You may have heard the term “hedged hedge funds.” It’s an expression some money managers use to differentiate what they do from the hedge funds that wind up in newspaper headlines.
If hedging is understood as a method of reducing risk, then most hedge funds that make the news aren’t hedged at all. Instead, they tend to employ levered, risky strategies designed to give high rollers double and triple-digit returns. Many of these funds won’t even look at clients investing less than $1 million.
Their mislabelling is too deeply ingrained in the financial world’s consciousness. So, to describe hedge funds that are actually hedged, we speak of hedged hedge funds.
“A true, authentic hedge goes back to the principles of Alfred Jones,” says Michael Kimmel, portfolio manager at Picton Mahoney Asset Management in Toronto. Jones was the American investor credited with creating the first hedge fund in 1949. His approach catered to “wealthy people who wanted to preserve and grow their wealth in a conservative fashion,” explains Kimmel. Jones used tools such as leverage and shorting to rein in risk, rather than augment it.
Hedged hedge funds come in a variety of mandates. The one that will likely appeal most to risk-averse clients is the market neutral strategy.
How it works
The purpose of the strategy is to make market direction essentially irrelevant to the fund’s performance. This is done by using both long and short positions (see sidebar, “Long versus short”).
A simple example illustrates the basic template. “An investor puts in $100. The first thing we do is put it in a risk-free asset like a [Treasury] bill,” says Kimmel. “Then we find a company we hate and we’ll short it for $100. We’ll then use the proceeds [of the short] to buy a stock [we like] for $100. So your net exposure [to the market] is 0%.”
Keith Leslie, portfolio manager at Norrep Investments in Calgary, uses a similar approach: but, instead of T-bills, he builds a portfolio of 15 to 20 investment-grade bonds. The bonds are held to maturity, making what happens in the bond market irrelevant. The average length of time until the bond matures is nearly three years and the average yield is about 3%. He uses the yields to cover his fund’s expenses.
Leslie’s fund has around 50 long names and 50 short, with about 2% of its assets per position. To maintain 0% net exposure, he rebalances daily. “I start each day by asking which positions are out by $50,000, for example. I set up a spreadsheet and my goal for the day is to trade them back to their target weights. If a long position goes up 30%, I sell some off and lock in profits to bring it back to target.”
He usually makes 30 to 40 trades a day. “With zero exposure, you have zero correlation to the market. A typical mutual fund will have 100% equity market exposure.”
Other market neutral funds can deviate slightly from 0%. “On the portfolio level, we hover around 0% net exposure, but when we’re wildly bullish we can take it up to 10% [net long]; when we’re wildly bearish we can take it down to 10% [net short],” says Kimmel. On a sector level, he allows 5% wiggle room in either direction.
Leslie notes both types of fund can have a place in client portfolios.
In both cases, downside protection is a key feature, thanks to zero or near-zero correlation to the equity markets. Market neutral won’t capture all the upside when the market’s on fire, but don’t be surprised if you see no losses—or even gains—when the broader market tanks.
The core feature of many market neutral funds is pairing long and short positions within sectors.
For instance, if the manager is long Bank A, he’ll short Bank B. Importantly, Bank B’s price doesn’t have to go down: to make money, all the manager needs is for Bank A to go up more or down less than Bank B. So:
- If Bank A (long) goes up 15% and Bank B (short) goes up 10%, it’s a 5% gain on the bet.
- If Bank A goes down 11% and Bank B drops 13%, it’s a 2% gain on the bet.
- If Bank A goes up 15% and Bank B goes up 20%, it’s a 5% loss on the bet.
- If Bank A goes down 11% and Bank B drops 8%, it’s a 3% loss on the bet.
“Sixty percent of our [positions] are exact pairs, right down to the sub-sector,” says Leslie. Matching longs and shorts on as granular a level as possible—bank to bank, rail carrier to rail carrier—reduces most external risk, leaving the outcome of the trade to the manager’s company analysis skills. For instance, “If I’m long a gold stock and short a gold stock, the price of gold is partially irrelevant to me. Both go up or down based on the price of gold, but I’m predicting the better company will do better regardless of the gold price.”
The other 40% of Leslie’s pairs match on the sector level only. One example is Canadian Tire (long) and Torstar (short): they’re both consumer discretionary and should be affected by consumer spending, “but one is a retail store and one is a newspaper, so it’s not a perfect pair.”