Introduction to Hedge Funds
Here we will give a brief overview of the hedge fund market in order to better understand the context of the kind of model we try to build and the strategy behind it.
Although there is no universally accepted definition of the term "hedge fund", the term has evolved over time to include a multitude of skill-based investment strategies with a broad range of risk and return objectives. The common element among these strategies is the use of investment and risk management skills to seek positive returns regardless of market direction.
"hedge funds" are an exciting innovation to the range of professionally managed investment vehicles that have brought sophisticated investment strategies and a new sense of excitement to the investment community.
They can serve as an important risk management tool for investors by providing valuable portfolio diversification. One might define a "hedge fund" as an information-motivated fund that hedges away all or most sources of risk not related to the price-relevant information available for speculation.
"hedge funds" use a wide variety of investment styles and strategies. Even among "hedge funds" that purport to use the same investment strategy or invest within the same asset class, there is a wide range of investment activities, performance and risk levels. Because the investment activities of "hedge funds" are so diverse, the "hedge funds" assigned to a particular investment category are likely to exhibit less similarity than more traditional investment vehicles, such as registered investment companies.
The investment strategies are typically designed to protect investment principal and engage in a variety of investment techniques that include fixed income securities, convertible securities, currencies, exchange-traded futures, over-the-counter derivatives, futures contracts, commodity options and other non-securities investments in order to generate specific risk-return profiles.
Strategies may be designed to be market-neutral (very low correlation to the overall market) or directional (a “bet” anticipating a specific market movement). Selection decisions may be purely systematic (based upon computer models) or discretionary (ultimately based on a person). A "hedge fund" may pursue several strategies at the same time, internally allocating its assets proportionately across different strategies.
"hedge funds" are often classified according to investment style including following categories: relative value, event-driven, equity "hedge funds", global asset allocators and short selling. Within each style category, funds are then classified according to the underlying markets traded. For example, within the relative value style classification, there are a number of sub-groups, including equity market neutral, fixed income arbitrage, convertible arbitrage, credit arbitrage and statistical arbitrage.
Various "hedge fund" return opportunities stem from the expanded universe of securities available to trade and the strategies that can be employed. Funds can access both financial and non-financial (commodity) markets and can easily take long, short, spread, and option positions in any of these markets. Expanding the set of investment opportunities results in providing diversification benefits to a portfolio that cannot be replicated through traditional stock, bond, and real estate investment strategies.
For alternative investments, such as "hedge funds", to grow as an investment alternative, individuals need to increase their knowledge and comfort level as to their use in investment portfolios. The logical extension of using investment managers with specialized knowledge of traditional markets to obtain maximum return/risk tradeoffs is to add specialized managers who can obtain the unique returns in market conditions and types of securities not generally available to traditional asset managers; that is, "hedge funds". In addition, investors must compare the unique returns available to each of the "hedge fund" styles to insure that the particular style does not duplicate existing investment opportunities.
