Ever questioned how hedge funds think and how they are occasionally able to generate explosive returns for their investors? You are not the only one who thinks like this. For years hedge funds have retained a definite level of ambiguity about them and the way they operate. And for years, public companies and retail investors have tried to discover the methods behind their (sometimes) noticeable madness.
It's not possible to uncover and appreciate each and every hedge fund's approach - after all, there are accurately thousands of them out there. Nevertheless, there are various constants when it comes to investment technique, the methods of analysis used and other preferences. Let's have glance on it.
Hedge funds will come in all kinds of shapes and sizes. Some might place a heavy prominence on arbitrage situations (like buyouts or stock offerings), while others may focus on special situations. Others yet may aspire to be market neutral and profit in any environment, or employ complex dual long/short investment strategies.
While many investors track metrics such as earnings per share (EPS), numerous hedge funds also have a propensity to keep a very close eye on another key metric, which is cash flow.
Cash flow is significant since bottom-line EPS can be manipulated or altered by one-time events, such as charges or tax benefits. Cash flow and the cash flow statement tracks money flow, so it can say precisely to you if the company has generated a large sum from investments, or if it has taken in money from third parties as well as how it's performing operationally. For the reason that of the detail and the breakup of the cash flow statement (into three parts: operations, investing and financing), it's well thought-out to be a very valuable tool.
This proclamation can also tip off the investor if the company is having trouble paying its bills or provide evidence as to how much cash it has on hand to repurchase shares, pay down debts or to conduct some other sort of other potentially value-enhancing transaction.
When the average individual purchases or sells a stock, he or she tends to do so through one preferred broker. The transaction is generally simple and straightforward. But hedge funds, in their effort to squeeze out every possible gain, tend to run trades though multiple brokers depending on which offers the best commission, the best implementation, or other services to assist the hedge fund.
Funds might also purchase a security on one exchange and sell it on another exchange if it means a to some extent larger gain (a basic form of arbitrage). Since of their larger size, many funds go the additional mile and may be able to pick and choose up a couple of extra percentage points each year in returns by capitalizing on minute differences in price.
Hedge funds may also appear for and try to snatch upon miss pricings within the market. For instance, if a security's price on the New York Stock Exchange is trading out of sync with its equivalent futures contract on Chicago's exchange, a trader could at the same time sell (short) the more costly of the two and buy the other, thus profiting on the differentiation.
This eagerness to push the envelope and remain for the biggest gains possible can easily tack on a couple of extra percentage points over a year's time as long as the prospective positions truly do cancel each other out.
Hedge funds characteristically use leverage to amplify their returns. They might purchase securities on margin, or get hold of loans/credit lines to fund still more purchases. The initiative is to seize on and/or take benefit of an opportunity. The short edition of the story goes that if the investment can create a big enough return to cover interest costs and commissions (on borrowed funds), this type of trading can be a highly effective strategy.
The downside is that when the market moves adjacent to the hedge fund and its leveraged positions, the effect can be distressing. Under such circumstances the fund has to eat the losses and in addition to this the carrying cost of the loan. The well-known fall down of hedge fund Long Term Capital Management occurred for the reason that of just this phenomenon
Hedge funds may purchase options, which frequently trade for only a portion of the share price. They might also use futures or forward contracts as a means of attractive returns and/or justifying risk. This enthusiasm to leverage their positions with derivatives and take risks is what enables them to distinguish themselves from mutual funds and the average retail investor. This amplified risk is also why investing in hedge funds is, with a few exceptions, reserved for high-net-worth and attributed investors, who are considered fully aware of (and perhaps more able to absorb) the risks involved.
Many mutual funds try to be inclined to rely on information they obtain from brokerage firms and/or their own research sources, and/or relationships they have with top management.
The downside to mutual funds, nevertheless, is that a fund may uphold many positions (sometimes in the hundreds), so their cherished knowledge of any one particular company may be somewhat limited.
Hedge funds - particularly those that preserve concentrated portfolios - often have the ability and willingness to get to know about a company very well. In addition to this, they may tap multiple sell-side sources for information and nurture relationships they've developed with top management, and even in some cases secondary and tertiary personnel, as well as maybe distributors the company uses, ex-employees, or a variety of other contacts. For the reason that hedge funds usually aren't beholden to the company/investment and since fund managers' personal profits are intimately tied to performance, their investment decisions are characteristically motivated by one thing - to make money for their investors.
Mutual funds develop somewhat comparable relationships and do wide-ranging due diligence for their portfolios as well. However hedge funds aren't held back by yardstick limitations or diversification rules. Consequently, at least theoretically, they may be able to spend more time per position. And again, the way hedge fund managers get remunerated is a strong motivator, which can support their interests directly with those of investors.
Many retail investors appear to buy into a stock with one hope in mind: to watch the security's price mount in value. There's nothing wrong with desiring to make money, but very few investors consider their exit approach, or at what price and under what circumstances they'll consider selling.
Hedge funds are a completely different animal. They frequently get involved in a stock with the purpose of taking benefit of a particular event or events, such as the benefits reaped from the sale of an asset, a sequence of positive earnings releases, news of an accretive acquisition, or some other catalyst. Nevertheless, once that occasion transpires, they often have the discipline to book their profits and move on to the subsequent opportunity. This is significant to note since having an exit approach can intensify investment returns and help mitigate losses.
Mutual funds directors often keep a track on the exit door as well, but a single position may only represent a portion of a percent of a mutual fund's total holdings, so getting the complete best execution on the way out may not be as essential. So, for the reason that they often maintain fewer positions, hedge funds usually require to be on the ball at all times and be ready to book profits.
Bottom line Even though often mystifying in nature, hedge funds use or employ some procedure and strategies that are available to everyone. They do, though, frequently have a divergent advantage when it comes to industry contacts, leveraging investable assets, broker contacts and the ability to access pricing and trade information.
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