How do Hedge Funds Work?

Knowing what a hedge fund is and how it operates is key information for the CSC®, PMT® and WME® exams.

In the securities world, hedge typically means to protect. With that in mind, is a hedge fund a safe investment? In this video, we’ll review the terms speculate and hedge, and then circle back to cover this question, which leads a student down the wrong path. Or does it? Well, let’s find out.

Investing strategies can be implemented either to speculate or to hedge a position. When speculating the investor is trying to make a profit. For example, if an investor were to buy ABC shares for $10 per share with the anticipation that they will increase in value and perhaps pay dividends along the way, the investor is acting as a speculator. Hedging on the other hand is done to protect the position from a negative outcome. As a memory aid, you may be familiar with the saying, “Hedge your bets.” To use the analogy, if you spent $10,000 on an upcoming vacation, but are worried about your health changing, preventing you from taking that vacation, you could hedge against the financial risk of not taking that trip by purchasing travel insurance.

In the investment world, an example of hedging would be an investor who already owns ABC shares that are currently worth $10 and is concerned about the share price declining in the near-term. She may purchase a six-month put option contract, which gives her the option to sell her shares for $10, essentially locking in a potential sale price. Now that we have defined the terms speculate and hedge, let’s circle back and address the trick question I asked you at the top of this video.

If I were teaching this lesson live, I would ask this question, nodding yes the whole time. “In the securities world, hedge typically means to protect. With that mind is a hedge fund a safe investment?” In other words, I would almost set up my students to make a mistake and get it wrong. I tend to get a bunch of students nodding along with me, and it creates a powerful learning opportunity.

If a student gets tricked once, they’re less likely to fall for that trick a second time. And don’t kid yourself. While an exam question is in written format, examiners tend to choose their words very carefully, not to trick you per se, but to make sure students know their stuff before being awarded with a mark. So, the answer to this question is no, not necessarily. From this perspective, the name hedge fund can be a little misleading. So let’s clear it up. Traditional mutual funds, which are made available in the general marketplace to everyday retail investors, are restricted from engaging in certain higher-risk activities, such as shorting a stock, using derivatives to speculate, or employing leveraging strategies. But hedge funds that are sold to only certain types of investors can do all of these things. Hedge funds can be defined as lightly regulated pools of capital.

This in itself adds risk. Where the fund manager has a latitude to invest in almost any situation, investment, or market where he or she sees an opportunity to make a profit, regardless of risk. Of course, to truly understand the risk associated with a hedge fund you would need to analyze the disclosure documents such as the offering memorandum, but the mere fact that they are lightly regulated cannot be overlooked. So why would an investor consider an alternative investment such as a hedge fund? Well, much like how adding equities to a portfolio can help diversify the risk and even enhance the return, for some investors adding an even riskier class of security, referred to as alternative investments, can have the same effect if done effectively. I should point out that mutual funds are expected to earn a positive return relative to the benchmark. For example, if the overall stock market was down 25% in a given year and ABC Mutual Fund only suffered a 5% decline, you’d likely think, “that isn’t too bad, relatively speaking”.

On the other hand, hedge fund managers are expected to earn absolute returns. In other words, a positive return regardless of market conditions. Since the manager faces fewer restrictions and can engage in strategies that essentially bet against the markets, such as a short sale, the hedge fund manager is expected to generate positive returns even if the overall stock market doesn’t. Hedge funds involve greater risk, but also provide greater potential returns for investors and even the hedge fund manager. Since hedge fund managers require great expertise and skill they’re in high demand and are typically paid an incentive fee, which is tied to the returns they are able to achieve.

If you’re taking the Canadian Securities Course, you will learn about various alternative investments, such as hedge funds and the different strategies they employ. As always, be sure to check out our exam preparation tools that will guide you along the way.