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Financial hedging was conceived as a way to reduce risk. Indeed anyone ‘hedging their bets’ is engaging in the same pursuit. But to many it’s seen as a sinister activity, conducted in a shadowy world that’s impossible to fathom.
Actually, hedging is just a way to reduce your exposure to something that is uncertain. For example, if there is a risk that ‘thing X’ could pan out badly, you make sure ‘thing Y’ is in a place to rescue the situation and vice-versa. So if a risk is perfectly hedged, no outcome involves unmitigated disaster. This concept may be easy enough to follow, but can it be pulled off in practice?
Hedging for business
Many businesses have been hedging their activities from the get-go. Far from being sinister, it’s common practice and can make good sense.
Companies hedge their activities in any number of ways, but to give just one example let’s look at airlines and fuel hedging. One of their biggest costs is jet fuel. The price of jet fuel can swing considerably. To help with planning, airlines may undertake futures contracts, a promise to purchase a set amount of fuel, on a particular date for a specified price. When that future date arrives, the current (‘spot’) price of jet fuel may be higher or lower than the price specified in the contract. However, the current price of jet fuel will not affect the airline company, as it will pay the price it agreed to pay when it entered into the futures contract.
To some extent, the airlines don’t mind either way. Admittedly, sometimes airlines miss an opportunity to buy cheap fuel if the spot price turns out to be lower than the contract price, but then they don’t have to worry about the spot price rising. Crucially, in either case, they gain comfort from the knowledge that the price they will pay for their jet fuel is fixed.
Agricultural crops, rather than jet fuel, were among the first commodities to be routinely hedged. If a farmer sells futures contracts to supply wheat, they can effectively ‘lock in’ the price of their crop when they plant it. They know exactly how much they will get for their produce in advance (assuming the contract is honoured) and don’t need to worry about volatile prices at harvest time. As with airlines, some risks of doing business are reduced.
Although the practice of fixing future prices for farm produce dates back to ancient times, the ‘modern’ system of formal exchanges developed rapidly in America during the second half of the 19th Century and spread – with over dozens of exchanges now operating around the world. Two of the biggest, for grains and livestock, are located in Chicago.
Hedge funds are a type of investment fund that date back well over half a century, although they only took off in a big way in the late 1980s and 1990s. As with hedging corn and other crops, the original intent was to explore new ways to reduce market risk – but over time the original hedge fund recipe mutated as new ‘hedge fund’ managers arrived on the scene.
Nowadays there is no precise definition of a hedge fund. Broadly speaking though, they tend to feature at least some of the following elements:
- Fancy investment strategies. Rather than sticking with conventional ‘buy and hold’ approaches to investing, hedge funds may invest in derivatives and other, more exotic, financial instruments.
- Called leverage in financial jargon, hedge funds often invest money they have borrowed. Leverage serves to magnify both gains and losses.
- Client restrictions. Hedge funds are subject to less regulatory scrutiny than ‘retail’ investment funds. As such, they are usually only allowed to accept professional investors as clients.
- A two and twenty fee structure. Hedge funds typically used to charge a 2% fixed fee, plus 20% of any outperformance over and above the fund’s benchmark. More recently, fees have come under pressure and many hedge funds now charge less.
Hedge funds have acquired something of a bad reputation. And indeed there have been instances when hedge fund managers made fortunes through dubious practices – even downright illegal ones, such as insider trading. That said, plenty of hedge funds are perfectly reputable and stick to the rules.
The negative public image is fuelled, at least in part, by the practice of hedge funds known as ‘shorting’ stocks – whereby positive returns are generated by a fall in share price instead of a rise. Usually investors go ‘long’, which means acquiring shares hoping they rise in value. To many people, shorting appears unsporting at best.
A more immediate threat for many hedge funds though has been a combination of lacklustre performance in recent years alongside high fees. This has caused some institutional investors to question whether hedge funds should appear in their portfolios at all. Nevertheless, around $3 trillion remains invested in hedge funds around the globe.
Regular investment funds, including OEICs, may also engage in some hedging activity. For example, it’s not unusual to hedge currency exposure. If a fund owns shares in foreign companies, currency fluctuations will affect overall fund performance. Here, hedging seeks to reduce risks posed by an unpredictable exchange rate.
By taking a quick look at the first hedge fund strategy, called ‘Long-Short’, we find that shorting stocks turns out to be less mean-spirited than it might seem at first glance.
The performance of a regular active fund will be affected by two components: firstly the movement of the market generally – as characterised by its benchmark - and secondly by the manager’s skill or luck in selecting stocks that beat (or don’t beat) the market.
The basic concept behind long-short was to create a fund that was only affected by the latter. Fund performance could be de-coupled from markets movements, at least in theory, by hedging the exposure to, say, the FTSE 100. As a result, it no long matters if the FTSE goes up 10% or down 10%. What matters is the relative performance of the fund’s stock picks.
Suppose that in a year the FTSE 100 fell by 10%, but the fund’s handpicked (unhedged) stocks only fell 6%. The Long-Short fund would actually generate a +4% return (excluding fees). That’s because it would earn +10% from shorting the FTSE 100.
Conversely, if the FTSE 100 gained 10%, but the handpicked (unhedged) stocks only managed 6%, then the Long-Short fund (after hedging) would actually lose 4%.
The Long-Short hedging strategy could thus avoid the full effect of market downturns that clobbered active funds. The flip side, however, is that poor stock-picking cannot be lifted by the rising tide of a buoyant market. Either way, the reduced level of market correlation proved to be of great interest to some investors.
But in order to pull all this off, Long-Short, as the name suggests, requires the fund to ‘short’ stocks as well as buying ‘long’. The purpose of the shorting is not to be mean or nasty to anyone. It’s just part of a wider mechanism devised to reduce market-based risk.
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