How do hedge funds work in a volatile market?

Hedge funds play a very important role in investment markets and come in many shapes and sizes. Because of this, it’s important for investors to understand what they are, how they operate and the role they play in a fully functioning market. 
 

What's a hedge fund and how do they work?

Hedge funds typically play an important role in financial markets. In fact, when markets are volatile, hedge fund managers are often able to spot, and take advantage of, interesting investment opportunities and inconsistencies in markets that can generate extra returns for a portfolio.

Alfred W Jones is widely considered to have started the first hedge fund in 1949 in the US when he raised US$100,000 to start his fund. Of this money, US$40,000 was his. Jones’ aim was to use some of the money he raised to establish the fund to minimise its losses.

Back then, the fund was known as a ‘hedged’ fund. That is, it tried to hedge its investments by using different types of financial instruments to offset the risks it took on its positions. This is a trait of hedge funds that continues to this day.

Hedge funds can invest in many different asset classes – shares, bonds, listed property trusts, as well as all the derivative instruments they use to hedge their positions such as options, futures and foreign exchange contracts. They can also invest in listed and unlisted investments.

This style of fund also has a number of other defining features, such as investors needing a large minimum amount to invest (an initial outlay of $50,000 or more is typical). 

Usually only sophisticated investors or professional fund managers allocate money to them, because of the significant risks to which hedge funds are exposed - they have the potential to make, but also lose, lots of money. So it’s not usually appropriate for retail investors to have significant exposure to them, unless it’s through an investment fund managed by professionals. 

Hedge funds are also relatively illiquid. This means it can be hard to withdraw money from them at short notice. They are often largely unregulated, which also increases the risks to which they are exposed. For instance, unlike other managed funds, they don’t have to produce extensive disclosure documents that clearly outline their risks.

In terms of fees, hedge fund managers are rewarded for the returns they produce. So while their fees can be quite high, so too can their returns.
 

So, how do they invest?

Let’s take a look at some of the common strategies hedge funds use:

How are hedge funds used in an investment portfolio?

An allocation to hedge funds can provide an important source of diversification, not just when markets are volatile, but over time. Hedge funds invest in many different strategies that are uncorrelated to equities markets, such as fixed income funds and emerging markets opportunities, so an exposure to hedge funds has the potential to smooth out a portfolio’s returns over time.

There are many, many different types of hedge funds, all with different target returns and investment profiles. So it’s often useful to delegate the choice of hedge funds to professional managers who are able to select funds based on their risk/return profile, to suit the investor’s objectives.

Next read: A guide to active and passive investing

References:

https://www.cfainstitute.org/en/research/cfa-digest/2007/11/hedge-funds-past-present-and-future-digest-summary