I thought about sharing something different today, a topic that many retail investors might not be familiar with. A category within the realm of investing, are considered ‘elites’; an entity that serves only wealthy and accredited investors. Did you guess it right?

That’s right. Hedge funds.

The hedge fund community has attracted a lot of limelight and glamour over the years, not surprising at all given the wide coverage by mainstream media of the luxurious lifestyles of hedge fund managers.

Do you know that in his early career Warren Buffett and his mentor Benjamin Graham ran investment partnerships that were similar to a hedge fund structure?

Ironically, in 2008 Warren Buffett made a bet against hedge funds that a low-cost index fund would outperform them in the next 10 years.

So what are hedge funds? How are they different from mutual funds?

In the professional world of finance, hedge funds are categorized as alternative investments, one key difference between a mutual fund and a hedge fund is investment strategy. Unlike mutual funds, hedge funds can perform complex investment techniques such as long-short positions, net long or net short portfolios, short-selling, arbitrage and the use of leverage.

Obviously there are a lot to know about hedge funds, but in this article, I would like to focus on explaining the different strategies it employs.

Activist

A breed that has been making headlines in Singapore lately, Activist investing seeks an active role in unlocking value by working with management to make significant changes in the company. In certain cases where the company is poorly run, activist investors will push for a vote to replace the existing management committee. This strategy can only be executed by well-funded investors who can take on large stakes in the company to gain voting rights. A recent example is Quarz Capital and Oxley boss, Ching Chiat Kwong using their financial muscle and influence to vote out the management of IHC.

Arbitrage

A strategy that exploits pricing inefficiencies of an asset that trades in different markets. In its truest form, a trader buys an asset in one market and simultaneously sells it in another market at a higher price. There many sub-forms of arbitrage such as merger arbitrage, statistical arbitrage, convertible arbitrage and so on.

Distressed Debt/Assets

A contrarian approach which involves acquiring debt or assets of financially troubled companies or countries at large discounts. Distressed debt or assets are usually not investment grade, hence limiting ownership to only large institutional investors like hedge funds, private equity and investment banks. Due to a high possibility of bankruptcy in these situations, investors would demand a high payoff to mitigate downside risk. Firms that specialize in these situations are often known as vulture funds.

Macro

Hedge fund legends like George Soros, Stanley Drunkenmiller, Jim Rogers, Paul Tudor Jones and Ray Dalio are adopters of top down global macro, practitioners seek to profit from predicting large scale macro-economic events or catalyst. Top down macro traders are often versatile as they look for opportunities across FX, Bonds, Equities and Commodities. Global macro involves the study of monetary and fiscal policy across developed and emerging economies.

Long/Short Equity

A market neutral strategy that attempts to hedge out market exposure by going long undervalued stocks and short overvalued stocks. A portfolio can be differentiated by market geography, sector, value or growth. Long/short portfolio can also be net long or net short bias as per trader’s discretion.

Relative Value

Similar to long/short equity, relative value is a subset of market neutral strategies. Relative value trading can be done in fixed income, commodities and FX markets. For example, a trader who is expecting the Australian 10yr government bonds to outperform, will go long and hedge out market risk by selling a basket of G3 10yr government bonds of equal weightage.

Quant

Increasingly popular these days, quant are trading strategies developed on mathematical concepts. A quant relies on historical data, backtesting and optimization systems to develop strategies. Hedge funds can leverage on technology such as A.I and machine learning to create ‘Black Box’ algorithms that automates analysis, development and execution of strategies. With technological advancement, quantitative trading and algorithmic trading are likely to grow in the coming years.

 

According to data from Hedge Fund Research, the estimated number of hedge funds globally is close to 10,000 with assets under management reaching $ 3 trillion dollars. These strategies are complex and requires a level of expertise to execute, it is important to note that we as retail investors should stay focus on a simple investment strategy and keep a long term focus in mind. Retail investors should develop a circle of competence as a way to focus only on areas we know best, this will improve our odds of success and minimize risk.