Heard of Hedge Funds? Here’s How Hedging Works
A nomad came across three brothers arguing over their heritage. He stopped by to find out the issue that was concerning them. Their story went as follows:
Their family possessed 17 camels. The father’s will mentioned that half of the camels would go to the eldest son, a third would go to the second son and a ninth to the youngest one.
To divide 17 camels into two halves, they had to either sell a camel and share the money in the proportions mentioned above or kill a camel and share it among them — neither of them being an option as they felt it goes against their deceased father’s wish. Their dilemma was a hard one to resolve.
After some thinking, the nomad suggested adding his camel to the lot and dividing it as per the will. Though initially hesitant, the brothers gave in. Now with a total of 18 camels, they took their proportional shares of 9, 6, 2 camels respectively. The nomad took the remaining camel and went on his journey.
Leverage
Seasoned mathematicians and riddlers are familiar with the above problem. You may ask how is this related to Hedge Funds? I am getting there.
First, let us understand leverage.
Leveraging is a way of scaling up your investment. Let’s take an example — say you have $100k for buying a house. This can go about in two ways — one being you buy a 2 bedroom house costing $100k and pay for it completely. The other being, you take a bank loan of $100k, bringing your total capital to $200k, buy two such homes and rent the other one out. This way the rent finances the loan and you’ve got two homes for yourself.
This is the simplest example of how loans can work in your favour. This is one of the reasons why companies prefer bank loans — they are cheap capital.
Note: Cheap capital indicates the low-interest rate paid on the capital.
It is important to note that leverage works when your expectations turn out to be right. If you can’t rent out your house, or if the interest rate is higher than the rent, leveraging wouldn’t be a wise move in such scenarios.
Hedging
Uncertainty calls for risk. Hedging is about managing that risk.
Markets are priced based on people’s expectations and the thing about expectations is they can change any time. And lord, change do they drastically.
How does one protect their investments in such turbulent markets? Comes in Hedging.
The following example was given by A W Jones to his fund partners in 1961. The reader is expected to understand terms such as long and short. Putting it briefly, a long position is when one buys a stock with the expectation that it will rise. Short-selling is when an investor expects stock price decline, therefore, borrows stocks and sells them on the market to buy them back cheaper.
Say we have two investors equipped with $100k each. Let’s assume their stock-picking skills are good at par and both are bullish about the market.
The first investor puts $80k in the stocks he finds the best (i.e. having a long position) and another $20k in safe bonds (such as government bonds). The second investor borrows $100k, thereby providing himself with a playing capital of $200k. He invests $130k in picking good stocks and uses the remaining $70k for shorting purposes. This way he has diversified enough to assume less net exposure to the market.
If the market goes up, let us assume the market index rises by 20%, and given our investors are good stock pickers, their longs yielded a return of 30%. As the market went up, the shorts performed moderately yielding a return of 10% (these shorted stocks gave positive returns but paid lower than the market average).
Things get even better in the down market. Say the market fell by 20%, and again given our investors are good stock pickers, their stocks took a loss of 10% on the longs. However, the shorts gained 30% in this same down market.
Sebastian Mallaby, the author of More Money Than God, puts it the best —
In sum, the hedged fund does better in a bull market despite the lesser risk it has assumed; and the hedged fund does better in a bear market because of the lesser risk it has assumed.
This provides a basic view of hedging. There are many assumptions here, a major one being good stock pickers. Hedging works the other way around — amplifying losses for back picks.
Modern-day Hedge Funds work on another scale altogether. Companies such as Renaissance Technologies, D E Shaw & Co. use complex algorithms and heavy computation to correct market inefficiencies where ever possible. Sky-high returns and impeccable track records of some of the founders created this air of mystery around Hedge Funds. I felt revisiting the concept of hedging might bring us back to where it all began.
