Hedge funds are managed investment pools that can trade various asset types and financial instruments. They attract high net worth investors looking for relatively steady returns in both bull and bear markets. Hedge funds attempt to deliver their returns using multiple techniques, including adjusting their net exposure to reduce risks.
Understanding Net Exposure
Net exposure is the amount of money, in percentage terms, allocated to its long and short investments, as given by this equation:
Net Exposure = Net Long Position Percentage - Net Short Position Percentage
A long position comprises assets that the hedge fund owns, whereas short positions are obligations to return borrowed assets sold by the fund. The net long and short position percentages reflect a hedge fund's leverage, which is money borrowed to finance positions.
For example, suppose a hedge fund has $100M in funds contributed by investors. Through leverage, it deploys $70M long and $50M short. The fund's exposed amount is $70M - $50M, or $20M long, which works out to a net exposure of 16.67 percent (i.e., $20M/$120M).
Its net long and short position percentages are 58.33 percent (i.e., $70M/$120M) and 41.67 percent ($50M/$120M) respectively. Finally, its leverage ratio is $120M/$100M, or 1.2, which means that for every $1.20 invested, $0.20 is borrowed.
Hedge Fund Techniques
Hedge funds have specific capabilities that allow them to hedge their risks. By and large, mutual funds cannot use these techniques, which include:
- Shorting: Borrowing securities and then selling them in the hopes of repurchasing them at lower prices.
- Leverage: The use of borrowed money to magnify positions.
- Derivatives: The trading of various instruments, including options, warrants, convertible securities, futures and swaps, whose value depends on the price movement of an underlying asset. Derivatives can be highly leveraged.
- Front-running: A practice in which traders pay to have their trades execute ahead of others. Funds often combine front-running with high-volume electronic trading, in which a few-microsecond advantage can yield profits.
Market Neutral Exposure
Hedge funds often seek opportunities to engage in risk-free arbitrage, locking in profits without any net exposure due to pricing inefficiencies across multiple markets. For example, suppose a Japanese manufacturer, Company X, issues both stock and convertible bonds that pay interest and can experience price movements based on its conversion ratio relative to the underlying stock.
A hedge fund detects a risk-free arbitrage opportunity in which the Stock X price in the U.S. exceeds its conversion price in Japan. It therefore shorts the overpriced stock while simultaneously purchasing the bonds, establishing a net stock exposure of $0 (excluding fees).
Shorting the shares drives their price down while buying the bond raises its price. Eventually, the stock/bond price disparity disappears, at which point the fund sells the bonds at the higher price and repurchases the stock at the lower price. Even though it had no net exposure to the stock, it made a profit.
Note that in this simplified example, the convertible arbitrage play did expose the hedge fund to other risks, including changes to the exchange ratio between U.S. dollars and Japanese yen and sudden fluctuations in interest rates. The fund can instantly revise its net exposure (i.e. change the amounts hedged) to adjust for these and other variables.
Hedge funds can offset positions with put and call options, futures contracts, swaps and other instruments. In each case, fund traders decide how much exposure to risk and adjust their positions accordingly.
Other Types of Hedging
Valuation is not the only risk that hedge funds face. For example, hedge funds can make bets on the direction and magnitude of interest rate movements, the quality of issued securities or the probability that a fixed-income security will default on its payment obligations. They may invest in mergers and acquisitions, betting on whether deals will go through or collapse. Many funds engage in financial engineering, buying and selling complex instruments.
Hedge Funds Are Secretive
Hedge funds are not required to disclose much information to the public. Only fund investors get to see results, but even they don't get detailed trade information. Hedge fund net exposure is a tightly held secret, giving funds a strategic advantage when negotiating trades within highly dynamic markets.
- U.S. Securities and Exchange Commission: Hedging Your Bets -- A Heads Up on Hedge Funds and Funds of Hedge Funds
- SEC. "Implications of the Growth of Hedge Funds," Page 32. Accessed Nov. 6, 2019.
- Harvard Law School Forum on Corporate Governance. "The Activism of Carl Icahn and Bill Ackman." Accessed Jan. 9, 2020.
- Ican Enterprises. "Board of Directors." Accessed Nov. 7, 2019.
- Congress. "H.R.3606 - Jumpstart Our Business Startups." Accessed Nov. 6, 2019.
- SEC. "Hedge Funds – A New Era of Transparency and Openness." Accessed Nov. 6, 2019.
- SEC. "Proposing Amendments to Private Offering Rules." Accessed Nov. 7, 2019.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.