Hedge fund managers can employ numerous strategies

In recent months, the term “hedge fund manager” appeared frequently in the press — usually in combination with the words “fraud,” “conflict of interest” and “crime.”

Before you begin to wonder how someone who manages “a fence or boundary formed by a dense row of shrubs or low trees” could commit fraud, let’s examine the definition of “hedge” as it applies to finance.

In finance, hedge means making an investment to reduce the risk of adverse price movements in an asset, usually through an offsetting position in a related security.

Hedge funds aren’t the same as mutual funds. Hedge funds are far more capricious in their investment options. They can use short selling, leverage, derivatives, put and call options, futures contracts and more. The hedge fund manager creates a far more complex and free-ranging set of financial instruments than mutual funds.

Hedge fund strategies attempt to be unaffected by the direction of the bond (debt) or equity (stock) markets — unlike conventional equity or mutual funds, which generally accept 100 percent of market risk. That is, the hedge fund is a “boundary” against market volatility.

Hedge funds are estimated to be a $1.1 trillion industry and growing every year, with approximately 9,000 distinct funds. Most of these funds are highly specialized, relying on the specific expertise of the manager.

In general, long-term hedge fund returns have outperformed standard equity and bond indexes with less volatility and less risk of loss than stocks.

Sophisticated investors, including many Swiss and other private banks — which have lived through, and understand the consequences of, major stock market corrections — favor participating in hedge funds. Endowments and pension funds also allocate assets to hedge funds.

Hedge fund managers employ 12 fundamental strategies. Here’s an overview of each approach.

1. Universal — Aims to profit from changes in global economies, typically brought about by shifts in government policy that affect interest rates, in turn affecting currency, stock and bond markets.
2. Arbitrage — Attempts to remove most market risk by taking offsetting positions, often in different securities of the same issuer. May also use futures to limit interest-rate risk.
3. Short selling — Sells securities (before buying them) in anticipation of falling prices and being able to re-buy them at a future date. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a declining cycle.
4. Opportunity event — Profits arise from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids and other actions.
5. Multistrategy — The manager employs various strategies simultaneously to realize short- and long-term gains. This style of investing allows the manager to combine different strategies to capitalize on current investment opportunities.
6. Special situation — Invests in event-driven situations such as mergers, hostile takeovers, reorganizations or leveraged buyouts. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread.
7. Value discount — Purchases securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may also be out of favor with analysts.
8. Aggressive growth — Invests in equities expected to experience accelerated earnings per share growth. Generally high price/earnings ratios, low or no dividends; often smaller and micro-cap stocks that are expected to experience rapid growth.
9. Distressed — Acquires equity and debt at deep discounts of companies in or facing bankruptcy or reorganization. Profits derive from the market’s lack of understanding of the true value of deeply discounted securities.
10. Emerging markets — Invests in equity or debt of emerging markets that tend to have high and volatile growth.
11. Fund of funds — Mixes and matches hedge funds and other pooled investment vehicles. Returns, risk and volatility are controlled by the blend of underlying strategies and funds. Capital preservation is generally an important consideration.
12. Income — Invests with primary focus on yield or current income rather than solely on capital gains.

With all the freedom and complexity involved in hedge fund management, it’s not hard to imagine how fraud and conflict of interest can arise.

In May 2006, Patrick Parkinson of the Federal Reserve testified, “Hedge funds clearly are becoming more important in the capital markets as sources of liquidity and holders and managers of risk. But as their importance has grown, so too have concerns about investor protection and systemic risk.

“The SEC believes that the examination of registered hedge advisers will deter fraud. But investors must not view SEC regulation of advisers as an effective substitute for their own due diligence in selecting funds and their own monitoring of hedge fund performance.”

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.