There have been many attempts to define hedge funds, and most definitions differ in one way or another. However, the hallmark of hedge funds is the pursuit of “absolute” return - that is the quest to generate a positive return regardless of whether equity or fixed income markets are rising or falling.
This is the critical difference between hedge funds and traditional investment funds. While hedge funds seek positivereturns through all market environments, traditional “long only” investment funds typically aim to outperform a benchmark index. Even if asset prices fall, traditional fund managers continue to focus on beating a declining benchmark.
The pursuit of “absolute” performance is highly dependent on the skill of the investment manager. Many hedge fund managers seek to exploit market inefficiencies with identifiable and understandable causes and origins. They may take advantage of pricing anomalies between related securities, engage in “momentum” investing to capture market trends, or utilize their knowledge of markets and industries to capture opportunities that arise from special situations.
Hedge fund managers are largely unencumbered by the sorts of regulatory and methodological restrictions that characterize traditional investment fund managers. They typically have freedom to invest in a range of assets and instruments employing a variety of styles and investment techniques in diverse markets. The ability to use derivatives, arbitrage techniques and, importantly, short selling (i.e. selling assets that one does not own in the expectation of buying them back at a lower price) affords hedge fund managers greater possibilities to generate growth in falling, rising and volatile markets.
The use of leverage is often cited as a defining feature of hedge funds, although this can be overstated. Leverage tends to be used to varying degrees by a variety of hedge fund managers to transform relatively small price movements into more sizeable profits (or losses). Managers of macro and fixed income arbitrage funds are generally known to use more leverage than managers of other styles, such as equity hedge, which is now the single largest category within the hedge fund industry.
If you would like to learn more about alternative investment strategies, AIMA Canada has issued a series of strategy overviews which can be accessed below, or through the AIMA Canada website at www.aima-canada.org.
AIMA Canada, the Canadian chapter of the Alternative Investment Management Association (AIMA), was formed in March 2003 to act as the voice of the alternative investment industry in Canada.
