How Hedge Funds Increase Returns

Buying and Holding is the Benchmark

Hedge funds seek to both increase investment returns and reduce investment risk, and what they seek to outperform on both counts is a buy and hold strategy. This buy and hold strategy, particularly with buying and holding components of a stock index, is used as a benchmark generally with investing, and this includes comparisons with hedge fund performance.

When we look at the performance of an actively managed fund, or any actively managed investment for that matter, we tend to not look at its performance itself, but its relative performance to something like the S&P 500 index. We could choose other indexes but the S&P is broad and also contains companies that are fairly significant.

How Hedge Funds Increase ReturnsThis gives us a good idea of how the stock market itself is performing, especially how large cap stocks are doing, and most of the money in the stock market is invested in companies with a large market capitalization. Market capitalization measures how much money people have in a stock, its current price multiplied by the number of outstanding shares, and this index represents a large amount of the money in the U.S. stock market.

If we get a certain return in the market, the return itself isn’t anywhere near as meaningful as the relative return of a general market indicator such as the S&P 500. If we gain 5% in a year and the S&P gains 10%, we have underperformed the market and could have done better if we just bought and held the index.

When we use index performance, the noted performance is independent of trading costs, but a buy and hold approach minimizes transaction costs as you are just holding it throughout this period. The actual entry and trading costs may have happened years ago in fact, and it does make sense to not include such costs when using an index performance as a benchmark.

This benchmark is what both mutual fund managers, hedge fund managers, and even individual investors strive to beat, and beat meaningfully, otherwise it would have made more sense just to hold a proportionate basket of stocks in the index.

When comparing our performance relative to the index, we do and must include transaction costs, as if we are managing our positions actively this will tend to involve higher trading costs and this also may vary quite a bit.

A frequent trader for instance may see a nominal return better than the index, but may significantly underperform it on a net basis if a lot of commissions are paid along the way. These costs are real and therefore do need to be accounted for.

Managing Portfolios Based Upon Performance

Just going with a basket of stocks in an index is a completely passive management style, which is another way of saying that it does not involve any management at all. Anything else, when we use some sort of strategy to decide what to invest in or how long to hold the investments, will involve an active management strategy, where we’re actually looking to manage things.

Managing our positions may be superior or inferior to doing nothing, depending on how well we manage them. Some individual investors may tinker with their portfolios for instance, without the proper knowledge and training to do so, and they may end up hurting their overall returns though mistakes.

Individuals can learn to manage their positions and when they gain enough skill they do have some serious advantages over mass managed funds, but merely setting your mind to do this is far from enough to have any sort of expectation of success.

Hedge fund managers trade much larger positions than individuals do, which in itself presents some real handicaps over what private investors face. Individuals can enter and exit positions at will, where funds cannot really do that and have to move in and out more gradually lest the sheer force of the orders they place have an undue and unacceptable effect on the market.

If you are buying 1000 shares of something for instance, you can usually do that at the market, at the best price, but if you are looking to move millions of shares, you may not even be able to do that right now, and if you could, you would get vastly inferior fills.

In spite of these constraints, hedge fund managers do have a skill advantage, and hedge funds look to hire the most skilled traders in the business, and compensate them well enough to make working for them attractive enough. The best ones earn hundreds of millions of dollars per year, with a few even topping the billion a year mark.

These fund managers earn their money by managing the assets of their fund with a view to both increase performance over the benchmark and increase it by as much as they can, and hedge funds are usually quite motivated to do so since this is tied to their compensation. The more money they make for their investors, the more they make.

Hedge Funds Aren’t Just Limited to Buying Things

Managing performance means that you are looking to position your assets in situations where there is enough of a positive expectation of doing so involved, which really means being on the right side of the market with something.

Traditional funds are limited to being close to fully invested on the long side, profiting when the price of their assets rise and losing when prices fall. Hedge funds, on the other hand, can invest in either direction, and do so depending on the circumstances.

If the goal is to be on the right side of market trends and you don’t have the ability to do that, this is a severe handicap. It does not seem to be one if the market is trending your way, on the long side, but when it is going the other way, and you are committed to your positions by way of strategy, you are powerless to act.

We’ve been so well conditioned to accept this fate though that this lack of power doesn’t even seem to concern us much, mostly because there really isn’t a good reference point, as people compare one fund or strategy with another among those who are just committed to the long side only, and end up just accepting this fate when it happens.

Hedge funds, on the other hand, do provide an alternative reference, and hedge funds both take positions on the other side when trends are going on to help mitigate risk and actively pursue downward trends to seek to profit from them.

The passive hedging of playing both sides of the market at the same time is really only necessary because hedge funds aren’t really that agile. Some of this least is misplaced even with the difficulties hedge funds have in turning around their portfolios, as this is a strategy that comes over from long side investing, hedging passively in the way that holding both stocks and bonds do.

Hedge funds do commit to positions over a longer time frame than individual investors would have to, and this can represent somewhat of a disadvantage, and offsetting risk to some degree does certainly have its place under these constraints. What really distinguishes hedge funds from other funds though is their ability to primarily focus on larger market trends, to be on the bull side or the bear side of a market as the need arises, and profit from both.

We can see some pretty large and persistent bear markets at times, and they need not even last that long, for example with the bear market of 2007-2009. 2 years isn’t generally a significant enough period to call something a bear market, although in this case it was the magnitude and not the duration of the move that made it so meaningful.

At a time where funds generally got hammered, some hedge funds boasted very good returns during this downward move, because they not only were able to step away from the bull side, they had the ability to run with the bears, who were stampeding during this period.

It is not anywhere near as easy as flipping a switch and moving to the other side of the market during a reversal, like individuals can, when you are managing portfolios of billions of dollars, but the fact that you can is a pretty big advantage, not only during turbulent times like this but with lesser reversals as well, and especially in persistent bear markets.

Hedge Funds Aren’t Just Limited to Stocks and Bonds

Another big advantage of hedge funds over other types of investment funds is their ability to trade in just about any sort of financial security. Instead of just being able to invest in the stock and bond market, hedge funds can buy and sell all sorts of other types of securities, and virtually anything that can be traded can be traded by hedge funds.

There are many hedge funds that just focus on these other things, like taking advantage of spreads through arbitrage. Many things that hedge funds trade in aren’t even trades that the public is that familiar with, like various types of so-called esoteric derivatives, which can be very complex and require a lot of expertise to manage, but hedge funds have this expertise and are in a position to hire the very best traders and analysts out there.

With virtually nothing beyond their reach, hedge funds are well positioned to seek to maximize returns for their investors while at the same time looking to keep risk within acceptable parameters. While we typically think of performance and risk as being opposed, where seeking increased performance means adding more risk, this is not necessarily the case, especially compared to mutual funds which really don’t do that much of either due to their limitations.

Mutual funds are prisoners of the market in a real sense, where both their performance and their risk are chained to market trends, and they just latch on to the market and hope that it is kind enough to them with performance and not too vengeful on the risk side.

Hedge funds, on the other hand, are able to exercise much more control over their fates, and do, where they decide what they will be in and when, and are also able to effect whatever changes are necessary in order to adapt to changing market conditions, and markets certainly do change quite frequently.

The actual performance is the ultimate measure here though, and it’s not surprising at all that hedge funds outperform mutual funds. This is why people are willing to pay amounts like 20% of returns to these funds as compensation, as they will often deliver results well in excess of this 20% premium, by having the ability to be much more adaptive.

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: [email protected]

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