Real and fake hedge funds

August 31, 2020
by Noriyuki Morimoto

For a hedge fund to be a real hedge fund, it is essential to meet the criteria of hedging. Here, hedging must mean to hedge risk.

Whatever the investment opportunities that managers pursue, there is always some inevitable market risk. Investing in underpriced stocks also means to accept the risk of stock price fluctuations in the whole stock market.

The origin of the hedge fund is the attempt to participate purely in the intended investment opportunity while avoiding the risk of market price fluctuation, that is, hedging the risk. The convertible bond strategy is a clear example.

A convertible bond is a composite of a call option of a stock and corporate bond, so its theoretical price should be the sum of the theoretical prices of the call option and bond. However, its actual price often differs from the theoretical price. This inefficiency presents an investment opportunity, and hedge funds try to take advantage of that inefficiency alone.

To do so, you should long the convertible bond, short the stock equivalent to the theoretical value of the call option, and hedge the credit risk contained in the bond value with a credit derivative.

Here, you can see the method common to hedge funds: capturing an investment opportunity from market inefficiency, combined with the strict hedging of market risk accompanying such an inefficiency.

As long as you strictly adhere to this principle of hedging market risk and purely capturing price inefficiency, you are free to decide whichever inefficiency to capture or whatever hedging technique to use. That freedom is the hallmark of hedge funds.

However, there are many hedge fund managers whose freedom has fallen into deviation. In other words, many of them are not able to strictly adhere to the principle of hedging market risks and capturing price inefficiencies. The problem with hedge funds is that there are very few real hedge funds and too many fake ones.

 

[Category /Hedge Fund]