The Fundamentals and Benefits of Hedging Strategies
By Cos Braswell and Chris Meyer
Investing in hedge funds has become more accessible over the last few decades, spurring debate about their potential role in investment portfolios. In July, Innovest Principal Sloan Smith conducted a webinar with Benjamin Zack, who invests in hedge funds for Ironwood Capital Management. As follows is a summary of their discussion of the fundamental principles of hedging strategies.
It is helpful to be clear on what distinguishes hedge funds from other investment strategies. In general, hedge funds have more flexibility than traditional investment products. For example, traditional managers normally invest in securities with the expectation that their prices will appreciate. These managers take “long” positions by buying such securities. In addition to taking long positions, hedge funds may “short” securities, benefiting if their prices fall. Hedge funds also have flexibility to invest in different types of securities, from stocks and bonds to commodities and currency derivatives. Many hedge fund managers use this flexibility to construct portfolios that are designed to perform quite differently from long-only traditional portfolios of stocks and bonds.
Because most hedge fund managers aim to perform differently from traditional stock and bond markets, many investors use hedge funds to diversify their portfolios. Having a portfolio position in hedge funds generating attractive returns without much sensitivity to traditional investments can reduce a portfolio’s overall risk, which is a meaningful contribution to the portfolio. Moreover, managing the risk of loss can add additional value. As Benjamin Zack of Ironwood Capital Management explained, “The role of a hedge fund is to preserve and protect capital, where the idea is to compound wealth for investors over time in an uncorrelated manner without being subjected to material losses.”
The following are a few categories of common hedge fund strategies:
· Long/Short equity strategies entail a fund manager attempting to identify future winners and losers in the stock market. The manager buys stocks expected to appreciate in price—known as “long” positions—and sells short stocks expected to fall in price—“short” positions. Some managers construct portfolios so that total “short” positions equal the overall “long” positions. These “Market Neutral” strategies often have low overall sensitivity to the stock market.
· Event-Driven strategies typically involve a fund manager taking positions in stocks or bonds of a company expected to undergo a significant corporate event. Such events can include a merger, acquisition, restructuring or spin-offs. If the expected event occurs, the positions could generate a profit for the fund. Another flavor in the event-driven category is distressed debt, where the fund manager buys debt securities of a troubled company with the expectation of generating a profit when the company emerges from bankruptcy.
· Macro Hedge Funds typically entail a fund manager developing a “big picture” view of various markets and economies across the globe and formulating forecasts of what they may do in the future. These funds may have long and short positions in equities, bonds, currencies, and commodities, and they often use leverage and derivatives as well.
· Finally, Quantitative Hedge Funds generally use proprietary statistical models to identify market patterns and mispriced securities, normally buying some securities and shorting others. These strategies often employ computer algorithms developed by advanced mathematicians and computer scientists.
Understanding the basics of these hedge fund strategies is helpful to recognizing why Zack believes the current environment is attractive for skillful hedge fund managers. Since January 2020, the S&P 500 experienced a 34% decline and a subsequent rebound that eclipsed previous all-time highs. Meanwhile, interest rates on bonds moved to all-time lows. Many businesses remain under pressure, including those in brick-and-mortar retail, travel, leisure, gaming, and energy. Other companies, particularly those in technology and online retail, benefited from the stay-at-home, work-from-home impacts of COVID-19. The gap between winners and losers provide opportunities for long/short equity and market neutral managers. Distressed debt investors may also find attractive opportunities among companies facing serious financial problems. Volatility in interest rates and currencies add additional opportunities for macro strategies. Under these conditions, Zack believes skillful hedge fund managers can generate attractive performance, though he added that managers must continue to carefully manage risk.
How does Zack and his team at Ironwood identify skillful managers that can take advantage? Though the process is highly complex, one attribute that Zack seeks is a focus on an industry or asset class. He believes that managers should stay within their areas of expertise where they can use their skill to drive performance and create value in an array of situations. Straying too far by diversifying into other industries and asset classes can dilute the value of the manager’s skill. Top managers who stay focused and follow their processes can often generate attractive returns in many market environments. Further, Zack warns that investors should not chase the “hot hand,” or invest in a hedge fund merely because it has performed well recently. Even the best managers must continue to improve, adjusting to the evolving investment landscape, which requires solid operational processes and procedures.
Innovest agrees that, with appropriate research and careful consideration of their advantages and disadvantages, skillful and proven hedge fund managers can play an important role in investment portfolios.