Hedge Funds .... how?

Hey guys ,

I am currently doing my L1 (goona take it on dec 2014) . the reson i took up the CFA was that it seems to explain on how to analyse an investment and it seems to be a very well recongnised charter .

I am very intruged on how hedge funds work and make money . I do know that they charge 2% for account maintancnce and 20% of the profits they earn . But i would like to know a more detailed explanation on how it works and how do they trade ?

I come from India and most of them dont even know what a “hedge fund” is . And I am looking forward to have one , but i guess its too soon to even dream of having one , without even knowing how exactly they operate .

I would love if anyone who works or has worked or knows how the hedge funds work ? I tried googling it only seems to say that they take huge risks to make thier money .

Curious ,


Hedge Fund is a general term. There are many types and strategies differ. You will learn this in the curriculum. Some funds are levered, some not. Some go long/short, use arbitrage, look for distressed debt, etc. Even within same strategy, methods used may greatly differ.

Yes exactly thats what i am talking about , the stratergies . can you tell me in which levels curriculums can i find them ? and do these stratergies work like this in real life like given in the books ? (i doubt them , book knowledge seems to be kinda crap in real life ).



Lvl 3 has a pretty deep review of the different types

The way I describe hedge fund is that it is a “regulatory category” more than a particular strategy. In exchange for being available to a limited number of (supposedly) sophisticated investors, they are exempt from many regulations about what they can invest in, how they report their AUM, etc… These exemptions mean that there are certain strategies that hedge funds can pursue that are harder for things like mutual funds. However, there are lots of different strategies that can be pursued with these additional instruments, so the mishmash of strategies often confuses people, particularly since some common hedge fund strategies don’t even involve any hedging.

If you want a nice description of hedge funds, Alexander Ineichen’s “Absolute Returns” is a good book, albeit a bit old (he has something newer I haven’t read yet, and I forget the title - Amazon will tell you). If you want a less technical description and analysis, Robert Jaeger’s “All About Hedge Funds, the Easy Way to Get Started” isn’t bad (despite the cheezy title).

(The association of “hedge fund” with hedging is mostly historical… many of the first funds were long-short funds where the short positions hedged out the market risk of the long ones. Since then, many other strategies have evolved, many of which don’t involve hedging).

The regulatory exemptions also mean that hedge fund managers can pay themselves using different rules, and that’s one reason they spring up all over the place… the managers can make a lot more money for themselves on smaller total AUM because they can set up arrangements like 2%/20% or 1%/10%, etc… This - in fact - is why many hedge funds look like traditional mutual funds. They basically are mutual funds that cater to accreditied (i.e. rich) investors so they can charge higher fees. It tends to work better with small-cap funds, where the smaller AUM size means they can take advantage of smaller, less-covered company mispricings without moving the market so much.

All that said, I find it amusing (though not really surprising) that the OP wants to “have a hedge fund” even though they can’t actually say that they know what one is. Yes, I want a money producing machine too, whatever that is…

Do these strategies work in real life? That’s debatable. Most hedge funds lately are getting their butt kicked by buy & hold investors due to the Federal Reserve’s actions.

Every sensible investment strategy has times when it works and times when it doesn’t (though some strategies are net wealth destroyers over time, which is why they aren’t “sensible”).

I was on a call on monday where people were discussing how hedge fund strategies finally seemed to be starting to show some profits again. Someone mused that it was always this way “Investors always leave just as the strategy starts working again.”

I pointed out that the reason the strategy may be working is because enough investors have left and AUM has shrunk. In arbitrage strategies, if everyone is trying to do the arbitrage, then the opportunities disappear and funds are more or less forced to make lower quality bets to show that they are still doing something to justify their fees. But they don’t perform well because there aren’t that many opportunities and they aren’t that juicy, so investors slowly dump them. But when all the money leaves, there are fewer people competing for arbitrage opportunities, so better ones become available.

It isn’t necessarily that investors are too dumb to hold on until the strategy works, it’s that investors have to be shaken out of these strategies before they start working again, and some are better at hanging on than others. And it’s not necessarily just a hedge fund thing. Bubbles often operate this way too.

Well said. Just the reminder i needed . Could you elaborate on the last sentence, regarding bubbles? Are you suggesting the peak, when everyone has jumped on the bandwagon, is similar to when the trading opportunity has been arbitraged away by too many participants?


Aribitrage takes advantage of usually short term price deviations.

Bubbles are the unjustified overvaluation of assets, usually done through a momentum effect. And traded solely based on price trend and not fundamentals, where a fool sells an overvalued asset to a greater fool for a profit, untill the greatest fool loses out holding the asset in question with the bubble popping.

Ah, yeah, thanks for the definitions. Those are hard to find. Don’t miss the sarcasm. I was specifically asking bchad to elaborate on his bubble comment. I’m interested in how he finds the two are similar. I might learn somethng. But, yeah, again, thanks for the cut and paste definitions. Adds quite a bit.

Well if you actually understood the concepts of the ‘cut and paste’ definition, then it would be clear what bchad tried to explain.

I’d try to make it more simple in that context, but you seem too thick for the effort.

Yeah, my thickness is evidenced by my difficulty with all things cfa and finance related. Definitely on the slow side. I’m impressed that you know exactly what bchad was implying. I’d prefer to stay open that he may be adding something in a way that I’m not familiar, rather than making an inference that may cause me to miss an important subtlety of his thought process. I’m much more interested in what somebody may be able to add, rather than rote regurgitation of a curriculum in which charterholders are familiar. Thanks for playing.

[Sorry for the long post, it took me a while to figure out how to describe the dynamic I was thinking about with respect to bubbles and momentum]

MrSmart is right in that the process I described is more clearly at work in arbitrage strategies.

My comments on bubbles was less of a definitive statment and more of a comment that a similar kind of process may work in trend following strategies and bubble markets: when strategies stop working, it doesn’t mean the strategy is innately bad, it may just be that investors have to be shaken out of the strategy before it starts working again.

For example, value investing is not a genuine arbitrage strategy, because there is no way to lock in a profit, but it has a similar quality in that there are only so many value opportunities out there at any one time and the more people who look for them the fewer there are and lower quality too. Value may seem to underperform in those environments, when the ratio of seekers to opportunities is high, and so in order to perform better, people need to leave that strategy, or seek less aggressively, both of which tends to result in worse performance over the short term. Growth investment strategies may well operate the same way, just likely out of phase.

In momentum strategies and potentially the market bubbles driven by them, the limiting factor isn’t the number of opportunities available (as in arbitrage and value investing), but deployable capital and/or available credit. In trend following, momentum attracts investors which pushes up prices which attracts investors (and the reverse in a decline, though those are more rapid). It’s the supply of capital and credit that runs out, and shakes investors out. Because capital has run out, this is what makes forced selling so prominent in bubble collapses, and why they may be much more damaging than something like merger arbitrage no longer performing well. People are selling to cover losses elsewhere when bubbles pop, so values can drop a lot before anyone finds a bid, whereas when arbitrage strategies underperform, people leave because they think they see better opportunities elsewhere, that makes the underperformance more gentle on markets as a whole.

(Arbitrage strategies that are very sensitive to credit may also have dramatic downturns, if everyone is forced to sell because of increased borrowing costs - and this can result in the unpleasant aspect of discovering that your longs have declined and your shorts have gone up - so don’t be too surprised if a nice long-short balanced portfolio turns to crap in a bubble or a credit crunch, either)

It still begs the question of whether one is better served by a dollar-cost-averaging + buy-and-hold approach or whether it makes sense to hold on while a shaking out is happening. It does seem that if you are going to panic, then you should panic early. If you haven’t panicked early, you may be better served by sticking to your strategy despite pain. It does seem that people routinely underestimate their ability to withstand pain, though, which is why people say they are sticking in for the long term, but so many bail out just as things seem to get better - the worst possible time.

But it’s not necessarily that people are so dumb as to sell because it is the worst possible time. Rather, it becomes the “wost possible time” because that’s when the largest number of people can no longer stand the pain and decide to bail out. Sure, it looks dumb in retrospect, but “worst possible time” is almost by definition the time that the largest number of people are selling. (That’s the insight you may be looking for)

One of my mentors in the macro field once told me: “Sometimes I just ask myself ‘what’s the thing that could happen that will completely screw the largest number of people,’ and I decide that that’s the thing that’s going to happen.” I don’t think it always works out that way, but I think it is a sensible question to ask yourself from time to time, and consider as one of your scenarios. This is a more and more sensible question to ask as the world becomes more unequal, because it will be a strategy of the haves to shake the tree and collect what belongs to everyone else once they can no longer hold on.

I think we’ve been in an environment that is bad for trend-following in general (certainly trend following strategies haven’t done well recently). In my mind what happens is if the recovery seems to be happening quickly, the Fed steps on the brakes to fight inflation. If the economy looks weak, the Fed pumps more cash into it. Depending on how quickly the fed acts on things, this can be bad for trend-followers because it leads to whipsaw action. We haven’t seen it in stocks, but it does seem to be the case in commodities and until recently in real estate.

That’s awesome. Thanks for the response. That’s exactly what I was looking for. The link in the psychology of the participants. Reminds me of modeling dynamic systems. One type of system(say hydraulic) can be modeled as any other system(say electrical).

Is it just me, or does MrSmart come off as the most arrogent and narcissistic personality on this forum?

^ We need a variety of characters on this forum.

I think it’s also important to point out that most investors have the wrong perception on what hedge funds, and alternative investments in general, are designed to do. While there are strategies that should perform well during bull markets, the best use of alternative investments in an asset allocation is diversification of risk without sacrificing a large amount of return potential. Allocating 20% of a clients portfolio to alternatives can drastically lower volatility without lowering the expected rate of return by too much.

Hedge funds in particular have the old saying of ‘2/3 up, 1/3 down’, which is to say that the industry as a whole should capture 2/3 of the upside in a bull market while only falling 1/3 as far during bear markets. Hedge funds, as tracked by the BarclayHedge, LTD. Hedge Fund Index, have significantly underperformed over the past 5 years, yet outperformed the S&P over the last 10 years. Judging a hedge fund by it’s underperformance in bull markets may be a poor analysis, depending on the particular strategy. Equity market neutral funds, for example, will never be able to compete with the S&P during periods like 2013.

Agree 100% that alt strategies are hurt when too much money chases limited arbitrage opportunities. I’d be very interested to see that quantified somehow, though I don’t know if that could even be possible.