Are You an Unintentional Hedge Fund Investor?

Categories: Drivers of Value

Hedge funds may sound mysterious, complicated, or secretive. Some of them undoubtedly are, but the world of 10,000 plus hedge funds is a diverse place, where many approaches are surprisingly simple, and you may already be following the same strategies.

You may be copying what the hedgies are doing, or you may be on the other side of their trades. Either way, it’s very important to know what some of the strategies that are commonly referred to as “hedge fund strategies” really means.

Trend Following

Some of the biggest hedge fund groups and many of the smaller ones are engaged in a deceptively simple strategy: buying whatever market is rising and short selling whatever market is falling. Short selling, or shorting, can profit from a down move.

Trend following first took off in the 1970s, when the end of the gold standard spawned freely floating currencies and some oil shocks helped to unleash a surge in commodity prices. Some of the early trend followers called themselves “turtle traders” because turtles in the sea swim together in packs. The mass psychology of herd behavior, or “the madness of crowds,” is one reason cited for trends in markets.

Retail investors are commonly caught trend following. If you or your pension plan owns any Treasury bonds, you are participating in a megatrend because Treasury prices have been steadily climbing since the early 1980s. It’s becoming widely understood that the potential downside in Treasuries is now many times greater than the potential upside. In fact, some trend funds have publicly said they have decided to cap their bond exposure for this reason.

The craze for Treasuries illustrates a common behavioral bias observed in mutual fund investors. They have a habit of latching onto trends late in the game and can be too slow to jump ship after a market has reversed course. These tilts help explain why the average mutual fund investor underperforms mutual fund industry returns. (A 2007 study suggests investor timing decisions sliced 1.56% off returns between 1991 and 2007.) High-dividend stocks and high-yield bonds are examples of following trends in these markets. A recent posting highlights some risks of high-dividend stocks.

Trend-following hedge funds often let rules make decisions for them. They will keep with a trend as long as it lasts. When the trend reverses, they too cut and move in the opposite direction. The systems set strict limits on how far they can let losses run. These kinds of rules can help private investors create a structured framework for trading and managing risk.

Macro Traders
Another trading strategy where hedge fund managers make their own discretionary decisions is found in global macro funds; these funds are famous for such trades as shorting Greek debt, buying gold, and shorting currencies (e.g., the euro).

You might be an accidental macro trader. Nearly all of us are in effect “short” oil because higher oil prices will raise our cost of living. Your jewelry might give you exposure to precious metals, such as gold, silver, or platinum, and any idle nickels may now be worth less than their base metal content. A holiday or retirement home in Mexico is an asset denominated in Mexican pesos, whereas one in Canada makes you long the “loonie,” or Canadian dollar. Going long any of these types of assets makes you in a sense a “macro trader” in a sense.

Trading Yield Spreads

“Carry trades” involving currencies are a popular strategy for hedge funds looking for yield and are one of a number of ways for investors to profit on the difference between two different yields. For example, the Argentine peso yields at least 9% (and more than 20% annualized at the three-month maturity) and the U.S. dollar, near zero. If you buy Argentine pesos with U.S. dollars, you are effectively borrowing in U.S. dollars to buy the Argentine peso and you could make 20% a year if the exchange rate stays steady.

So long as the peso/dollar exchange rate doesn’t drop by more than the interest difference you get (and the currency remains freely tradable), it’s a winning trade. The strategy can get more dangerous if you use borrowed money or margin to directly or notionally trade more than your capital — then you can get wiped out or worse when the higher yielder heads south. Latin Americans working in the United States send billions and billions back home to their folks, and these remittances, before they are spent, can be seen as a carry trade.

There are other types of spread trades as well: How can some hedge funds aim at yields of 10% or 15% a year when rates are near zero and most corporate paper yields single digits? Companies or consumers with good credit ratings don’t need to pay that much to borrow. But many Americans have a low credit rating and FICO score and have to pay more. Your credit card or auto loan receivables could be on the other side of one hedge fund trade, packaged or “securitized” into juicy parcels, and then wrapped up in a hedge fund. Improving your credit rating is one way to take this trade away from the hedges!

If, instead, your credit rating is getting worse — you may even be getting delinquent with payments — your borrowings could become fair game for distressed debt hedge funds. They are looking for higher yields, often due to delinquencies, defaults, or bankruptcies, and some have spent billions buying distressed mortgages.

Investing in Mortgages
Any mortgage could be the flip side of a hedge trade. It’s quite likely that your loan has been split into at least two parts: the interest and the principal repayments. As a borrower, you have the option to prepay the mortgage. Hedge funds might own the same option, or they might be short the option through buying a slice of your loan.

They could either win or lose from you prepaying earlier or later, depending on how they are positioned. These hedge funds hire rocket scientists who drill down to the zip code to figure out whether anyone will prepay, as well as when, who, and how much. The world’s biggest bond funds can be investors in mortgage securities, so you may already have some indirect exposure through such funds. Even when mortgage-backed securities are backed by the full faith of the U.S. government, they pay more than Treasuries because uncertainties over prepayments make them more volatile.

Currently, the extra yield or spread you get from mortgages keeps making new record lows, possibly helped by Ben Bernanke’s Federal Reserve buying up the mortgage bonds.

Your mortgage loan in the United States contains a unique option. Unlike in most countries, mortgages in the United States are “nonrecourse,” so the lender cannot chase after your other assets if you decide to “strategically default” and walk away from the loan and the home, like the character played by Tom Hanks did in the film Larry Crowne. Effectively, you own a put option that lets you put the property back to the lender. But this option is not completely free. Your future credit rating will suffer, making it harder for you to get credit and forcing you to pay more for it.

In such a situation, hedge funds might be the lenders of last resort. Some hedge funds fill the gap created by banks that are tightening up lending. If you have ever made a personal loan to friends or family, you have engaged in a direct lending strategy. Some hedge funds lend against collateral and dub themselves asset-backed lenders, and others may even lend without security.

The Legal Landscape

Unlike trading on margin, hedge fund investing nearly always has a put option that limits losses to 100% because hedge funds are almost invariably limited liability vehicles. If leveraged funds or those facing contingent liabilities rack up losses bigger than the fund, they can leave their counterparties “holding the baby” and liable for those losses. If the counterparties are deemed “too big to fail,” then it’s likely the authorities will orchestrate some kind of rescue, as happened with Long-Term Capital Management in the 1990s. The good news for taxpayers is that in the recent credit crisis of 2008, it was banks and not hedge funds that required taxpayer support.

So, we have seen how you may be unknowingly or passively involved in some hedge fund strategies. Remember that it can be difficult to really understand the risks in some of these trades, particularly ones where you are mimicking the strategy that better-informed, better-funded professional investors are following. Whenever you find yourself in a crowded trade (as in the trend-following example) or invested in something that may reverse (as in the case of trading spreads), be sure to really have a good handle on your risk. If you can’t get your mind around it, seek the help of a good financial adviser.

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