge funds to flee to tax havens, where financial regulation was more tolerant and loyal.
Hedge fund: what is it?
A hedge fund is a private equity fund type, which is aimed at profit maximization and risk minimization. In fact, any hedge fund is an asset pool of a group of investors, which is managed by professional traders and risk managers. One of the distinctive and important features of hedge fund activities is a soft and loyal regulatory policy by the countries where they were registered. Hedge funds implement complicated multilevel trading strategies, short selling along with buying, margin lending, and trading derivatives. Major participants of hedge funds are a manager and investors.
Key features of hedge funds
- Openness only to professional investors: they have to own at least 1 million dollars, excluding the value of their residence.
- Availability of different strategies: the choice of instruments is not limited by a hedge fund mandate. In fact, a hedge fund can invest in everything: land, real estate, stocks, derivative instruments, currencies, etc.
- Use of financial leverage: hedge funds often operate using borrowed money to maximize their earnings.
- Commission scheme: hedge funds charge investors not only with a fixed commission for managing their assets, but also percentage of profit. Usually, these commissions are 2% and 20% respectively.
A brief conclusion: hedge funds are not suitable for everyone. They have a lot of advantages in comparison with traditional investment funds, such as an opportunity to make money not only on growing markets, but falling as well. Portfolio balance helps reduce risks and volatility and increase profitability. Different investment approaches, which often don’t correlate to each other, allows investors to make their investment strategies as accurate as possible. Hedge funds hire the world’s most talented analysts, traders, and managers. Of course, there is no way round risks: a sector-specific investment strategy may result in huge losses.
Hedge fund structure
A hedge fund may be established by a managing company with subsequent attraction of investors. Operations start only after interested investors place their funds under management. A managing company’s staff perform all selling/buying operations via their partners, brokers and banks.
A big difference is made by a guarantor bank, which keeps investors’ assets (money, gold, securities, etc.). As a rule, not being a prime broker, it performs all transactions, that’s why requirements imposed to the bank are quite high: it must be pretty big, have the quality of inspiring confidence to clients, and be influential in the financial world.
To perform transactions, hedge funds require prime brokers with a great variety of functions. When a managing company orders to perform a financial operation, prime brokers take care of the technical part, starting from executing a transaction on a stock exchange to custody business and lending. Since hedge funds operate in different parts of the world, prime brokers must be able to perform transactions everywhere their clients find it necessary. So, quite often prime brokers are large international banks, such as Goldman Sachs, Merrill Lynch, or Morgan Stanley.
An integral part of hedge funds’ activities is a fiscal audit. Auditors watch them and assess their asset values independently of a managing company. The purpose of this is to reduce potential risks. In addition to that, auditors control accounting of funds and prepare various financial reports, including the ones for investors.
Types of hedge funds
- The principal classification of hedge funds is based on recommendations from the International Monetary Fund and offers 3 basic types:
- Global funds. They perform operations on markets of any countries and build their investment strategies by analyzing statistics of different companies individually.
- Macro funds. They operate on the market of some particular country and make decisions to open any given position on the basis of the current market situation in this country.
- Relative value funds. They are classic hedge funds, which operate on national markets and implement standard operation schemes, which are based on differences in the price or rate of the same or similar assets.
Currently, 70% of leaders of the industry with assets under management worth more than 350 billion USD are algorithmic hedge funds. Abilities of computers to process enormous amounts of data with fantastic speed result in a situation where portfolio managers just can’t compete with them.
There is an opinion that a professional manager may effectively control a portfolio consisting of 30-40 stocks, but algorithmic models prove to be more efficient. It goes without saying that each manager has their own approach and system, analyzes data and makes decisions based on fundamental indicators, assesses financial instrument dynamics from the point of view of technical analysis, keeps in touch with representatives of an issuing company, and checks public information.
An algorithm, which is preprogrammed in computers of a fund, does the same, but in larger volumes and at higher speeds. Software can process any references to some particular company in mass media, social networks, and documents as well as process audio data – some hedge funds have their own speech recognition systems. For instance, it is well known that the fund called Two Sigma scans and analyzes informational flows in 70 different languages.
Apart from this, algorithmic hedge funds have an opportunity to assess clients’ activity using satellite images. Advanced and up-to-date technologies allow to take almost any company to pieces to learn all necessary information. The system operates 24/7 in all corners of the world, analyzes everything that was said and written, and uses this data to generate new trading strategies. Of course, talented managers may beat hedge funds in expertise, but they are just physically unable to process the same amount of information.
As for a secret of success, it lies in the fact that the software assesses every stock by several parameters: fundamental, technical, event-related, and Alpha Capture, unique models of the company. The system evaluates market assets and then offers the highest-rated (according to its evaluation results) of them to a manager. Thanks to this approach, algorithmic hedge funds are able to maintain high level of profitability. In other words, hedge funds don’t’ care about the direction markets are moving at some particular time, the dynamics itself is what counts. Decline of one particular stock or market segment is often counterbalanced by growth of some other assets.