How do Hedge Funds work, and what returns do they make?

...a look into what makes hedge fund managers perform better than the rest.

7 minute read

Hedge funds are organizations which build a portfolio of investments that are designed to outperform the regular index markets like the S&P 500. Organizations like ours are run by hedge fund managers who have a team of technical, fundamental and quantitative analysts working alongside them, in addition to individuals who are capable of forming a strategy with which to guide the fund (yes, I’m a pretty big deal at work). The practices we carry out and strategies we adopt are kept highly secretive so as not to disclose our edge to any competing funds. For this reason, it’s virtually impossible to get any kind of access or gain any understanding of precisely what our trading methods involve, unless of course, you have a mole who wants to start their own website and help regular traders (I’m allowed to hate the banking world, whilst still being part of it, right?).

How do Hedge Funds Work
Hedge funds usually aim to make their investors anywhere from around 5% - 20% returns annually, and trade using highly risk averse strategies. Limiting our client’s exposure so that they can make solid returns relatively safely is what we get paid to do.

You certainly do want to copy the best performing hedge funds, at least to a certain extent, and you can achieve that by mimicking the types of portfolio balancing and diversification techniques which they use. Portfolios work best when they genuinely mean something to you, so if you have no interest in the products you are trading then it’s unlikely you will make consistent profits in the markets.

 

Hedge fund managers have different affiliations when it comes to companies, market sectors, commodities and products which they are interested in; and we will use these affiliations to become experts in these areas of the market so that we can profit within them. This is one way we gain a significant edge in the markets. Work doesn’t really feel like work when you are doing something which genuinely interests you, and it’s this philosophy that fund managers use to gain an advantage over opposing funds and retail traders alike. Investors who have taken an interest in a certain company over many years will have an understanding of it that the majority of the market won’t be able to match, and it’s this expertise which allows them to trade that market with unprecedented confidence and conviction.

 

Having a genuine level of interest is a trait which tends to sort the good from the bad, at least when identifying profitable and consistent investors. Individuals with a genuine interest in the markets tend to significantly outperform the market participants who are just trading the charts because they want to make some fast cash. It sounds like an obvious statement, but it’s one worth taking extra note of because it holds more true in the world of financial investing than in some other industries. Everyone is interested in something (even if that something is Swarovski studded cat leashes), and it’s a fantastic place to begin when developing an investment portfolio.

"The most effective investors are the ones who trade the things they are passionate about, and a diversified portfolio can represent just how diverse an individual is… or isnt’t!"

When traded as a true reflection, the investor’s portfolio is as diverse as the investor themselves. If an individual has an interest in airplanes but not much else, they might seek to own stock in American Airlines, Airbus, aviation fuel companies, or Pratt and Whitney. This is anything but a diversified portfolio, and whilst they might have incredibly detailed knowledge about all the companies respectively, a black swan event could wipe out their trading account, quite literally overnight (did somebody say Covid-19).

 

The market has an incredible knack for finding out how genuine a person is, and if an investor has a range of different interests that they follow keenly, it is likely that they will perform relatively well in the markets, providing of course, that their macro economic outlook and trading strategy are sound.

 

You need to ask yourself how authentic you are being when taking up a position in a market, whether it be with a bullish or bearish outlook. If your sole intention is purely financial then it’s highly probable that you’ll suffer greater net losses than profits. Of course, there are investors who buck the trend, there always will be, in every industry, but be aware that they are few and far between. If you want to give yourself the best shot at becoming successful then it’s crucial that your main purpose should be to develop a portfolio that you have genuine interest in, and that you would still be interested in if money was taken out of the equation.

 

Portfolio balancing is a constant process which involves testing your portfolio against various economic events and the impact they would have on various areas of the market (we are constantly doing this every day at work). You might want to test your portfolio against a long-term hawkish interest rate policy implemented by Central Banks, and see how your positions stack up in this scenario. It may be that you anticipate a rising dollar and weakening gold price, so in this instance, you can the stress-test your portfolio to find out how much the dollar has to rise before you need to take up a new position which hedges against this. Of course, this is an over-simplified example, and there are literally endless amounts of economic events you can test your positions against; and whilst you can’t test all of them, it is important you are at least doing some form of modeling.

 

Making economic predictions and assessing how they will impact your investments may seem like pointless work, especially as it’s a lot more likely for most of your testing, that events won’t play out that way. The value really lies in the work involved and gaining a greater understanding of what is happening around the world on a macro level. Furthermore, whilst not every event will play out, certain events will, and when they do, it’s likely you will have a pretty good idea of any alterations you will want to be making to your portfolio as soon as they occur.

 

Hedge fund managers have two distinct advantages over the retail trader, the first is the team we have around us (we cherry pick, and even headhunt the best candidates in the industry). Whilst it may be possible for a particularly skilled individual to have an equally high performing portfolio as a fund, the second advantage is one which most retail traders can’t match. Funds like ours have millions, if not billions of investors capital to trade with, and we don’t need to make such high returns as a retail trader would. If we make a 10% return on a client's $1m investment then this would likely be regarded as very good performance, whereas retail traders would feel fairly underwhelmed if they made the same 10% annual return on a $10k investment.

 

Performance is relative, and you must have confidence in the fact that by compounding your profits, you will eventually win through. Hedge funds have a high status that comes with the term itself, but to be truly successful and conquer the markets proper you will likely need to outperform some of these funds on your journey to the top. This is where you have a distinct advantage. Funds play things safe most of the time and since it’s not their own money which they are investing, they tend to adopt a very cautious approach. This is why it’s not wholly unrealistic to believe that with a little more appetite for risk you can action many of the opportunities which they are too scared to take, use this advantage to its fullest, and make gains in situations where they can’t.

 

I do trade a personal trading account in my spare time, and take considerably larger risks than I would do with positions at work. You need to mirror some of the more professional approaches we use, but certainly not all of them. And of course, finding areas of the market, and companies which you have genuine interest in will be very much a personal choice (for anyone interested, I own some 2006 Apple shares, a few 2017 Louis Vuitton, and some 2015 L’Oreal along with various others).

 

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