Welcome back! Last week, we talked about what makes a hedge fund and went through the specific requirements in order for a fund to be considered a hedge fund and if you would like to review part 1 of this series you can do that here. Now that we know what a hedge fund is let’s talk about why it is!
A hedge fund is a vehicle that can invest in financial assets in an attempt to produce a return for its investors. So, what makes hedge funds special? Well, hedge funds are largely unregulated by the Securities and Exchange Commission or SEC. This is why the third-party administrator is essential to ensure that the fund managers are doing their job properly.
This low level of regulation also has a couple of ramifications. The first thing you need to know is that this is what gives hedge funds their name: they are allowed to “hedge” or protect their market positions. Because of their free reign to invest in pretty much anything that lets them achieve their mandate, hedge funds are allowed to protect their investments by hedging any downside risks they may occur. Let’s look at an example to see how this works.
Let’s say that I run Burgess Capital Management, a New York based hedge fund. And let’s say that I think the Canadian banking sector looks like an attractive investment, especially compared to the European banking sector. So I find a Canadian bank to buy shares in. At the same time, I want to find a weak European bank to short. By betting on the Canadian bank’s stock to go up in value and the European bank’s stock to go down in value, I’m essentially hedging out market risk and sector risk.
But, I’m still exposed to currency risk; because even if the Canadian bank’s stock goes up in value and the European bank’s stock goes down in value, I can still lose money if the Euro goes up in value against the Canadian dollar. In order to hedge that risk, I can take the opposite position in currencies and go long Euros and short the Canadian dollar. In this way, I’ve hedged out market risk, sector risk, and currency risk. Now I’m only exposed to the unique risks of each bank’s stock, which is exactly the risk that I want to be exposed to.
So that’s an example of a position that a hedge fund could take. Instead of just buying the Canadian bank’s stock and taking on nearly unlimited risk, the fund can eliminate or “hedge” the market and sector risk by shorting the European bank’s stock. And the fund can also eliminate the risk that a change in currency exchange rates could wipe out my position by putting on the opposite currency trade to the one the fund is exposed to, in this case, long Euro and short Canadian dollar. This is what hedge funds do all day long. They look for opportunities in any asset class, whether it’s stocks, bonds, currencies, or commodities, and they protect against losses by hedging their downside.
I’m sure that example was probably a lot to take in, so if you have any questions about how that works, feel free to send them to me at firstname.lastname@example.org. We’ll leave it there for the day to give you time to digest all this. Next week, I’ll be back with the third and final part about who can invest in a hedge fund and what the costs are. See you then!