How to Follow the Hedge Fund Investment Model
When you look at your investment portfolio, you likely approach it like any individual investor would. You rely on many of the same investing strategies other individual investors use—buy and hold, growth investing, technical analysis, and so on.
But, what if you could achieve more growth by mimicking a different investment model? Like those followed by some of the largest and most successful hedge funds in the world.
It takes a bit of work and strategy, but savvy investors can use their approaches to realize good returns.
What is a Hedge Fund?
A hedge fund is an actively managed investment pool, kind of like a mutual fund. It collects investments from multiple investors into a single pool, then invests the pool with the goal of achieving positive returns.
Hedge funds have a long history with roots in the concept of a hedge as a line of ownership, the notion of “hedging a bet”, and the rise of speculative finance. One of the most essential concepts now driving hedge funds began in the work of a young man called Louis Bachelier, whose dissertation, “The Theory of Speculation,” is recognized as the first to use calculus to analyze trading on the floor of an exchange. It was not a well-understood theory at the time, but it formed the basis of the now-eponymous Black-Scholes model for option pricing. The two economists who crafted it, Fischer Black and Myron Scholes, read Bachelier’s work and used it as the foundation of their model in a 1973 edition of the Journal of Political Economy—an article that would become one of the most famous works ever published in quantitative finance.
However, the first hedge fund is credited to an Australian investor and financial writer called Alfred Winslow Jones, whose company A.W. Jones & Co launched in 1949 and is now recognized as the first hedge fund. He crafted the innovation that would become the classic long/short selling model, and in 1952, Jones converted his company from a general partnership to a limited partnership and added a 20% incentive fee as compensation for the managing partner, now the standard (and infamous) 2 and 20 fee structure used by hedge funds across the globe.
How Do Hedge Funds Invest?
With that in mind, it’s time for the real question: how do hedge funds invest?
Hedge funds get their name from their original investment strategy, which is called hedging. Hedging is an advanced financial risk management strategy that recognizes every investment comes with certain dangers and aims to mitigate them. Basically, it’s a type of insurance—you offset potential losses in an investment by taking an opposite position in a related asset.
Let’s say you own shares in a car company. You think the company will hold strong over the long-term, but you’re also worried about short-term losses in the automotive industry. To protect yourself against losses, you can buy a put option in the company, also known as a married-out strategy. This gives you the right to sell your shares at a specific price (the strike price). If the value of shares tumbles below the strike price, you can offset your losses through gains from put option sales.
Common Strategies Hedge Funds Use
That said, hedge funds are no longer limited to hedging. In fact, hedge funds are only limited by their mandate, which basically means they’re free to use any strategy the fund manager is comfortable with. This is why hedge funds often specialize in a specific strategy based on the background of the fund manager.
Some common hedge fund strategies include:
- Long/short equity
- Market neutral
- Short only
- Global macro
- Convertible arbitrage
- Merger arbitrage
- Capital-structure arbitrage
- Fixed-income arbitrage
Because of their leeway with strategy, hedge funds more closely resemble individual traders than investment firms. They are also characterized by market direction neutrality, which means they aim to make money regardless of whether the market booms or busts.
How to Mimic Hedge Fund Investing
The good news for individual investors is that hedge funds actually resemble the activity of an individual trader more often than an investment firm—they operate with a single pool and use any strategies at their disposal. This gives you leeway to mimic how hedge funds profit.
Technically, you could attempt to mimic any of the strategies a hedge fund uses. However, because many strategies now rely on large amounts of data and are time-consuming, we’ve focused on the basics.
Cash Flow is King
First and foremost, remember that in a hedge fund, cash flow is king. Hedge funds are often unique animals, but they all carefully monitor cash flow.
This is important because understanding your cash flow metrics is essential to understanding your overall performance and the performance of an investment. For example, a company’s cash flow statements track money flow in three categories (operations, financing, and investing), so you can see how the company’s investments are performing, how it’s performing operationally, and whether it relies on money from third-party sources to stay afloat. It’s also a clue if a company can’t keep up with its debts, which is a sign of a bad investment.
Leverage and Derivatives
The central strategy of hedge funds (hedging) relies on derivatives, primarily options and futures. The hedge fund model also relies on leverage, which is when you use borrowed capital to grow your asset base and generate returns on risk capital.
By using leverage, hedge funds have a much larger asset pool than they would have with an individual, which gives them far greater investing options and higher potential returns. Granted, it also comes with more risk—if the market moves against the hedge fund’s bet, the fund has to eat the cost of the loan to pay out investors and carry on.
This is why hedge funds rely on hedging to mitigate their losses. The use of hedging is also what differentiates a hedge fund from a mutual fund (and an individual investor).
The Basic Strategy: Hedging
Hedge funds can use pretty much any strategy they like, but the foundational strategy is hedging. This particular strategy isn’t commonly used by individual investors, in part because of its complexity. The technique itself is fairly simple—if you buy life insurance, you’ve used hedging—but you need a bit of financial know-how to pull it off successfully.
The reason why many individual investors use hedging but don’t employ it in finance is because hedging relies on derivatives, primarily options and futures. There are a lot of options and futures contracts out there, which means you can hedge against almost anything. The trick is figuring out when to hedge and how to hedge successfully. If you’re just starting out, you should do this with the help of an advisor.