About hedge funds
What is a hedge fund?
A hedge fund is a type of mutual fund that is intended to provide returns regardless of market conditions. It is therefore not dependent on the market going up in order to be profitable, as is, for example, an index fund.
In a financial context, the term "hedge" means "protection". Hedging is a way of protecting an investment, often by taking two or more conflicting investment positions at the same time.
The aim is to cover any loss on the first position with the profit from the other position(s). A hedge fund aims to protect your investment through hedging and minimize the risk of you losing money when things are volatile in the stock market.
A hedge fund is always an actively managed fund, meaning that both strategies and risks/possible returns can differ greatly between funds. Hedge funds can have low or high risk, depending on the fund's profile and the manager's approach. Both are things to consider before choosing a fund. You, as an investor, should aim to understand the hedge fund's strategy and get to know the fund's managers before making any investment.
What differentiates hedge funds from equity funds?
Hedge funds have freer investment rules compared to traditional equity funds. This means that hedge funds have more possible investment strategies available. While a traditional fund usually only invests in a single type of security, the hedge fund manager is, in principle, free to choose the investment strategy.
Thus a hedge fund manager has greater opptunity to invest the fund's capital in different types of financial instruments than the manager of a traditional fund, such as an equity or interest fund. A hedge fund can, for example, contain a mixture of equities, fixed-income securities and/or derivatives.
Many hedge funds allow deposits and withdrawals only on a monthly or quarterly basis, while regular stock and bond funds offer daily liquidity. Investors with a shorter investment horizon should keep this in mind.
Different types of hedge funds
Hedge funds are usually divided into four main categories. Each category represents a collection of sub-categories which in turn may focus on different management strategies, asset types and market situations. The four main categories commonly mentioned are:
Relative return hedge funds
This category refers to hedge funds that focus on generating returns regardless of market trends. The name comes from the fact that the fund generates returns when the relative ratio between different assets returns to its normal/expected level. For example, it could be assets that have been undervalued and given an incorrect price in relation to their actual value in the market.
Directional hedge funds
A directional hedge fund generates returns by the manager acting on a price movement in the underlying asset. For example, the manager buys a share after noting a positive signal that the value of the share will rise. In the same way, the manager sells and/or closes a share if there are signs that it will decrease in value.
Event-driven hedge funds
This type of hedge fund buys or shorts a stock after a major and significant event has occurred. Events can be, for example, a buyout where the current share price deviates from the bid price or instances where the hedge fund believes that the company's underlying value deviates from the bid price and wants to stop, and in some cases force, a higher bid. The hedge fund's strategy is thus to create returns within a shorter interval.
This strategy means, as the name suggests, that the hedge fund manager uses several different strategies in parallel. This is usually done by a hedge fund investing in a number of complementary hedge funds.
How do I choose a hedge fund?
A hedge fund's performance is primarily assessed by looking at the return generated relative to its risk, usually measured as standard deviation.
Before investing in a hedge fund, it is very important that you understand the fund's strategy and risk profile, as well as the fund's historical returns. It is also important to study the fund's return in different market climates.
A hedge fund can consist of a relatively complex portfolio with several different types of securities. Hedge fund managers generally do not communicate information about the fund's portfolio holdings as frequently as managers of equity and bond funds.
This means less transparency, which means that you as an investor have to be more active in reviewing the current hedge fund's strategy.
The Sharpe ratio is an important measure. A fund's return is usually measured in relation to its risk, often expressed as standard deviation. A higher level of risk should result in a higher return, conditions being equal. A classic measure of this relationship is the so-called Sharpe ratio.
The Sharpe ratio was developed by the economist William F. Sharpe, who also received the Norwegian School of Economics' prize in memory of Alfred Nobel in 1990. The Sharpe ratio is a way of assessing the relationship between risk and return.
If an asset has a high Sharpe ratio, it has generated a high return in relation to the risk taken. The formula for calculating the Sharpe ratio is as follows: (return – risk-free rate) / standard deviation.
A traditional fund is relatively easy to assess, it has served its purpose if it develops stronger, relatively speaking, against its benchmark. Hedge funds are judged differently. Hedge funds have a low correlation to the market.
Normally, an assessment is made based on the fund's correlation to the underlying market and its absolute risk-adjusted return. A low correlation is preferable and hedge funds that only show a positive return during a strong stock market climate have generally not delivered on their purpose.
For traditional fund's it is generally accepted that 80 percent of returns are due to how the underlying market develops, while 20 percent depends on the skill of the manager.
For hedge funds, the exact opposite relationship prevails. It is normally said that 20 percent of the fund's return depends on the market situation, while the remaining 80 percent is a result of the manager's skill.
How to invest in hedge funds?
Investing in a hedge fund does not differ, in principle, from other types of funds such as equity, index or interest funds. You as an investor can invest in hedge funds via the fund company's website, your internet bank or online broker.
You need an account, for example, a fund and share depository, capital insurance or an Investment Savings Account (ISK) before you can invest.
Some hedge funds have a minimum investment requirement and these amounts are normally higher for hedge funds versus traditional funds.
In recent years, however, there have been more and more hedge funds that have lower minimum investment requirements and this can be a good option for investors who want to invest on a monthly basis.
Investors should also note that some hedge funds generally do not trade as frequently as traditional funds. Often it is only possible to make deposits and withdrawals on a monthly or quarterly basis.
Of course there are a number of hedge funds that are traded daily, you as an investor, should consider the fund's liquidity so that it matches your requirements.
The High-water Mark Principle
Hedge funds are actively managed and often have higher fees compared to traditional funds. Most hedge funds have two fees to consider: a fixed fee which is calculated annually and a performance-based fee which is commonly 20 percent of the excess return.
This means that Hedge Funds only charge a performance-based fee when their return, net of the fixed fee, exceeds its previous high threshold value (so-called Hurdle).
The absolute majority of hedge funds apply a so-called high-water mark. The High-water Mark Principle means that the hedge fund must both beat its historical high and its threshold value before a performance-based fee can be charged.
If the hedge fund has developed negatively, the hedge fund must therefore recover the lost return and exceed its historical high point before any performance-based fee can be charged.
The basic idea motivates the manager to create the highest possible return, regardless of what the underlying market looks like, while avoiding excessively risky investments, in order to protect the fund's investment portfolio.
For example, if a fund rises to from 150 to 185 and then falls back to 170, no performance fee is charged (after the fixed fee is deducted) until the fund is above 185 again.
Something to consider
A hedge fund, like traditional funds, aim to generate as high a return as possible. Historical returns, especially in relation to the hedge fund's level of risk, provide an indication of the manager's skill and what you can expect going forward.
However, remember that there are no guarantees that the hedge fund will generate a return similar to its historical average and no investment is without risk.
- A hedge fund aims to generate a positive return regardless of the market's development
- A hedge fund protects against downsides and should therefore have a lower risk of negative returns when the market goes down
- The fee for hedge funds is usually performance based
- The manager's skill and performance track record are more significant for the fund's performance compared to a traditional fund
- A hedge fund can have both high and low risk, it is important that the investor understands the hedge fund's strategy and risk profile
- A hedge fund can be a suitable complement and lower risk in a diversified portfolio