How Hedge Funds Reduce Risk

There are two main ways to manage risk in an investment portfolio, which consist of passive management and active management. Passive management involves looking to offset some of the risk with certain positions by investing in others.

These offsetting positions either reduce the overall risk of the combined positions by either being less risky themselves or by having a negative correlation with the investment that is sought to be hedged and may be expected to increase in value more often than not when the hedged investment sees its value fall.

An example of diluting the risk of an investment would be holding part of a portfolio in cash to dilute the risk of stock market positions. When the value of your stocks declines, your overall portfolio will decline less the more of it you have in cash.

Mutual funds use cash to a small degree in hedging, although their mandate is to have their investors close to fully invested in whatever asset or mix of assets that the fund is directed toward holding, some combination of stocks or bonds essentially. While it would be a real advantage for these funds to be able to move to cash a lot more when market conditions demanded, they really don’t have much of an option here.

How Hedge Funds Hedge Risk Passively

Hedge funds, on the other hand, can do virtually whatever they want, including going to cash with a percentage of their portfolios, holding positions on the short side for hedging purposes, going short for growth purposes, using options to manage risk, or investing in a number of other assets and derivatives.

The original hedge fund got its name for taking both long and short positions in the stock market simultaneously, which was called a hedged fund at the time, and the main idea here was to protect against the risk of bear markets by having these short positions offset the risk.

Mutual fund investors use bonds to perform this dilution, although they generally do not dilute their positions all that much, and advisors prescribe a fairly aggressive degree of exposure to stock market risk and will often throw in hedges more to benefit investors psychologically than to provide any sort of robust and reasonably effective hedging strategy.

How Hedge Funds Reduce RiskPassive hedging isn’t really that effective anyway though, but at least hedge funds have a much larger tool box to select from when using these hedging techniques. The size of hedge funds requires some sort of passive hedging due to their relative lack of responsiveness, as they can’t just bail or change directions at the drop of a hat like individual investors generally can.

During any transition from the long to short side or vice versa, or from one asset class to another, to adapt to changing conditions, there does need to be a buffer in place to help manage the risk during this time, and this is the benefit that passive hedging provides to hedge funds.

Passive hedging also can be useful in helping manage risk among those who are unwilling or unable to manage risk actively, which includes all mutual funds who are unable and the great majority of investors who are either unwilling or unable. Hedge funds are both willing and able and in fact use sophisticated techniques to manage risk in a number of ways, and are set up to take advantage of both passive and active risk management to seek to deliver both superior returns and reduced risk over mutual funds.

Hedge Funds and Active Hedging

The use of the term hedging in investing comes from the idea that you protect something by building a hedge around it, and the hedge in the case of investments is taking action to reduce the overall investment risk of the portfolio.

When we speak of hedging investments though, we usually just think of passive hedging, which generally involves putting a portion of your funds in an asset which will both dilute performance and risk.

Most people therefore believe that the higher the performance potential of an investment, the greater the risk, and they look to achieve a balance of higher performing and higher risk investments with lower performing and lower risk ones.

Stocks perform better than bonds for instance, but are also riskier, so people will add a certain amount of bonds to their portfolio, which involves sacrificing potential return but also limiting the downside because bonds do not decline in value to the same extent as stocks can.

This is considered to be a passive hedge because it is not set up to be responsive to market conditions, you just go with a certain percentage of your portfolio in bonds and retain your positions regardless of what happens.

While hedge funds do rely on this sort of passive hedging to some degree, when it is wise to do so, just buying and holding different assets like this is not what these funds do. Hedge funds have the means to hedge much more actively than this.

While investors can and sometimes do change the proportions of their portfolio in asset classes, more or less in bonds in other words, this actually is quite unusual and people generally do absolutely nothing to help themselves here.

Most mutual funds only contain one or the other type of asset, a certain allotment of either stocks or bonds. It is up to the investor to seek the right balance here and advisors will have them investing a certain proportion of their portfolio in bonds as a hedge, and generally not a very significant portion.

There are also balanced funds which do invest in both stocks and bonds but also use a limited amount of hedging in order to seek out higher returns. If a bear market hits, they are not so worried about poor performance because other mutual funds are going to be in the same boat and people will just blame the market.

Hedge funds generally don’t care whether we’re in a bull or bear market, as they have the means to profit and profit well from both, just like individual investors do, those who are aware of this and have the means to profit from either market condition.

The proper and rational way to judge any investment is by outlook. The great majority of investors rely on the very long term for their outlook and investment strategy, but along the way, there is risk that they both may not achieve their desired objectives and may even lose money.

Along the way, there also may be opportunities to profit from trends shorter than the very long term, and if for instance if something is mired in a downtrend, we may ask ourselves why we would prefer to incur losses that likely will result while we wait for this trend to reverse.

When these risks come home to roost, when the feared bear markets appear and dominate the market, hedge funds have the ability to not only just sit idly by and take it, they can move more to the short side and not only manage the downside risk, but profit from it as well.

How Active Hedging Manages Risk

When we enter an investment with a certain strategy, we need to define our risk with it, or allow it to be undefined. Long term investing actually does not define risk, meaning that there isn’t a situation that will arise which will prescribe that the positions be closed, when we have lost a certain amount or undergone a certain drawdown, or when the likelihood of the losses just piling up more becomes or should become more of a concern.

To understand how hedge funds really manage risk, it is important to think of risk management as defining risk, and we need to set limitations on risk if we are ever going to manage it.

Some hedge funds do not even invest in traditional assets at all, as they may instead seek arbitrage opportunities which manage risk extremely well, and while they may not be capable of the returns you can see at times in the stock market, during a bull run for instance, it’s not just about the upside.

Few investors understand just how important risk management really is, as they just accept whatever risks are involved in their investment plan, because they have no idea what else one might do. Sure, we could just put our money in a savings account or in treasuries, but these investments do not provide anywhere near the returns that investors seek and require, so there seems like no other way but to take on unmanaged risk and hope for the best.

The secret to moving beyond this apparent conundrum where you have to choose either to go low risk and low return or higher risk and higher return is to actually seek to manage the risks involved, to actively hedge, the way that hedge funds do. Many people are puzzled by the fact that hedge funds can both increase returns and lower risk over mutual funds but it is because they don’t understand the power of active risk management.

The reason why hedge funds can pull this off isn’t because they are picking higher performing investments. It is simply because they manage risk better, and can even be in the same investments as a mutual fund but beat them due to being on the right side of them more.

Risk with the stock market involves having to suffer losses when the value of the stock declines, but if we do not have to always take a beating when the stocks do, that certainly can reduce our risk. This means losing less when the stock is losing, which means less risk, and it also means better performance, especially when we can gain and not lose when this all happens.

This does all flow from defining our risk with our investments and managing them accordingly. Instead of just holding a position regardless, we’re now looking to define what conditions should make us change our mind about whether we want to hold this right now and this even might have us looking to short the investments if the conditions dictate.

Regardless of our time frame for investing, the present always matters and all we can really manage is the present and the near term. We can’t really predict what the price of something will be years from now, although we can assume based upon the past that it may be more likely than not to deliver acceptable returns.

Along the way though, a lot of things can happen and we might not even get there in the end. This is called risk, and managing risk is the most important thing with investments, and this both promotes better returns when done correctly and makes these returns more reliable, in addition to looking to keep us out of trouble more.

Hedge funds really are primarily concerned with hedging, even though a lot of people mistakenly think that these funds take on even more risk and the term hedging doesn’t fit at all.

There have been some instances where certain hedge funds did take on way too much risk and ended up failing, so not all hedge funds take risk management seriously enough, but they do for the most part. Hedge funds do have the means to manage it very well though, and generally do.

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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