Not long ago, hedge fund managers were the maverick outsiders of the financial services world. Filled with ambitious former traders from investment banks and fuelled by money from private investors, they were embodiment of the Wild(er) West. These days, hedge funds are much (much) more tame – although the principle behind their daily activities remains much the same.
The term, ‘hedge fund’, refers to the fact that they try to ‘hedge’ their bets. Hedge funds try to ensure that they can make good returns in any market. And they seek to make money by investing in things that are falling in price as well as things that are rising. So, how do they make money in a falling market? By ‘short selling.’
Short selling, or ‘going short’ is a bit like "borrowing something from your friend and then selling it into the market,” says David Hesketh, an ex-Merrill Lynch trader and COO of trader profiling company Financial Skills. “If you’re lucky, the price will drop before you have to buy the asset back and return it to your friend. In this way, you benefit from a fall in prices.”
By using short selling and other techniques to hedge their investments, hedge funds aim to generate super-charged returns for their investors. Traditional ‘long-only’ funds (funds which only ‘go long’ or invest in products whose prices they expect to rise) rarely achieve returns of more than 10% when investing in ‘safe’ products like European equities, but top performing hedge funds can achieve returns of 47% in just ten months.
Given that hedge funds charge investors a 2% management fee (2% of the funds they invest) and a 20% performance fee (20% of the profits they earn), this can make working for a successful hedge fund very lucrative indeed. "In a hedge fund you eat what you kill so you are very dependent on investment performance so everything is geared towards improving returns," says Lex Van Dam, a former Goldman Sachs trader who now manages a hedge fund and helps graduates into finance careers.
If you’re interested in a hedge fund career, it helps to know which kind of hedge fund you want to work for. Hedge funds pursue ‘strategies’ and these are distinct. Some of the main hedge fund strategies are:
Long/short: Long/short hedge fund managers go long some of the time. And they go short some of the time. They go long when they expect the price of a product to rise. And they go short when they expect the price of a product to fall.
Global macro: Global macro funds can go either long or short. They invest to benefit from global macroeconomic trends
Arbitrage: Arbitrage-focused hedge funds seek to make the most of price differentials between related securities products. At their simplest, for example, so-called ‘statistical arbitrage’ (Stat Arb) funds put stocks into related pairs. If one pair does well and outperforms the other, it will be sold short (in the expectation that its price will then fall again). The underperforming stock will be bought (in the expectation that its price will rise to meet its pair). Arbitrage funds are often quantitative – they use complicated computer programs to determine what to buy and sell.
Event driven: Event driven hedge funds try to profit from one-off events. For example, when one company decides to buy another, it will usually pay more than the current price for the shares and event driven funds will seek to benefit from this.
Hedge funds are also differentiated by the products they invest in. Hence you'll find credit hedge funds (investing in credit), distressed hedge funds (investing in credit which might never be repaid), emerging markets hedge funds (investing in emerging markets), and so on...
Before you decide hedge funds are the financial services sector for you, be warned: they're not what they use to be! As hedge funds have got bigger, they've become increasingly like banks. Instead of being the Wild West of the financial services industry, they're now the tame middle. The top hedge funds have billions and billions under management - much of it from the pension funds and other institutional investors that like nice safe returns instead of risky mavericks.