IN A NUTSHELL: The very essence of hedge funds is to hedge investors’ capital against market downturns. That’s why these funds tend to thrive in volatile markets.
Heightened market volatility should attract large amounts of capital to hedge funds, as they are constructed to protect, or hedge, investors’ capital against major swings in valuation. Hedge funds achieve this protection through their ability to use investment tools, such as derivatives, leverage, and short selling, which are not always available to traditional unit trusts.
For example, geopolitical tensions can lead to unexpected energy shortages in countries that also have high inflation. In such a volatile economic situation a hedge funds can adopt a macro investment strategy to mitigate the impact on their investment returns.
For instance, after considering research on the oil and natural gas market, a hedge fund manager may conclude that the price of oil will stay elevated for an extended period and that there is a high probability that the oil price would increase over the next 12 months.
The fund manager now considers which economic sectors – across the world – are sensitive to oil price increases. A very simplified approach would be that the fund manager buys forward oil contracts (e.g., expiring in a year’s time) and short sells airline stocks. The biggest cost for airliners is fuel, after all. The manager can also opt to buy the currency of an oil-producing country and short that of an oil-importing nation.
Through buying and shorting assets that will react oppositely, the hedge fund manager tries to protect the funds he/she is managing. Again, this is a very simplified approach and active fund managers will always aim to outperform their benchmarks – whether beating the downturn with a smaller decline in capital or returning more to fund clients when asset prices increase.
In this example, short selling plays a cardinal role in protecting the value of the fund. Taking a macro view of global events, such as higher inflation, runaway oil prices and interest rate movements, necessarily means some assets will benefit from these events while others will struggle. To take advantage of both gains and declines in asset prices means a fund manager must buy or short sell certain assets.
In summary, there are various hedge fund strategies that can be employed to preserve investors’ capital and which aim for outperformance. During global market turmoil a macro strategy could be a winner.
What is a macro investment strategy?
A hedge fund manager who takes a macro investment approach to investing will aim to benefit from changes in economies around the world. Such a manager will typically look at a country’s response to an event (for instance a supply shock) and consider the nation’s bonds, currency, interest rate market, commodities and equities. The manager will then take a position regarding the event and utilise all the investment tools, such as derivatives and leverage, to achieve an investment aim.
Short selling in South Africa
An easy way for South African investors – both professional and retail – to short an asset is through the trading of contracts for difference (CFD). A CFD is an agreement between two parties to trade in a financial asset based on the price difference between the entry price (when the agreement is concluded) and closing price (when the agreement is ended). The investor can bet on either a price increase or a price decrease when concluding the agreement.
A practical CDF example:
An investor believes the share price of Company X will decrease from R100 apiece to R50 over the next three months. The investor approaches Bank A and sells 100 CFDs on Company X at R100 apiece. After two months, the price of Company X declines to R60 apiece and the investor decides
to close out his/her position. He/she does this by buying 100 CFDs on Company X at R60 apiece. As no underlying assets have changed hands, Bank A will pay the investor (R100-R60) x 100 = R4 000. If Company X’s share price rather rose to R140 apiece, the investor would need to pay Bank A R4 000.
Derivatives: Financial instruments that derive their value from underlying securities and other variables, such as indices or reference rates, have either no or a small initial investment and
allow firms to speculate or hedge risks that arise from factors beyond their control, such as foreign currency rates.
Leverage: Gaining an economic exposure that is larger than available capital resources.
Short selling: The act of selling securities that are not owned by that seller.
Quantitative easing (“QE” for short, or “Monetary easing”): An economic monetary policy used by central banks intended to lower interest rates and increase money supply The Standard and Poor’s 500 (S&P 500). The S&P 500 is a stock market index tracking the stock performance of 500 large companies listed on exchanges in the United States.