Citadel LLC reported a $16 billion profit in 2022, the largest ever for a hedge fund. This represented a 38.1% return for investors, but what’s even more impressive is how the industry fared up in 2022; hedge funds on average fell 4.2%, losing almost $125 billion in assets. In a world of runaway inflation, monetary tightening, and geopolitical turmoil, profiting as a hedge fund is no small feat.
As much of a riddle Citadel’s prosperity may be, there is a larger, more fundamental one to be addressed: what exactly is a hedge fund?
They are pools of investments managed by professional fund managers. The stereotype is that hedge funds are particularly risk-prone, and this is somewhat accurate. Hedge funds are known for using all sorts of investing strategies such as leveraging (using borrowed money to invest) or short selling (betting against an asset) to generate larger gains.
But the real difference between hedge funds and, say, mutual funds, which are categorized by the kinds of assets they invest in (i.e. stocks, bonds, etc), lies in their regulation. Hedge funds can generally accept money only from wealthy individuals and institutional investors, as they’ll be able to handle the potential risk that hedge funds get themselves into. As such, hedge funds face comparatively little regulation from the Securities and Exchange Commission.
This is also why you won’t see advertisements for hedge funds in financial magazines; they aren’t allowed to collect money from the general public.
Additionally, hedge fund investors typically can’t redeem their money anytime they please; there are limited opportunities to do so. This distinguishes hedge funds from closed-end funds, wherein the shares aren’t redeemable. Hedge funds, being open-end funds, allow investors to “trade back” their money at certain windows of opportunity.
The incentives are also different. Mutual fund managers receive a percentage of the assets under management; the more assets invested in the fund, the better. Hedge fund managers, on the other hand, earn a percentage of the profits. Hence, hedge funds typically charge a 2% management fee and 20% performance fee, whereas mutual funds tend to charge no more than 1.5%.
A brief history
The Roaring Twenties was marked by significant economic prosperity and cultural development across the Western world. The boom gave birth to several investment vehicles, the most famous being the Graham-Newman Partnership. Benjamin Graham wanted to test and fine-tune his value investing philosophy (discussed in our stock market forecasting article), and saw plenty of success. It’s broadly thought of as the first hedge fund.
Hedge funds became more institutionalized in the 1950s, with Australian investor Alfred Winslow Jones creating the first hedge fund strategy that involved “hedging” against the market. By purchasing and shorting assets that he expected to generate above and below-market returns, respectively, he created a market-neutral portfolio. Jones also introduced 2 key components that define modern hedge funds. First, the practice of leveraging investments to enhance returns. Second, charging the now-standard 2% + 20% performance fee.
Fast-forward to the 1980-90s, and the industry expanded like never before. Hedge funds turned to a wider array of complicated strategies to gain an edge on the rapidly-growing competition. It’s no fluke that the rise in the number of hedge funds roughly coincided with the rise in financial complexity. Managers had to come up with more creative methods to amplify returns and soften risks.
This trend continued until the 2008 financial crisis, when hedge funds’ assets under management sharply declined. Investors grew tight-fisted with their money and moved it to the safest assets they could find, very few of which involved hedge funds. Things turned around in 2014, with assets under management rebounding to a total of $2 trillion. Hedge funds managed more than $5 trillion of assets in 2022.
A maze of an industry
It goes without saying that hedge funds are faceless and enigmatic blackboxes to the general public. This is partly because of how intricate the sector is, with the myriad of variations and specialities preventing any layman understanding of it. Still and all, we’re going to attempt to untangle the chaos.
Hedge funds can be broken down according to the type of investment vehicle offered:
Commingled fund: pools capital from multiple investors into one account managed by the fund manager. This is the standard kind of hedge fund
Managed accounts: manages the funds of a single investor. The individual investor still owns the assets being invested, but they’re overseen by a hedge fund manager. This lets the investor customize the portfolio as they see fit
Fund of one: Just like managed accounts, there’s only one investor. The catch is that the fund manager is given control over the portfolio and decides the investment strategy
UCITS: stands for “undertakings for collective investment in transferable securities.” Through EU regulations, these “hedge funds” can be marketed to non-acquitted European investors. They’re characterized by greater corporate transparency as well as tighter regulation with the kinds of investments they can make and how much leverage they can use
Alternative mutual fund: as the name suggests, “40 ACT funds” are technically mutual funds under US law, but they’re allowed to use some hedge fund strategies
This list is by no means exhaustive, as there are several other hedge fund structures, but we’re not going to get into those. Another way to categorize hedge funds is through how they make investment decisions:
Global macro: actively managed funds focusing on political or economic events that could cause broad market swings
Equity: as the name suggests, the stock market. Equity hedge funds look at under or overvalued companies and either buy or short shares accordingly
Relative value: evaluate investment options by comparing prices to related assets. For example, with stocks, relative value hedge funds will compare the stock prices of multiple companies in the same sector and decide from there
Hedge Fund Strategies
So investing-wise, what makes hedge funds different from other actively-managed funds? What do they do that retail investors simply can’t?
One popular method is the long-short equity – taking both “long” (buying a security expecting that it will appreciate) as well as short positions at the same time in order to minimize market exposure. The long positions will profit if the security’s value increases, whereas the short positions (usually in the form of put options: the right, but not the obligation, to sell an asset at a certain price at a certain time) will profit if the security depreciates.
Hedge funds often employ this strategy through 2 stocks in the same industry – short $500 of Apple shares and purchase $1000 of Microsoft shares, for example. Regardless if technology stocks rise or fall, either the short or long position will yield returns. And that difference in positions – the $500 in Apple shorts vs $1000 Microsoft shares – is called net exposure. Expressed as a percentage, this describes the extent of the impact of market fluctuations on the position’s value.
The obvious problem with the long/short approach is the short position, as their losses have no theoretical limit – the stock being betted against can simply keep increasing in value.
Another technique is arbitrage; buying and selling the same assets in different markets in order to profit from tiny differences in the listed price. Ideally there wouldn’t be such discrepancies, but market inefficiencies create these opportunities for savvy investors to exploit.
Volatility arbitrage, for example, involves exploiting differences between the forecasted price volatility of an asset and the implied volatility (how likely the market thinks a security’s price is going to change) of that asset’s options. Again, these differences shouldn’t theoretically exist because an option’s price is supposed to reflect the forecasted price volatility of the underlying asset. But, again, market inefficiencies exist, presenting money-making opportunities.
Above is a graph of the the S&P 500 index value vs the VIX - the “Fear Index.” It represents the expected annualized volatility of the S&P 500. Its price is how much, in percentage terms, the market expects the S&P to fluctuate over the next 30 days. Keep in mind, however, that because it’s annualized, the expected volatility is in the context of a year, not a month. So if the VIX is at 10, then the expected volatility for the next 30 days isn’t 10%, but rather 2.87% (10 x the square root of 30 divided by 365).
The negative correlation between the VIX and the S&P shouldn’t be surprising: when prices are volatile, investors will panic and market prices then decline.
Say an investor thinks a stock option is underpriced because the implied volatility is too low (volatility is positively correlated with an option’s price, since dramatic price movements present money-making opportunities). They could purchase long call options (the right, but not the obligation, to sell an asset at a certain price at a certain time) and also short the underlying stock to profit off its volatility.
Remember, options’ prices are (more or less) reflective of the stock’s expected volatility, so an option’s price being “too low” suggests that the stock’s expected volatility is also too low. In other words, the market doesn’t see the money-making opportunity in that stock, whereas our investor does.
That explanation probably raised more questions than it answered, but recognize that this is just the tip of the iceberg. Volatility arbitrage deserves its own article, as does each of the other arbitrage strategies (yes, you read that right). But if firms like Citadel, Bridgewater Associates, and Renaissance Technologies routinely use these methods, then perhaps that’s why the SEC barely supervises them: imagine having to wrap your head around all this just to enforce some regulations.
Econ IRL
It’s reasonable to assume for a firm’s age to be reflected in their capital: young startups use the latest technology, whereas older establishments may lag behind. Surprisingly, that isn’t necessarily the case. This week’s paper documents this interesting phenomenon after analyzing over 1.5 million transactions and 70,000 machine models.
The authors found that startups purchase a disproportionate share of older capital from older firms, with a firm’s first machine being around 5.2 worlds. What’s more interesting is that as the firm grows older, they start to acquire newer capital; the average machine age by the firm’s 5th year is 3.7 years. One reason could be because in instances where capital is hard to come by, the local supply of used equipment incentivizes start-up entry and hence, newer firms acquiring older capital.
This could explain another of the paper’s findings: young companies that start surrounded by used capital tend to invest in more and in a greater variety of machinery later on than firms who didn’t.
‘Till next time,
SoBasically