Hedge funds are renowned for making explosive returns for their investors, so perhaps we should learn from them.
Watch The Video To Find Out What A Hedge Fund Does
Five Common Traits Of Hedge Funds
For years, hedge funds have retained a certain mystery about them and the way they operate. As there are literally thousands of hedge funds out there, it’s impossible to uncover and understand each and every hedge fund’s strategy. However, there are some things that are common to pretty much every hedge fund.
1. Cashflow Is King
Whilst many investors track indicators like earnings per share, hedge funds keep a very close eye on cashflow. Cashflow is important because it tells you if the company has generated a large sum from investments, or if it has taken in money from third parties, as well as how it’s performing.
The cashflow statement can also alert an investor if the company is having difficulty paying its bills. It provides evidence as to how much cash it might have on hand to repurchase shares, pay down debt or conduct other value enhancing transactions.
Some hedge funds place a heavy emphasis on arbitrage situations. That’s the simultaneous purchase and sale of an asset in order to profit from the difference in the price, generating instant cash. Arbitrage exists as a result of market inefficiencies, exploiting price differences on identical of similar financial instruments, on different markets or in different forms. Some focus on special situations. Others aim to be market neutral to profit in any environment, or employ complicated dual long/short investment strategies.
2. Trade With Many Brokers
To squeeze out every possible gain, hedge funds tend to run trades through many brokers, depending on which one offers the best commission, the best execution or other services to help the hedge fund.
Hedge funds may purchase a security on one exchange and sell it on another, if it means a slightly larger gain. They look for mispricings within the market. For example, if a security’s price on the New York Stock Exchange is trading out of sync with its corresponding futures contract on Chicago’s exchange, a trader could simultaneously sell (short) the more expensive of the two and buy the other, profiting on the difference.
Because they play with vast sums of money, making a couple of percentage points over a year can yield significant profit.
3. Use Leverage and Derivatives
Hedge funds typically use leverage to magnify their returns. They may purchase securities on margin, effectively borrowing money to complete the trade. They obtain loans and open lines of credit to fund even more purchases. Providing they can make a big enough return to cover interest costs and commission, it can be a highly effective strategy. The downside is that when the market moves against the hedge fund, the result can be devastating.
Hedge funds may purchase options, which often trade for a fraction of the share price. They may also use futures or forward contracts as a means of enhancing returns and mitigating risk. This willingness to leverage their positions with derivatives and take risks is what enables hedge funds to differentiate themselves from mutual funds and the average retail investor. As a result, hedge funds tend to be reserved for high net worth and sophisticated investors, who are considered fully aware of, and are better placed to absorb the risks involved.
4. Unique Knowledge From Good Sources
Rather than relying on secondhand information from brokers, hedge funds often have the ability and the willingness to get to know a company really well, including all its key personnel. Because hedge funds aren’t usually beholden to the company or the investment, and because the fund manager’s profits are intimately tied to performance, their investment decisions are typically driven solely to make money for their investors.
Hedge funds aren’t restricted by benchmark limitations or diversification rules. As result, they can spend more time and effort per position, aligning their interest to make maximum profit for themselves and the investors who they represent.
5. Know When To Sell
Whilst many retail investors buy a stock to watch its price rise, few investors consider their exit strategy, or at what price and under what conditions they will sell. Hedge funds are very different. They often purchase stock with the intention of taking advantage of a particular event, such as the sale of an asset, a series of positive earnings releases, news of an acquisition or some other catalyst.
Once the event transpires, they’re disciplined enough to bank their profits and move on to the next opportunity. This exit strategy can amplify returns and help mitigate losses.
Hedge Fund Rich List
Anyone Can Invest Like A Hedge Fund
Although often mysterious, hedge funds use tactics and strategies available to everyone. They do, however, have the lead when it comes to industry contacts, leveraging investable assets and the ability to access pricing and trade information. And that’s often the reason why a hedge fund has the edge over the rest of us.
Please Share This
If you’ve found this article interesting, there’s a simple way you can repay me. All you have to do is send a link to this article to your friends using the buttons below. You’ll be helping me out, and your friends might appreciate it too, so please do it now. Thanks.
If you enjoyed this article, get email updates (it's free)
As SIPPclub neither advises on, nor arranges, nor recommends specific investments or strategies, we're unable to say whether a SIPP or SSAS or any investment within it is right for you. Ultimately, it’s your money and your decision, and you should only proceed once you're satisfied you've undertaken sufficient due diligence. If you need advice, you should speak to your trusted adviser, or you could find a local adviser from Unbiased.co.uk. Alternatively, we'd be pleased to introduce to a suitably qualified independent financial adviser.
Please read our full Terms which includes criteria for SIPPclub membership.