Why hedge fund strategies are an important component part of a managed portfolio

Why hedge fund strategies are an important component part of a managed portfolio

By definition, a hedge fund is an investment fund that trades in relatively liquid assets. They are able to profit from complex trading, risk management techniques and portfolio-construction. They are alternative investments that can manipulate market opportunities to their advantage. Strategies to improve a hedge fund’s performance and gain active returns include short selling, derivatives and leverage. It is also worth noting that no two hedge funds are identical and most generate returns by combining different strategies.

However, hedge funds require larger initial investments in comparison to other investments and usually they are only accessible to accredited investors. This is due to the fact that hedge funds are not subject to the strict criteria and allocation model that allow promotion to retail investors, such as UCITS funds, but are free to make use of more specialist instruments and strategies. Due to their illiquidity, investors are often required to keep their money invested for longer periods of time.

It is critical that hedge fund investors understand the different investment strategies types and the risk each of these strategies carries when they buy into this financial product.

Short selling accredits the sale of a financial instrument that a seller has borrowed in order to make a short sale. When a seller does this, they believe that the price of a borrowed security will decrease, thus enabling it to be bought back at a lower price. The seller makes a profit based on the difference between the sale price and the bought back price. Selling short is risky and expensive. To sell short involves several costs and trading commissions. A significant cost is the one associated with borrowing shares to short. Alongside this, an investor will have the interest that is payable on the margin account and is also liable for dividend payments made by the stock that been shorted.

The strategy behind selling short is reliant on timing of the sale. If a seller initiates a short sale the wrong time, this can have disastrous consequences due to the fact sales are conducted on margin. If a price increases instead of decreases, a seller will quickly see losses. It is therefore critical that short selling requires strict trading discipline and traders cut their losses when required. There is skewed risk-reward payoff, whereby a short sell carries a hypothetical risk of infinite loss, but can also have a significant gain.

Other strategies that hedge funds can employ to generate active returns include leverage and derivative trading. Examples include futures and options. The reason why hedge funds invest in deviates is due to the fact they can offer asymmetric risk meaning that the maximum loss is much smaller than their potential gain.

Over the last decade, hedge funds have become a hot topic and their numbers have grown exponentially (Investopedia). Hedge funds vary in their offering and employ different investment strategies as aforementioned and also invest in different asset classes. Due to this, a hedge fund’s risk and performance must be managed on an individualised basis with an established benchmark and risk metric put in place that reflects its appropriate style. By being able to understand the type of hedge fund and its strategy is critical for investors to assess potential risks that could be associated with the fund. When it comes to investors implementing hedge fund strategies, often they will be buying into mutual funds or ETFs in order to construct a portfolio. Due to the fact they are expensive and require proficient knowledge of financial markets, hedge funds are often an investment style suitable for HNWIs and accredited investors.