Inside Hedge Funds
The function of controlling risk over long periods of time is the single most important variable in running a successful hedge fund.
A hedge fund should be a vehicle funded by investors and partners (that are clear as to the expected risks incurred by the fund) that trades the correlation of one asset against another (one stock against another, one bond against another) in an attempt to extract "value" from the spread between the two (or three, or four, or thousands).
- A fundamental long/short equity hedge fund will buy Proctor & Gamble (PG) stock and sell the equivalent dollar amount (probably beta adjusted) of SPX (through futures or ETF) against it thinking PG stock price will outperform the market by a great deal over a long period of time. Their reasoning is PG is a well run company with stable cash flow and great product research and introduction. They will also sell J. C. Penney (JCP) stock short and buy SPX thinking JCP stock price will under-perform the market by a great deal over a long period of time. They will do this with many stocks.
- A statistical arbitrage long/short equity hedge fund will sell Ford (F) stock against General Motors (GM) stock thinking F stock price has statistically outperformed GM stock price by a small amount and it should revert back to the mean of the range that the two trade against each other. They will do this over and over again taking small profits on small range moves between many highly correlated stocks.
- A credit hedge fund will sell short General Motors bonds and buy treasury bonds thinking GM's balance sheet will worsen causing their credit costs to rise (bond price will drop) relative to overall market interest rates.
The more "uncorrelated" those spreads can become (there is more potential for the price of Proctor & Gamble's stock to move away from General Motors' stock price than there is for the price of Newmont Mining's (NEM) stock from the price of gold), the more risk in the hedge fund.
A hedge fund will borrow money (leverage) to increase the return on those spreads. In general, the more money they borrow, the more risk in the hedge fund. The amount of leverage must be a function of the level of correlation risk between the assets traded: the more volatile (or potentially volatile) the correlation, the less leverage that should be applied.
Because a hedge fund employs leverage (it can lose more than the investors put in) it is essential that it controls risk. Risk is potential loss and this must be calculated both on a total basis and an individual security basis. As you should see, the total risk is a function of how much leverage is used and the correlation between the individual risks incurred by each security: the more the actual correlation between assets behaves like the expected correlation, the lower the risk.
The function of controlling risk over long periods of time is the single most important variable in running a successful hedge fund. Funds that incur too much equity risk, such as private equity funds or even some long short funds, are not really hedge funds and should not be using leverage since the directional risks are great. These funds require a longer time horizon.
Similarly, risk control necessitates controlling concentration risk (as a percentage of assets) and mitigating different types of risk (like interest rate and currency risks) if the fund does not specifically target these risks.
Another important variable is being opportunistic. A hedge fund that enters into trades where spreads are not above fair value (however that is determined) is not trading alpha. Many hedge funds that promise a "target" return find themselves increasing leverage where there is no opportunity in an attempt to make that return. This skews the risk for reward unfavorably and will eventually cause negative returns.
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