Hedge funds are alternative investments that pool investors’ dollars and invest them into various financial instruments. Hedge funds try to generate positive return, regardless of market direction by taking advantage of arbitrage opportunities, using long and short strategies and utilizing options, to name a few. Due to the flexibility of investment strategies that hedge funds are able to engage, they’re considered high risk and available only to accredited investors.
Accredited Investors
An accredited investor is an individual, entity or institution that meets certain income, financial or net assets criteria. In Canada, the exact definition of an accredited investor can be found in section 1.1 of the National Instrument 45-106. There are over 20 situations in where a person might qualify as an accredited investor.
These types of investors are allowed to invest in certain investment instruments that may not be available to an ordinary investor. Accredited investors would be allowed to invest in hedge funds. The most common criteria used are mentioned below.
- Income Criteria
- Your income before taxes has been at least $200,000 or greater in the last two years and you expect to earn the same level of income this year; OR
- You and your spouse have earned at least $300,000 or greater before taxes in the last two years and you expect to maintain the same level of income this year.
- Financial Assets
- You and your spouse have financial assets worth at least $1 million before taxes, net of related liabilities
- Cash and cash equivalents would be considered liquid or financial assets.
- You and your spouse have financial assets worth at least $1 million before taxes, net of related liabilities
- Net Assets
- You and your spouse have net assets of at least $5,000,000
- Fixed and liquid assets would be included to meet this exception.
- You and your spouse have net assets of at least $5,000,000
- Other Criteria
- For a list of other criteria, please refer to the National Instrument 45-106.
Characteristics of Hedge Funds
As hedge funds have more flexibility and freedom to pursue complex investment strategies, they’re often considered riskier than traditional investments. Higher risk means higher returns that accredited investors are willing to accept. Below are common characteristics of hedge funds.
- High Fees
- Hedge funds aim to generate positive return regardless of the market direction. They will use various types of investment strategies to do so and if successful, the fund managers will get compensated in the form of a performance fee. If the hedge fund generates returns above a certain percentage, known as the hurdle rate, it would start charging a performance fee.
- Illiquid
- Hedge funds limit their investors in how often they’re able to withdraw money out. They may have lock up periods that can extend for up to two years. Be aware of any lock up period before investing in a hedge fund.
- Lack of Regulations
- Unlike mutual funds, hedge funds are not regulated to the same extent. A fund manager is not going to disclose the type of investment strategies that they’re pursuing or their top 10 holding. If a hedge fund were to go bankrupt, there is no regulatory body that would provide you with financial relief.
- Lack of Transparency
- Many hedge funds are secretive about their investment operations. They’re not required to report financial performance, disclose their holdings or answer questions to shareholders.
Hedge Fund Strategies
Hedge fund strategies are broad with various risk appetites and investment philosophies. These strategies utilize various investment instruments such debt, equity, commodities, currencies, derivatives, real estate and more! Below we’ll discuss the most common strategies that hedge funds may engage in.
- Global Macro
- Hedge funds that embrace a global macro strategy aim to make their investment decisions based on the political and economic outlook of various countries. This type of strategy would analyze the country’s economy and evaluate various economic trends. Currency traders and interest rate portfolio managers rely heavily on global macro strategies when managing their portfolios.
- Long & Short
- This is one of the most common used strategies and would involve establishing a long and short position in equities while utilizing derivative securities. Funds will tend to use fundamental and quantitative techniques when making investment decision. Typically, a fund will seek to take a long position in undervalued securities and short overvalued securities. Their investments tend to be publicly traded companies with a long-biased outlook.
- Market Neutral
- Market neutral funds aim to generate above market returns with lower risk. They’d typically hedge their bullish stock picks through the usage of options and short their bearish positions. The goal of market neutral funds are to keep low net exposure in comparison to the overall market.
- Merger Arbitrage
- Merger arbitrage funds aim to profit from the merger of two or more publicly traded companies. They aim to take advantage of price discrepancies that might occur before and after the merger. Typically, the company that is getting acquired, their stock price rises and the stock price of the acquiring company, falls.
- Convertible Arbitrage
- Convertible arbitrage aims to take a long position in a company’s convertible securities while at the same time, taking a short position in the company’s common shares. These strategies aim to exploit price inefficiencies between the convertible security and common shares.
- Capital Structure Arbitrage
- Capital structure arbitrage seeks to exploit price inefficiencies between the various security classes issued from the same company. Mispricing opportunities often happen between equity and debt issued securities.
- Fixed Income Arbitrage
- Fixed income strategies aim to exploit inefficiencies in fixed income securities. Typical strategies would include swap-spread arbitrage, yield curve arbitrage and capital structure arbitrage.
- Event Driven Arbitrage
- Event driven strategies seek to exploit pricing opportunities that may arise due to specific corporate events. This includes mergers, takeovers, reorganizations, restructuring, asset sales, spin-offs, bankruptcies and other events that may cause stock price inefficiencies.