SMSFundamentals | Apr 04 2023
SMSFundamentals is an ongoing feature series dedicated to providing SMSF trustees with valuable news, investment ideas and services, in line with SMSF requirements and obligations.
For an introduction and story archive please visit FNArena's SMSFundamentals section on the website.
Hedge Fund Strategies for Investors' Advantage
Hedge funds employ a combination of pooled funds and strategic investment techniques tailored to their investors' risk tolerance and investment principles to generate alpha returns. While the strategies may seem intricate, individual investors can take a page from their playbook to craft their portfolios and take greater ownership over their investment returns.
-Hedge funds employ a combination of strategic measures to generate excess returns
-Various strategies, such as credit, sector-based long/short, global macro, statistical arbitrage, and niche, can assist investors in managing risk and optimising returns
-Metrics such as Beta, Alpha, the Sharpe ratio, and the information ratio can be useful to evaluate a strategy's performance and risk
By Anuj Sharma
Hedge funds and their mechanism
Hedge funds are not solely concerned with hedging market risk. They aim to achieve controlled exposure to a diverse range of non-traditional return streams. Benchmarking is crucial in hedge fund strategies as it provides a point of reference to outperform the market.
Hedge funds utilise three key philosophies to manage risk and optimise returns: diversification through alternative risk and return sources, asymmetry and convexity by seeking upside-oriented returns regardless of market conditions, and quality return that efficiently compensates for risks taken.
Hedge funds are often distinguished by their top-level investment strategies, such as equity, relative value, event-driven, macro, credit, niche, or alternative risk premia.
Hedge fund strategies and their performance
Credit hedge funds typically focus on investing in higher-yielding, non-investment-grade securities such as corporate or sovereign debt with a long-bias approach.
Some funds may adopt a balanced long/short approach, with short positions that can either be outright or related to the same capital structures.
The core objective of these strategies is to generate returns from coupon income and capital appreciation, which result from spread tightening. The key lies in identifying the right credit market opportunities and carefully selecting credit events that can lead to higher returns.
For instance, investing in Brazil's 10-year government bonds with a yield of 13.19% (as of March 9, 2023) could provide investors with a potentially higher stream of income over a decade. And if the country's economic outlook improves, it could result in a tightening of spreads and potential capital appreciation, leading to a favorable outcome for the investors.
The strategy involves investing in specific sectors, both on the long and short sides of the market. The focus is on certain sectors such as technology, healthcare, energy, financial services, or industrials, aiming to identify market inefficiencies and generate profits.
Investors may prefer value or growth investment themes and use technical analysis, market flows, and dynamics to optimise their investment decisions.
For instance, if a long-biased investor is considering the resource-rich Australian economy and historical trends in sector equities, In that case, they may choose to go long on ASX 200 Materials (XMJ) through sector ETFs.
The strategy involves investing in various financial instruments such as currencies, bonds, equities, and commodities based on qualitative and fundamental judgments.
Investment decisions are typically based on the investor's views of the global economy, inflation, government policies, interest rates, and geopolitical factors. Investors should also consider the relative valuations of securities within or between asset classes when making investment decisions.
The approach is usually more general and does not focus on specific areas. It takes a broader view of the investment landscape and considers various factors that may impact global markets. For instance, to implement the global macro strategy, an investor may long the US dollar index (DXY), the Commodity index (CRB), and the ASX200.
Statistical arbitrage involves analysing market data like prices, correlation, and volatility to identify patterns that can help predict future stock returns over a short time frame.
These strategies typically use mean reversion, momentum, and event-driven signals to take advantage of imbalances in supply and demand and trends in price movements.
It also uses additional information like analyst earnings estimates or news flow to make investment decisions. Statistical arbitrage-based investments generally have a low beta, are market-neutral, and have a low correlation with markets over time due to their high-frequency trading nature.
An example could be the direct negative correlation between airline stocks and crude oil prices. The strategy can be based on a benchmark airline and an energy index, and its performance can be compared with market returns.
These strategies in hedge funds involve investing in specific, small market niches. These niches can include high-dividend yield, low or high volatility, upside or downside capture, cryptocurrency, real estate, solar, or other unique investment opportunities often overlooked by traditional investors. Investors can implement this strategy through a factor-based ETF.
Metrics for performance analysis
When it comes to analysing fund performance, there are four key metrics that investors need to keep in mind: Beta, Alpha, Sharpe ratio, and Information ratio. These metrics can help investors evaluate a particular strategy's performance and risk.
Beta (β) is a measure of an asset's or portfolio's risk compared to the market's risk.
For example, an asset with a beta of 1 has the same risk profile as the market. To achieve a desired beta level, investors can adjust their portfolio composition by investing in the market and/or risk-free assets. If an investor wants a beta of 1.3, they could invest 100% of their capital in the market and borrow an additional 30% to invest in it too. It would result in a risk level of 30% higher than the market.
Alpha (α) measures an asset's or portfolio's excess return relative to its expected return based on its level of risk (beta).
For example, if an investment has a return of 12% with a beta of 1 and the market returns 8%, the Alpha would be 4%, i.e., [12% – (1 x 8%)]. Positive Alpha indicates the investment has outperformed the market, while negative Alpha indicates underperformance.
The Sharpe ratio helps investors compare the performance of different assets or portfolios based on their risk levels. It measures the return percentage per unit of risk.
The Sharpe ratio formula subtracts the risk-free rate of return from the asset's return and then divides the result by the standard deviation.
For example, asset A returns 12% with a standard deviation of 5%, and asset B returns 16% with a standard deviation of 20%. If the risk-free rate of return is 2%, the Sharpe ratio of asset A would be 2, i.e., [(0.12 – 0.02)/0.05], and the Sharpe ratio of asset B would be 0.70, i.e., [(0.16 – 0.02)/0.2]. In this case, asset A would be the better-performing asset because it offers a higher return per unit of risk.
The Information ratio measures the excess return of an investment divided by its Alpha. It helps determine if the risk of outperforming the market is worth it. For example, if the information ratio is high, the strategies are more likely to pay off, but if it's low, they may not be worth the added risk.
To conclude, these strategies and metrics only represent a speck of hedge funds' vast array of strategies.
Using strong logic and performance metrics, investors can gain a unique perspective on fund performance and understand how a strategy can outperform its benchmark while reducing the associated risk.
Exploring the techniques and mechanisms of hedge funds can help investors build a strong foundation for wealth creation.
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
FNArena is proud about its track record and past achievements: Ten Years On