WCM Educational Recap #6: Introduction to Hedge Funds & Asset Management
Recapped by Annie Lai
Hedge Funds & Asset Management
This week we went over the world of hedge funds and asset management, including how they operate, careers in the space, and some strategies used by these firms.
What are Hedge Funds?
Hedge funds are investment pools contributed by partners (investors) and operated by managers. They also form one of the largest categories of alternative investments as measured by assets under management (AUM) and employ different strategies to earn active returns for their investors.
Example of a Hedge:
A “hedge” is an investment that is intended to reduce exposure and risk in a related security
For example, Emily has an expensive painting she plans to sell down the line. She wants to protect the painting (asset) from the risk of getting stolen — so she will hedge this risk by taking on artwork insurance. Although hedging will lower her overall profits (due to insurance payments), it greatly reduces potential risk.
Hedge Funds: Key Tasks
Important responsibilities for hedge funds include:
- Design: Creating proprietary research tools
- Valuations: Financial & industry analysis
- Due Diligence: Studying business & potential opportunities
- Portfolio Management: Managing investments and updating positions
Common Strategies that Hedge Funds Employ
Equities:
For equities, you hedge against declines in equity markets by investing in stocks/indices and shorting them simultaneously. You can either have a long position, where you are betting on the stock to perform well or a short position where you are betting on the stock to perform poorly.
Relative Value Arbitrage is where you buy securities that are expected to appreciate while also selling short of similar securities expected to depreciate
Macro strategies are where you maintain long and short positions in stocks, bonds, futures, options and sometimes currencies. This strategy hopes to maximize on changes in macroeconomic variables and has highly liquid holdings.
Distressed strategies occur when you invest in securities of a firm that has declared bankruptcy or likely to do so. You may help companies turn around by buying some of their securities and this can also involve loan payouts or restructuring.
A Closer Look at Long & Short Equities:
Indicators of Long Positions:
Many long investments start with choosing a company with:
- Competitive advantage
- Superior management
- Market leadership
- Attractive industry dynamics
Indicators of this might include:
- Appealing valuations and bottoms-up analysis
- Leadership through industry obstacles
- Superior margins/cash flows
Indicators of Short Positions:
- Mature business models in decline or major industry structural changes that make company obsolete
- Industries that suffer slowdowns in growth based on business cycle
- A company deteriorates based on increasing competition
- A company has too much debt and not enough cash flow
Hedge Funds and Their Investment Process:
Idea generation is where the investment team sources ideas from meetings with companies and competitors and fundamental analysis of company value is conducted.
Afterwards, position review occurs. This is where the portfolio manager evaluates ideas, and challenges models, leading to further due diligence being conducted on challenges.
Lastly during implementation and management, the position is analyzed to incorporate fund liquidity, macro views, and volatility of underlying names.
Hedge Funds as A Career Pathway:
A career path of at a hedge fund typically progresses with a start in investment banking (IB) or equity research (for 1–3 years), then a move into the hedge fund space is made. The most junior role is typically that of an analyst (for 2–3 years), then senior analyst (for 1–3 years) and finally portfolio manager.
Hedge Funds work when the markets open and close (9:30 am EST — 4 pm EST) and they receive “2 and 20” compensation, which is 2% of assets (management fee) and 20% of incentive fee of profits every year.
Key Roles & Responsibilities:
IB & Equity Research
- Fundamental research, building models, and creating research tools
- Listening to calls and reading equity research
Analyst
- Becoming value-add and developing networks
- More independent investment analysis
Senior Analyst
- Generate their own investment ideas and add value to other sectors
Pros vs Cons of Working at a Hedge Fund:
Pros
- Idea generation and specialized work
- Work alongside very intelligent individuals
- High pay and compensation
Cons
- Performance-driven pressure
- Difficulty moving up the ladder
- Lack of job security
Character Qualities for Working at a Hedge Fund:
- Skepticism and understanding of risk
- Strong and genuine passion for investing
- Understanding of instruments and markets
- Knowledge of portfolio construction
Hedge Funds vs Mutual Funds vs Index Funds:
A fund is a pool of money where a fund manager can invest it in different stocks, bonds, or other investments to produce gains for its investors
Hedge Funds:
- Private investments which employ different strategies including long-short equity, marketing neutral and volatility arbitrage
- Most expensive fund
- Only available to accredited investors with a certain net worth
- Risky and aggressive to earn larger returns of investors
- Limited transparency and regulations
Mutual Funds
- Regulated investment products offered to the public and available for daily trading, typically following a range of investing strategies
- Less expensive than hedge funds
- No investor requirements
- Less volatile than hedge funds
- Harder to make money when the market is down due to high regulations
Index Funds
- A passively managed fund which grows consistently with the overall growth of a chosen market index
- Least expensive fund option
- No investor requirements
- Matches the return of a benchmark stock index like the S&P 500
- Passive management style which is automated
