Hedge Funds

What is a Hedge fund?

A hedge fund seeks to produce absolute returns irrespective of the underlying trends in the financial markets.

For instance, hedge fund managers employ strategies that aim to take advantage of pricing anomalies between related securities, engage in momentum investing to capture market trends, or apply their expert knowledge of markets and industries to capture profit opportunities that arise from special situations.

The ability to use derivatives, arbitrage techniques and, importantly, short selling – selling assets that one does not own in the expectation of buying them back at a lower price – affords hedge fund managers rich possibilities to generate growth in falling, rising and range-bound markets.

Hedge funds are usually structured as partnerships; the general partner is the portfolio manager making the investment decisions, and the limited partners are the investors. Because they tend not to correlate with equities or bonds, hedge funds often enhance a traditional portfolio.

What are futures contracts?

Futures contracts are standardized, legally binding agreements to make or take delivery of a commodity at a future time for an agreed upon price.

Why are futures contracts used?

The first contracts traded were agricultural and were established to address the issue farmers faced when bringing grain to the marketplace. Harvest would occur near the same time and create an over-supply for producers, thus decreases in prices. Consumers faced the opposite issue during non-harvest months, where supply would diminish and prices would rise. The futures marketplace offered the opportunity for both producers and consumers to ‘lock in’ a price for the product they produced or needed to use. This allowed for greater control over the budgetary decisions for both parties of the transaction.

Today, futures contracts are traded in both physical and financial products such as: grains, meats, coffee, lumber, precious metals, crude oil, sugar, natural gas, cotton, bonds, currencies and stock indices. They are not only traded here in the United States, but also on numerous exchanges from around the globe in places such as the United Kingdom, Germany, Dubai, Singapore, Australia and Brazil.

Even though not obvious, I would venture to say that almost everyone of legal driving age has experience as a ‘futures trader’. What do I mean by this statement? The past year has seen quite a bit of volatility in the price of unleaded gasoline: from January of 2008 price levels of $2.35 per gallon, to July 2008 price levels of $3.78 per gallon to January 2009 price levels of $1.15 per gallon to where we are today. Have you held off on filling up the tank hoping for lower prices the following week? Or filled the tank up sooner before prices rose again? Or if you just turned driving age, you may have waited until the supply of dollars in your wallet increased before heading out to fill up the tank! Purchasing a product in advance of expected cost increases or holding off on a purchase due to anticipated cost decreases are both ways of timing the market. It is an example of having an opinion about where prices are going and are attempting to use dollars on hand as effectively as possible. Trading in futures contracts function along similar lines, whereby a producer or consumer can agree on the price of the product months or even years in advance of needing it or distributing it.

By being able to establish a fixed price for a product well in advance, a producer or consumer is better able to plan other personal or business decisions.

Of course, this is an oversimplification but my hope is that it provides a little more tangible understanding of why the futures markets exist in the first place: the transfer of price risk.

What are futures exchanges?

If you had to cold call or go door to door to find someone willing to take the opposite side of your transaction, would this be a good use of your time? Futures exchanges were created to address the issue of bringing together buyers and sellers and operate in a similar nature to stock exchanges. A few of the major U.S. futures exchanges include: the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange and ICE Futures US which owns and operates the New York Board of Trade.

These exchanges all provide centralized clearing for their specific products offered and act as counter-party to all transactions which assures the integrity of the transaction.

Another responsibility of the exchanges is to disseminate price information for their products. The price of the futures contracts are easily identified as they are available on a real-time basis. This is one of the advantages provided in the futures markets and is in stark contrast to the difficulties that many in the banking industry are having as they try to find accurate values for the opaque assets (CDO’s, CMO’s, SIV’s etc) they now find on their balance sheets.

There are numerous factors that lead to price changes for a product: trade agreements, supply, demand, weather, business cycles, sentiment, alternatives, technological advances and currency values to name a few. It is here that the opportunity for profit exists for the investor because prices fluctuate.

Below is an example price change using a weekly chart of the June 2009 Gold Futures Contract

Prices can be further investigated to a specific hour, minute or second of the day. Real-time data requires subscribing to data feeds from the exchanges through a quote/charting vendor.

Although the futures markets were established for commercial purposes, participants also include exchange members, hedgers and speculators. Most investors would fall under the speculator classification and as such have no interest in either providing or taking delivery of the product being traded. They are simply looking to take advantage of price fluctuation and the contracts will be bought and sold prior to those contracts ever expiring for delivery. Here is an example using unleaded gasoline futures: An unleaded gas contract is for 42,000 gallons and requires $9,450 to be posted as margin to trade or hold this contract. The margin amount for any contract is determined by the exchange and can vary, but is usually around 5-10% of the value of the contract. These are leveraged transactions so risk management becomes an even more important component of trading. If a contract was purchased at $1.15 per gallon On February 19, 2009 and sold 4 weeks later at $1.40 per gallon, the investor would realize an investment gain of $10,500 ($.25 x 42,000 gallons)

Below is the daily price chart of May 2009 Unleaded Gasoline Futures

These markets can be accessed by an individual opening and trading their own account, working with the advice of a broker or by investing with a Commodity Trading Advisor in either a fund or fully disclosed account basis.

What is a Commodity Trading Advisor?

Commodity Trading Advisors are licensed investment professionals that specialize in trading futures/commodities. They typically have many years of futures industry experience and are regulated and monitored by the NFA (National Futures Association) and CFTC (Commodity Futures Trading Commission)

What are managed futures?

Managed Futures refers to a situation where your investment in exchange traded futures contracts is managed by one or more Commodity Trading Advisors (CTA惻Ts).

There are a large number of Commodity Trading Advisors registered with the NFA. They are professional investment advisors who have a unique approach to the marketplace and methods of using fundamental and/or technical analysis. More importantly, they all have unique risk to reward profiles. Therefore, selection is a key component to your success.

Once an advisor is selected, an account must be opened with a licensed Futures Commission Merchant (FCM). An FCM is an organization which solicits or accepts orders to buy or sell futures or options contracts and accepts money or other assets from customers in connection with such orders. All must be registered with the Commodity Futures Trading Commission.

The process is similar to the steps to open an account at a stock brokerage firm. After the account is opened, the CTA would then direct trading activity in the account.

Managed futures programs have been available for over 30 years and this investment class has seen assets grow from $45 billion in 2002 to over $200 billion at the end of 2007. The benefits of adding managed futures within a well-balanced portfolio include:

  • Potential to lower overall portfolio risk
  • Opportunity to enhance overall portfolio returns
  • Broad diversification opportunities
  • Limited losses due to a combination of flexibility and discipline
  • Opportunity to profit in a variety of economic environments, whether long, short or market neutral

Before adding managed futures to your portfolio, first have a clear understanding of your investment goals and educate yourself on whether managed futures is an investment for you.

The universe of hedge fund strategies is vast, as is the range of risk/return profiles they offer. Hedge fund strategies are often grouped into styles and, although style definitions vary among hedge fund managers, the following is a widely accepted description of various hedge fund styles:

Equity hedge
Aims to profit by taking long and short positions in equities deemed to be respectively under and overvalued.

Event driven
Purchases and sells short securities of companies experiencing or involved in substantial corporate changes.

Global macro
Opportunistic approach which takes advantage of shifts in macroeconomic trends.

Managed futures
Trades futures and derivatives in a range of financial and commodity markets.

Relative value
Applies arbitrage strategies and techniques to take advantage of perceived pricing discrepancies between similar or related securities.

Fund of funds
Harnesses the competitive advantages offered by different styles and strategies to preserve capital in a variety of market conditions.

Funds of hedge funds are widely regarded as comprising a distinct style group as very particular skill-sets and knowledge are required in this area of the hedge fund industry. The fund of hedge funds approach offers investors the advantages of automatic diversification among strategies and managers as well as professional portfolio management.

Give us a call if you would like more information on how to add this to your portfolio.