Hedge Funds Made Easy

What is a hedge fund?  You’ve probably heard of them, but if you’re like most people, you probably don’t know what they are.  A Hedge Fund is a managed portfolio much like a mutual fund, but more complex.  However, there are some differences.  They have more latitude with how they invest the money within the fund.

Many hedge funds us sophisticated derivative techniques.  They might be long oriented at times and short oriented at other times.  You must be an accredited investor to invest in these funds and you will pay out the nose because they come with enormous performance fees for the manager.  Some of the managers are worth it, but the vast majority of hedge funds do no better than your average mutual fund.

We bring this up not to recommend hedge funds, but to introduce the concept of a fund or portfolio which is hedged.  To be hedged means that you have different assets that will react in opposite ways given certain economic events.  When you understand this concept, you can combine different assets to hedge your own portfolio.

You can also invest into funds which are hedged in one way or another.  This might be a mutual fund or ETF which invests money into multiple hedge funds, or which simply mimics some of the most popular hedge fund strategies.

This might also mean that you have a fund which utilizes a strategy of going long certain assets while simultaneously going short other assets.  This gives you the added benefit of being “market neutral”.  This means that whether the general market is rising or falling is not important to you because you have a perfectly hedged portfolio where half the assets benefit and half the assets suffer due to this general rise or fall.  The key to your performance is how the particular assets within each class that you have chosen perform.

A simple example of this which you could do on your own would be to buy one stock and sell another in the same industry.  Let’s say that in early 2010 you felt like Exxon Mobil would outperform British Petroleum.  You could buy the same dollar amount of XOM that you sold short of BP.  Can you guess what would have happened over the next several months?

When the BP oil disaster hit, the oil industry as a whole suffered.  That means that most oil stocks went down.  This in and of itself doesn’t really affect you very much though because you own an oil stock and you have sold short another.  So you have very little net change due to this event.

However, you would see considerable change in your portfolio due to the fact that you bought one and sold the other.  In this case, BP went down much further than XOM went down, so you would have been able to exit the BP Short with a large profit and exit XOM with a small loss.  You would have a net gain because of your solid stock picking in the oil sector even though the oil sector as a whole declined.  Of course, if you would have bought BP and sold short XOM, you would not have fared as well (although you still would have been better hedged (protected) then if you simply bought BP.

Another hedge fund concept could be applied by buying one industry and selling short another.  Since both industries are part of the larger stock market universe, they would have some correlation either up or down.  By picking the better industry to hold long and shorting the worse industry, you could hedge your overall market risk.  And of course, there is always the chance that you’ll be wrong, so there should be a solid fundamental reason for your allocation.

Other recent posts in this series have covered Dividend Investing, Financial Company Investing, Shorting Treasury Bonds, and TIPS Investing.

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