Hedge Funds Actually Do Hedge

What Does Hedge Mean Anyway?

There are a lot of people who claim that hedge funds should not be called hedge because this is not the way that we normally use the word hedge in investments. Do hedge funds still deserve to be called that, or is this a misuse of that term?

This all comes down to a proper understanding of what hedging is. We usually think of this as taking on a position which will reduce the overall risk of our investments, for instance holding a certain percentage of one’s portfolio in bonds to offset the risk of our stock positions.

Hedge Funds Actually Do HedgeShould the value of our stocks decline, it is less likely than not that the bond portion of our portfolio will decline at the same or a greater rate, resulting in less losses during these events.

This does not mean that both types of investments won’t decline together, but when they do, bonds tend to decline at a lesser rate on average, and enough of a significantly lesser rate to make this a viable option in managing risk.

This type of hedge does come at a price though, and it’s that in the good times, one will tend to make less. This is because the hedge, in this case the bonds, are less volatile in both directions, and produce lesser returns on average over time.

Some people take this concept of hedging and assume that this is the only way to do it, to limit both their returns and their losses. Hedging though as a concept is really just about risk management and one need not necessarily limit one’s potential returns to manage risk, in fact it’s possible to hedge and shoot for even higher returns.

This is the approach that hedge funds take. Hedged portfolios usually aim to become more conservative, while hedge funds seek to become less conservative, while at the same time, actually doing some hedging.

Hedge funds do look to offset risk by balancing positions, but the biggest way that a lot of hedge funds hedge is by seeking to reduce risk by being on the right side of the market rather than looking to maintain their positions and offset this risk through other instruments.

Depending on the strategy used with hedge funds, this may result in approaches that may involve higher risk than your traditional buy and hold stock approach, although that doesn’t mean that these hedge funds hedge as well. They still may seek to manage risk actively, hedging if you will, to create a better risk to reward ratio.

Misperceptions of Risk with Long Term Investing

There is a view out there that the safest way to invest is just to buy and hold and when you balance your portfolio with other investments such as bonds, this is even safer.

Beyond that, any attempt to time markets is seen as riskier, and the more timing you do, the riskier it is held to be. For instance, those who hold positions less frequently such as position traders are seen to be using much riskier approach than buy and hold investors, and those who only hold positions for briefer times such as swing and day traders are seen as taking the riskiest strategy.

People don’t think too much about why this is believed to be the case though, and if they did, they would see that these ideas should actually be even counterintuitive.

Most investors tend to just believe what they are told by those who claim to know more than they do, although the problem is that many of these so-called experts haven’t really thought much about this either.

To be fair though, there are certain risks that can and do increase in proportion to how much you seek to time investments, and we can call this the risk of doing stupid things, in other words poor execution of your trading plan or just having a poor one to start with.

Trading more frequently and trading poorly isn’t a good combination, although this is apart from whether trading more frequently is in itself riskier. This is the point of confusion with most people, as exposing yourself to more risk with less timing is riskier by definition, all other things being equal.

It is assumed that most investors do not have the skillset to time their investments, and this is for the most part true, although we’re told to not even bother to acquire and develop these skills and just look to minimize mistakes.

If you bury your money in the back yard you will not make any active mistakes, or rather, any further ones, although it’s true that some people do need to be protected from themselves and will invariably screw things up given the chance. We should not assume all of us are like this though, as is the norm.

All we really need to outperform doing nothing, holding in other words, is results better than random less transaction costs, and as it turns out, this is nowhere near as difficult to achieve as many people think.

Aside from that, if we’re talking about market risk here, as we need to, looking to actively manage risk, at least if done skilfully, is superior than not looking to manage it at all.

This is one of the things that active investors and traders as well as hedge funds do, they look to manage risks in an active fashion, and certainly more actively than buy and hold investors would.

Managing Market Risk

We do know that the value of assets moves in cycles, and this is something that is very widely accepted. Other than a few academics who claim that markets are completely random, we all know that there are market forces that act upon prices and that we do indeed have bull and bear markets of various lengths.

Prices of bonds, for instance, move with interest rates, and even in a way that can be mathematically determined to a great degree, due to the changing yields that interest rate fluctuations produce. Stocks do move in patterns as well, and generally speaking, the better the economic climate, more money is poured into stocks, which in itself puts prices up. with poorer conditions resulting in a contraction of investment funds as well as prices.

The ideal here is to look to match the market that we are in, to place our bets mostly on the long side when prices are increasing, and to place our bets mostly on the short side when we expect prices to decline.

This may be seen as a more aggressive approach than just going and staying long, but this doesn’t mean that that this is much risker as well. The most risk in fact, market risk anyway, is being unresponsive to market changes.

When you are unresponsive, staying long come what may, or staying short come what may for that matter, although people don’t typically do this, this involves taking on the maximum amount of risk, the entire move against you.

When you look to modify your positions to limit your risk exposure on the downside, this does not involve taking on more market risk, it seeks to reduce it.

When you trade with the trend, seeking to go long in bull markets and short in bear markets, this is actually the best approach to managing market risk, because one does not expose oneself to an overabundance of it and will exit trades when conditions and expectations dictate.

So, this approach is at least in theory less risky, and when applied skillfully enough, it will indeed result in less risk than other means of investing in financial assets. This is because by minimizing market risk, we can achieve our goals of risk management much better than just looking to re-allocate certain percentages of our holdings in other assets to dilute our losses.

The reason is that by using diversification, one’s primary market risk exposure remains, and all we end up doing is exposing a smaller portion of our portfolio to the full brunt of market risk. While it is better to expose less of our portfolio to this rather than more or the whole thing, it is preferable to seek to avoid exposing a large percentage of our holdings to full market risk.

How Hedge Funds Hedge

We can understand financial markets in the general sense as either being bull markets, bear markets, or neutral markets. We need not concern ourselves with neutral markets though as the risk here is low, and it is only the bull and bear markets that present a lot of market risk.

Hedge funds hedge in several ways, as they are able to invest in a number of things that individual investors generally do not and mutual funds never do. Overall though, the primary way a lot of hedge funds hedge is to look to ride the current wave that we are on, to seek to be long during bull markets and seek to be short during bear markets.

With a fully invested, long only strategy, the kind that mutual funds are limited to and the sort a lot of individual investors prefer, you love bull markets but are left unprotected for the most part during bear markets.

Hedge funds are not limited to this though and can pretty much do what they want, and what they want is to be on the side of the trend. Instead of being long during the dreaded bear markets, they not only look to step aside, they also have the ability and authority to go short, to take advantage of these markets and seek to make money from them rather than losing a lot of it.

Hedge funds also will take both long and short positions in markets simultaneously, which is clearly hedging by any definition, as this in itself seeks to minimize one’s exposure to major market trends.

While stock markets have always come back, thus far anyway, it’s better to look to make money from both bull and bear markets, and this does involve hedging. If you pull or reduce your long positions during bear markets, this is a hedge in itself, hedging the risk of losses should negative conditions persist.

If you’re looking to capitalize on these downturns, this is at least in theory even better, although this of course requires that one properly determine what the trend actually is to be on the correct side.

Hedge funds don’t just go long and short stocks to accomplish this, as they also have the ability to hedge with derivatives, and they can use them to both actually hedge their risk and also shoot for bigger returns by way of speculation.

Hedge funds do tend to speculate a lot more than mutual funds, and to a level that some investors may not be comfortable with, but that is another matter, although the risk reward ratio does tend to be higher and this is why hedge funds tend to outperform mutual funds over time as well as achieving more stability on average.

Contrary to what people tend to think though, there’s quite a bit of hedging that happens with hedge funds, and they are not so inappropriately named after all.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.