Although there is no clear set of investment sectors in which hedge funds invest, following are some of the important sectors in which a majority of them invest.
Global Macro Funds : Although their numbers are small, global macro funds are the largest hedge funds in terms of assets under management. The most famous of the global macro hedge fund managers is George Soros. His Quantum Fund, established in 1969 with just $4 million, now has an estimated value of $ 18 billion.
Operating on a global scale, macro fund managers view the entire world as their playing field. They can invest anywhere and in any financial instrument — equities, bonds, currencies or commodities. They monitor changes in global economies and hope to realize profits from significant shifts in global interest rates, important changes in coutries’ economic policies, etc. A shift in government economic policy that affects interest rates, in turn, affects all financial instruments including currency, stock and bond markets. Macro fund managers speculate on such trends and profit by investing in financial instruments whose prices are most directly influenced by these trends. They extensively use leveage and derivatives to accentuate the impact of market moves. No doubt the returns can be high but so can the loses because leveraged directional investments (which are not hedged) tend to make the largest impact on performance. This is why macro funds are considered a very high risk and volatile investment strategy.
The most famous of Soros's activities was in September 1992 when he took on the Bank of England. He bet $10 billion worth of sterling (much of it was borrowed) on the speculation that sterling was overvalued and would be devalued. In a futile attempt to save the sterling, the Bank of England raised the interest rates several times and spent an estimated 15 billion sterling to defend the currency. Still, they could not prevent the dropping of the Pound and subsequent pull out from the European Monetary Union. It is estimated that Soros and his investors made a neat $2 billion on this bet.
But these macro managers many a times also cause abrupt fall in profits. For instance, during the first quarter of 1994, hedge fund superstar Michael Steinhardt (whose funds produced an average annual return of 24 per cent over several decades) placed huge unhedge bets thinking that the European interest rates would decline, causing bonds to rise. Instead, his finds lost 29 per cent when the Federal Reserve raised interest rates in the US, causing European interest rates to rise.
Global International Funds : Similar to the macro funds, these fund managers also invest in international equity markets of the US, Europe and Asia. They follow what is known as bottom up approach — they stock pick individual companies, looking at what they have to offer in their sector or what opportunities there are for buying or shorting. These funds are also extremely volatile.
Emerging Markets Funds : These funds invest in equity or debt of emerging markets that tend to have higher inflation and volatile growth. The expected volatility of such funds is very high.
Short Selling Funds : This strategy is based on finding overvalued companies and selling the shares of those companies. The investor does not own these share. Anticipating that the share price of the company will fall, the investor borrows the shares from his broker. Ideally, when the share price does fall, the investors buys shares at the new, lower price and thus can replace to the broker, the shares sold earlier, this netting a gain. This strategy is also employed where the investor believes that the share price will fall due to problems in the company, etc. These funds are extremely volatile and risky.
Market Neutral Funds : These funds tends to exploit perceived anomalies in the prices of different bonds by buying under-priced ones and selling short the overpriced ones. LTCM was a market neutral fund. These funds are also highly volatile.
Aggressive Growth Funds : Invest in equities expected to experience accelerations in growth of earnings per share. These funds tend to be highly volatile.
Event Driven Funds : Event driven managers take significant positions in a limited number of companies with ‘special situations’, that is, where companies’ situations are unusual offering quick profit opportunities (e.g., depressed stock, an event offering significant potential market interest mergers and acquisitions, ect.). This is one of the few investment sectors where economic or market conditions are of marginal concern.
Fund of Funds : This is a fund that mixes and matches the hedge funds and other pooled investments among many different funds or investment vehicles. These funds are the largest in number.
The collapse of the Russian rouble during August 1998 proved fatal to several global hedge funds. Although many hedge funds have failed in the past, the failures in the aftermath of the Russian cirsis were across the board from global macro funds to event driven funds. The fund managers made a mistake by underestimating Russia’s economic problems. Facing severe financial problems, Russia not only devalued the rouble but also defaulted on its debt. The hedge funds that had considerable exposure in the Russian financial markets suffered heavy losses. Hedge funds which did not have any exposure in Russia also suffered because the Russian turmoil sparked the flight to safety syndrome among the investors. The Quantum Fund, owned by George Soros, reportedly lost almost 52 billion. Five prominent hedge funds went bankrupt including market leaders III’s High Risk Opportunity Fund and the Mc- Ginnis funds run by San Antonio Capital Management. The average losses in 1998 for all hedge funds are estimated to be 50 percent of their equity. The failure of LTCM was spectacular and brought the financial cirsis of Russia to the center of Wall Street.
Started in 1994, the US-based LTCM was headed by John Meriwether who had earlier worked with the Salomon Brothers. After being forced to resign for his involvement in illegal rigging of the US Treasury bond market, John founded the LTCM. John was a legend in the financial world of Wall Street known for his extraordinary skills. Same was the case with his other partners in LTCM which included David Mullins, former Vice Chairman of the Federal Reserve Board; Myron Scholes, who won the Nobel Prize in economics for his work on the pricing of options; and Robert Mert, another Nobel laureate in economics.
Despite charging a higher fee (25 per cent of the profit), LTCM was able to raise billions of dollars from commercial banks and securities companies. The list of investors included the Rockefeller Foundation, Dresdner Bank, Credit Suisse Group, UBS AG, Presidential Life Corporation and Bank Juluis Baer. The heads of prestigious finance companies such as Merrill Lynch and Paine Webber had also put their personal wealth into LTCM. Besides millionaires, investors in LTCM included the Italian central bank, Banca d Italia, which had contributed $250 million to the fund. Investors were required to put in a minimum $10 million for a minimum period of three years. But they were kept in the dark about the trading strategy of the fund. In spite of being arrogant and secretive, LTCM was flooded with huge funds by investors much impressed by its extraordinary performance. The investors of LTCM earned returns of 42.8 per cent in 1995, after fees, 40 per cent in 1996 and 17 per cent in 1997. In 1997, LTCM was flooded with so many funds that it decided to return $2.7 billion. That is why LTCM was often referred to as the ‘Rolls Royce’ of the global hedge fund industry.