(Francis Akpata) In 1997, after the devastation of his country’s currency and stock exchange, the Malaysian Prime Minister Mahathir Mohammed described hedge funds as the “highwaymen of the global economy”. This is because they usually have fewer than 100 investors and are not normally regulated by bodies such as the FSA and SEC. They pool the capital of high-net-worth individuals and institutional investors and invest it in a manner that they calculate will give them the best returns and at the same time manage risk. Their objective is absolute return, which is achieved by putting together a portfolio of securities uncorrelated to the benchmark index (S&P 500, FTSE 100), and this differs from the objective of other investors (e.g. mutual funds and retail investors), whose performance is normally assessed relative to an index.

Integral to this objective is their perception of the market. An investor who intends to give relative performance has consciously or unconsciously internalized the EMH (the efficiency market hypothesis of Eugene Fama). This states that it is impossible to “beat the market” because market prices are already incorporated and reflect all relevant information. At any given time, the prices of securities reflect all information available on a particular market. One investor cannot have the advantage of predicting the return on a security, since no one has access to information not already available to other people. Whereas most investors aim to mirror the performance of a stock exchange such as the Dow Jones or the S&P 500, hedge-fund managers search for investment opportunities by locating undervalued stocks or predicting trends in markets through techniques such as fundamental analysis and technical analysis.

Fundamental analysis is a way of evaluating stock by trying to assess its intrinsic value. This is also achieved by studying the economy, the financial situation, the industry sector and how the particular company is managed. The analysts would attempt to evaluate the company’s value and potential for growth by looking at the profit margins, the return on equity, the earnings, etc.

Technical analysis involves assessing securities by paying careful attention to and analyzing the data generated by market activity such as volume and past prices. The intention is not to evaluate the intrinsic value; instead, the analysts believe a security’s performance in the past is an indication of how it will perform in the future. This they work out by using charts to identify trends that would imply future performance.

After using either technical or fundamental analysis, an equity long/short fund manager would put together a portfolio of equities including some he intends to hold onto with the expectation that the price will rise. He would sell others other stocks (this is normally borrowed from a broker) with the expectation that they will fall in value (described as “shorting”). The equity long/short fund manager would use a strategy called the bottoms-up strategy, which does not emphasize the importance of economic and market cycles. It places more emphasis on the value of individual stocks. These long/short funds believe that individual companies can deliver good returns even when the sector is not yielding good returns.

The important issue for most investors is whether the market is efficient; if it is efficient, participants such as hedge-fund managers should not be able to generate returns where others are unable to do the same. Information should be made available to all participants at any given time. If the market is efficient, prices should be random, not predictable, and it should be very difficult to discern patterns. Even if information is available the critical question is whether they perceive information in the same way. Where hedge funds would distinguish themselves is in the way they value and analyze securities. Some look for stock that has growth potential, while others purchase securities perceived as underperforming and hold their positions till the market rebounds. A good example of a hedge-fund strategy like this is the convertible bond arbitrage. The fund manager seeks to profit from mispricings in the convertible bond market. They take a long position in the converting stock and short the common stock. Most convertible bonds are issued because the company is small and may have a lower credit rating. The hedge fund aims to make a profit from the equity component in a bullish market and from the bond in a bear market. The risk is hedged out by shorting the underlying stock, which locks in the mispricing and generates a return when the bond returns to fair value.

If the market is efficient, any single investor should not be able to attain greater profitability than any other when they have the same amount of invested securities in the same market. Because they possess the same amount of information they should achieve very similar returns. One investor should not be able to achieve more than the average annual returns of most investors. This implies that it is better for most investors to aim to invest wisely and at best mirror the index or invest in an index fund that would reflect the current state of the market.

This can be described as relative return (the investor’s performance versus the benchmark), while hedge funds aim for absolute return (returns uncorrelated with the market benchmark). A hedge-fund manager would develop a strategy for investing that would aim to generate returns under several conditions. A hedge-fund manager with an event-driven strategy would look for acquisitions, management changes, balance sheet restructuring and changes in the dynamics of the market which would generate returns. Some would have a portfolio with securities that generate profits in the short term and others that (owing superior research) would be profitable in the long term (the market overreacts to securities when there are changes in its structure). Event-driven hedge-fund managers have a strategy called distressed investing. Here they invest in securities of companies with low credit quality, companies that have filed for Chapter 11 or those that have a coupon default. They are able to make money out of these situations because mispricings occur owing to the irrational actions of creditors who respond to their distressed situation. They panic and sell because the creditors would rather recoup a small amount of capital than wait for the restructuring to take place. The hedge fund would research and identify the chances of the company paying debtors; they would meet the managers of the company, and they would point out the assets and debts (evaluate their worth if there is liquidation). They would choose the area to purchase, watch the different stages of recovery and sell their securities at a time when the company has improved. Many hedge-fund managers have a bias towards small-cap securities because they can make a lot more profit from this sector, which is less efficient than the large cap stocks.

At this juncture we need some clarity on the notion of efficiency in the market. Eugene Fama did not imply that the market would always be efficient. It would take some time for new information that was released to investors to begin to affect stock prices. The time it would take is not something he stressed. It takes time before there is an equilibrium in the market (this is the price at which the supply of goods matches the demand). In efficient markets, incidental events occur but are ironed out as prices return to the norm. Making profit from the market before securities return to their mean value would result in beating the market, but this is not a regular phenomenon. The laws of probability will not allow that. The probability laws state that at any given time in the market with several investors there will be those that overperform, those that maintain an average and then those that underperform. The hedge-fund strategy called global macro is one that aims to overperform. Their investments are based on macro-economic political views of several countries as well as on short-term opportunities to make profit. They have unrestrained global mandates and could trade across several markets in an effort to profit from global trends. The Malaysian Prime Minister Mahathir Mohammed was referring to macro funds like George Soros’ Quantum Fund. They would purchase stocks, currencies and bonds in one market after carrying out research. A global macro hedge-fund manager would short the FTSE 100 if he felt the British economy was bound to fall and go long on the Japanese Yen if he felt the Japanese economy was in recovery. They are able to influence the value of currencies and move indexes because they borrow money to buy and sell futures contract, which is in essence taking a bet (on the currency or index). This is similar to what Soros’ Quantum Fund did in 1992, when they earned $1 billion in profit by betting against the pound, which led to its departure from the single exchange rate mechanism.

A sceptical person would ask if Eugene Fama’s theory is weakened by its allowance of random incidences. Stock prices should react immediately to new information. If this is not the case, then outright market efficiency is impossible. Burton Malkiel in his book Random Walk down Wall Street emphasized that stocks take a random and unpredictable path. In spite of the fact that stocks maintain an upward trend with time, it is impossible to outperform the market without additional risk. Another counter-argument is that there are consistent patterns in financial markets, such as the January effect, which describes higher returns in the first month of the year. This is just one among several anomalies that go against EMH. Nassim Taleb in his book Fooled by Randomness stressed the importance of comprehending the structure of randomness. As investors, we are trained to recognize patterns and trends in financial markets. This allows us to suggest a cause and effect, which confirms our rationality (or makes sense of data). This does not mean that markets do not have large random factors that can surprise us.

Investors now use computerized systems to analyze their stock investments, trades and other activities. Some even use automated systems to take positions based on mathematical models. These computers are able to process new information and carry out trade executions. In spite of this, most decisions are still made by human beings who could make mistakes. Behavioural finance examines the effects of investor psychology on the price of securities. Investors tend to have a mass mentality. They would buy and sell the latest and most trendy security. This “herd mentality” results in distortions in the market prices as they seek to make a profit and avoid loss. In some other cases, overconfidence leads investors to not react adequately to new information concerning rewarding decisions they may have taken in the past. They may have the illusion that they have control in an uncertain market. At best they may react slowly instead of spontaneously.

CTA (commodity trading advisor) is a strategy of hedge funds that aims to reduce possible human error by trading in a systematic and directional manner. It is systematic because they use a trading system that is made up of a set of algorithms (rules) which is coded as a computer program. They trade using futures contract. We could describe them as trend followers, as they try to identify long- and short-term trends. They take up more positions as trends continue, which is called “leg into”, and exit positions when their objective is achieved, which is called “leg out”. An investment approach typical to CTAs is the top-down method of investing. With this method they evaluate the country’s economy and the sector giving the best returns due to the economic state of affairs and then decide which securities are the most attractive within the sector.

Stronger efficiency will occur when there are universally accepted systems of analysis for pricing stocks; there is very little trace of human emotion in investment decision-making and internationally there is access to high-speed and advanced systems of pricing stocks.

It is also important that we ask ourselves what makes markets move, what enables markets to gain points or shrink, and what makes them go through cycles or waves. The state of the market at any time is driven by the activities or the overall effect of many individuals trying to serve their interests by making profit through trade (Adam Smith’s invisible hand). These individuals have little impact; hedge funds, institutional accounts, arbitrage firms and mutual funds have the greatest impact on the market. In their attempt to beat the market index they develop highly sophisticated algorithms to discover the overbought and oversold conditions in the market. These tools enable them to determine when to take and exit positions. A strategy called equity market neutral is one where the hedge-fund manager takes long and short positions of equal amounts so his or her total net exposure is zero. They do this to generate consistent returns in an up and down market. Investors like hedge funds that intend to take advantage of the anomalies indirectly help to keep the market efficient. Markets are not entirely efficient or inefficient. They are normally a mixture of the two states of affairs.

Hedge funds in particular carry out superior analysis to determine these conditions and make profits from them while minimizing the risk. Before making investments they discern the Alpha, which is the risk attached to buying a particular security. The alpha is positive when there is extra return awarded to the fund manager for taking the risk instead of accepting the market returns. The Beta is the measure of a portfolio or security’s volatility in comparison to a market or an index. These two concepts enable the fund manager to focus on generating profit while at the same time assessing how much risk he is taking. The hedge fund would also allow the evaluation of the level of volatility of the portfolio, which could affect the ability to give clients the promised absolute return.

Hedge funds also keep well diversified and unconcentrated portfolios. This is best achieved with multi-strategy funds and fund of funds. The multi-strategy funds are single managers investing across a number of other hedge funds. In some cases the managers have some funds of their own that they run. They then allocate funds to other funds that may have similar strategies or a variety of them. This means that their investments are diversified across several sources of returns and thus less susceptible to Nassim Taleb’s random factor. The fund of fund strategy is one in which a single management company invests across a range of hedge funds without managing a fund themselves. Their skill is in the ability to pick the right funds after research and due diligence. They tend to give investors access to the best hedge funds in the market and the minimum investment is not as high as in single-strategy hedge funds.

Hedge funds have a slightly different perception of the market from most investors. With sophisticated methods of analysis they are able to search for investment opportunities before there is equilibrium in the market. This is where the technique of shorting is very useful. Although Eugene Fama is correct in claiming that information is available to everyone, hedge funds process the information faster, with more computerized systems, which enables them to minimize human error and not move with the herd (thereby identifying the 20% of securities that have been mis-priced). They are able to beat the market on several occasions because they are able to gather enough capital (which they can keep for longer periods called lock-ups) and invest in the most proficient way while reducing risk and remaining diversified. The activities of Warren Buffet and John Templeton provide enough evidence of this.