From the outside, hedge funds can seem opaque, secretive, and difficult to find any good information on. Private equity firms and investment banks are typically more outward-facing and focus more on public relations than their hedge fund counterparts. However, coming from a hedge fund insider myself, the basics of hedge funds are quite simple and easy to understand if you have the right information. In this iteration of Demystifying Hedge Funds, I walk through the basics of long-short investing, single manager vs. multimanager hedge funds, and the research and diligence processes hedge funds employ to drive returns.
A long-short hedge fund is a type of investment fund that uses the strategy of simultaneously buying (long) and selling (short) assets in the market. The fund manager takes a long position in assets that they believe will increase in value and a short position in other stocks that they believe will decrease in value.
For example, in the long-short equity strategy, the fund manager will borrow shares of a stock they believe will decrease in value and sell them on the market, with the expectation of buying the shares back at a lower price and returning them to the lender. On the other hand, they will take a long position in a stock they believe will increase in value, with the expectation of selling it at a higher price in the future.
The goal of the long-short equity hedge fund is to achieve positive returns regardless of whether the overall market is going up or down. The fund manager can profit from both upward and downward movements in the market, as long as they have accurately identified which stocks will increase or decrease in value. This strategy can also help reduce overall portfolio risk because the fund is not entirely reliant on market movements. Instead, it can generate profits by focusing on specific companies and their financial performance relative to the overall market. The ultimate goal of a long-short hedge fund is not to necessarily beat the market every year, but to generate better risk-adjusted returns than the overall market.
Single Manager vs. Multi Manager Hedge Funds
The main difference between a single manager hedge fund and a multi manager hedge fund is the number of fund managers (portfolio managers, PMs) responsible for making investment decisions and managing the fund’s portfolio.
A single manager hedge fund is managed by a single portfolio manager (or team) who makes all the investment decisions for the fund. They are responsible for selecting which assets to invest in, the amount of capital to allocate to each asset, the risk management of the fund, and the timing of trades. Some notable single manager funds include Tiger Global, Lone Pine Capital, and Third Point Capital. These funds are often referred to as “Tiger Cubs,” as Tiger Management, founded by Julian Robertson, was one of the first hedge funds to employ a long-short equity hedge fund strategy. After Tiger Management closed, many of its employees went on to establish their own hedge funds.
On the other hand, a multimanager hedge fund is managed by a team of portfolio managers, each responsible for managing a portion of the fund’s assets. Each portfolio manager is given a sum of capital and is typically in charge of their own strategy. Assets can be split among several investment strategies or asset classes, including equities, credit, systematic trading, quant, etc. The performance of each individual team or portfolio manager is typically not dependent on the performance of other teams. While it depends on the fund, multimanager tend to have more stringent risk controls on their teams than single managers, not letting their portfolio managers’ assets swing too much in one direction. Some notable multimanager hedge funds include Citadel, Point72, Millennium Management, and ExodusPoint.
The benefits of a single manager hedge fund include a clear and consistent investment strategy and the ability to take bigger bets and take on more risk to drive greater returns. However, with higher potential returns comes more risk. If a single manager is okay with the risk they are taking, they can weather more market volatility in the hope of realizing greater returns down the road.
In contrast, a multimanager hedge fund can benefit from the expertise and returns of multiple investment managers, each with their own area of specialization. By diversifying the portfolio across multiple strategies and managers, the fund can potentially reduce risk. Additionally, when one asset class or strategy is struggling, the others can pick up the slack to drive greater returns each year. For example, equities could have a negative return in a bear market, but quantitative or macro strategies can pick up the slack.
Ultimately, the choice between a single manager hedge fund and a multi manager hedge fund depends on the investor’s or employee’s preferences and risk appetite.
Research, Diligence, and Data Science
Hedge funds typically operate in the public information domain, investing and trading in the public debt, stocks, and assets of companies. This is different than for private equity firms, which primarily operate in private markets. Private equity and debt firms have access to non-public information about the companies they are looking to invest in through NDAs and the deal process. Thus, private investment funds can see all of the information about a potential investment, whether it is public or not.
Hedge funds, however, can only use the publicly available information provided to them by the company and the market. For individual companies, this information includes public SEC filings like 10-Ks and 10-Qs, earnings calls, and management meetings. For market information, this can include equity research, paid third-party research firms, and data. Hedge funds will spend their time analyzing these public filings and research reports to come to their view on investments. Rarely do hedge funds have an information edge over their competitors, given how widely financial reports and data are distributed. Where hedge funds differentiate themselves from others is in their analysis of that data, including their financial models, industry expert networks, and data science teams.
Data science teams have become increasingly important at hedge funds as the amount of data produced has exploded. Data science teams analyze credit card data, web site traffic, web scraping data, and just about any other data they can get their hands on. They use this data to help their teams better understand the companies they invest in and better forecast their financials. Data scientists help with the research process by uncovering how traffic to certain websites is changing, how buying patterns are changing, which companies could be taking or giving market share, etc. Again, while the hedge funds may not be able to differentiate based on what data they are using, they can differentiate themselves based on how they use and analyze that data with their fundamental research teams and data science teams.
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