Hedge Funds - How do they operate?


Diagram: Operation of Hedge Funds
Weeks ago, I talked to a friend regarding hedge funds. He mentioned that the risk of hedge funds is low as they hedge investors’ money. If you have the same thought, I am afraid that it may not be what the fact is.

The reality is that hedge funds are highly speculated and risky, and it is not for ordinary investors. Their complexity makes them unintelligible, and sometimes arcane. Although there is no rule or constraint to the operation of hedge funds, hedge funds usually ride on a specific investment strategy and make a huge leverage through derivatives, such as options. We shall discuss these strategies below.

Arbitrage


Hedge funds adopting this investment strategy usually employ many math and computer geniuses to build various models to identify the arbitrary opportunities or mispriced securities. Since arbitrary opportunities exist only in a very short time window, various technologies, such as algo-trading, quant engine, parallel computing, are applied in the models. In addition, the models may run in the data center of the Exchange to minimize the time latency of market data and order placement. For instance, there may be a time window for the change of interest rate and securities price. If the model determines the securities price does not reflect the change of interest rates, the model will place orders to take this arbitrary opportunity.

Marco Analysis


This investment strategy employs quantitative and quality analysis on the macro economy such as interest rates, exchange rates, trade volume and governments policies. As there are cycles in the macro economy, the end of the cycle (no matter its bear or bull) is the moment the hedge funds place their bets. For instance, if a hedge fund determines the exchange rate of a country does not reflect the country's economy, the hedge fund could long or short the country currency to seize profit. The Quantum Fund from George Soros is famous for this investment strategy. In 1992, it made a profit of over USD 1 billion by shorting USD 10 billion pound sterling.

Event-Driven


The Event-Driven investment strategy often applied to the stock market. By researching and analyzing corporate events and financial status of listed companies, investment opportunities could be identified. For instance, if a hedge fund bets an acquisition of a listed company by another will take place, it can short the share of the acquiring company and long the share of the acquired company, as acquiring company normally pays extra premium in the acquisition price. Other corporate events such as mergers, liquidation and restructuring also present investment opportunities to hedge funds.


Leverage


Investment strategy is only part of the operation of hedge funds as it is a means to identify investment opportunities. The other part is the execution strategy. Normally, hedge funds would maximise the profit by leverage. In addition to doing the margin trading of the target securities, they could invest in derivatives to make a huge profit or loss. This is exactly why hedge funds are so risky. For instance, if a hedge fund determines the stock price is going down, instead of shorting the share in which the transaction cost may be higher, it could buy the put option as an alternative.


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