What is Hedge Fund Investing and How It makes the Rich Get Richer
There is a part of the market that only the rich are allowed to invest in, only open to the millionaire investors. In this video, I’ll show you this private world of hedge fund investing, how hedge funds work and how they make the rich even richer. Then I’ll reveal three hedge fund strategies you can use in your portfolio for market-busting returns! We’re talking hedge funds explained, today on Let’s Talk Money!
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What Securities Act of 1933 Says That Made Way for Accredited Investors
Nation, regular investors see just a fraction of the market when they go to invest. You flip on your favorite investing channel or website and you might think investing is all about buying stocks or bonds, maybe even options.
But there is a whole other world of investments…and the tragedy is, you’re not allowed to invest!
Due to a law that goes back all the way to 1933, the Securities Act, certain investors, Accredited Investors are allowed to put their money to work in certain investments like hedge funds, venture capital and private equity.
Accredited investors are those with over a million net worth or with incomes above $200,000 a year…so yeah, rich people.
You’re locked out of some of the best investment opportunities out there because you weren’t born with a silver spoon up your ass! Nation, I spend a good portion of my professional career as a venture capital analyst helping this group of investors get five- and ten-times their money on pre-IPO deals…these are the types of investments you need in your portfolio!
How to Create Your Own Hedge Fund Investment
So in this video, I’m going to show you how to create your own hedge fund investment. How to take advantage of this private world of finance without being an accredited investor. We’ll start by looking at what is a hedge fund and how do they work. I’ll show you a few hedge fund examples and then I’m going to reveal three hedge fund strategies that you can use in your portfolio!
It’s part of a special investing education series I’m starting, showing you what it really means to analyze stocks and invest your money. I’ll be using content straight out of the curriculum for the Chartered Financial Analyst designation, the gold standard for stock analysts working on Wall Street. The designation involves three years of exams and thousands of pages of curriculum but I’ll be laying it all out for you in these videos.
I’m going to be putting this one and all those videos into a playlist called How to Invest in Stocks on the channel. Make sure you tap that subscribe button so you don’t miss any of these because I’ve got some great in-depth videos coming from options trading strategies to technical analysis and how to beat those investor behaviors that lose your money!
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What is a Hedge Fund?
Hedge funds are actively managed funds, so by comparison to the index funds and passively managed funds that just invest in a set group of stocks, hedge fund managers can buy or sell stocks, futures, options, anything in their investing mandate to create excess returns.
The other thing that makes hedge funds unique is the manager is trying to do more than just create higher returns, they’re trying to create hedged returns.
Now the definition of hedge fund has been perverted over the last decade to include just about any kind of actively managed fund, but in the past, these funds would take long and short positions. So for all the long positions investing in a stock or bond, the fund manager would also take a short position in something else, selling against another investment.
How Does Hedge Fund Work
This is why it’s called a hedge fund, the investment is hedged against market risk so the manager is focusing their bet on one specific stock.
An example will make it clearer. Let’s say the hedge fund manager thinks inflation is going to jump soon and thinks the price of gold will be the biggest beneficiary. He decides to invest in gold miners to get that leveraged return and decides Newmont, ticker NEM, is the best in the industry.
But if that bet on gold prices doesn’t work out, the manager wants to hedge his exposure, to place another investment that will work if the thesis is wrong. He looks for a weaker company and decides Barrick Gold, ticker GOLD, is heavily leveraged and doesn’t have the same margins as Newmont…and that shares could crash if the price of gold doesn’t pick up soon. So he shorts shares of Barrick against that long position in Newmont.
So here, if gold prices do take off, the manager believes that shares of Newmont will rise faster than those of Barrick. The long position will make more money than the short position loses.
If on the other hand, the price of gold does nothing, the belief is the short position in Barrick will make more money than the long position loses.
And this is just one example of how hedge funds work. I’ll detail three hedge fund strategies in a minute, three strategies and how to use them in your portfolio, but generally these funds are focusing their investment in one idea or thesis and then shorting something else to take all other factors out.
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Hedge Fund Investing Strategies That Work
But a hedge fund can take this kind of targeted investment in other ways. The example we looked at is called a long-short strategy where you buy one investment and sell another. The manager might also buy a group of stocks and sell futures against the index, something called a market neutral strategy we’ll look at later, that effectively takes the market risk out of a portfolio and just bets on the best companies. A manager could also just be long on a group of investments, so only buying and no shorting, but one group of stocks might work if an idea goes one way and the other stocks will work if the idea goes the other way.
So the hedge fund uses a complex strategy to reduce risk while still maintaining the higher level of return through carefully investing in or against different stocks, futures, options or other investment types.
And hedge funds are big money. The hedge fund industry manages over $3.1 trillion globally and investors typically pay what’s called a 2-and-20 fee structure. This means the fund charges 2% of assets as an annual fee AND also takes 20% of profits as additional compensation!
A couple of hedge fund examples, Bridgewater Associations is one of the largest funds in the world, and founded by Ray Dalio in 1975. The company runs four main funds with total assets under management of $138 billion and an annualized 11.5% return over the last three decades.
Renaissance Technologies was founded by mathematician Jim Simons in 1982 to use statistical models that drive automated strategies. The fund has $166 billion undermanagement and its flagship fund, Medallion returned 9.9% in March of last year when the overall stock market plunged 35%!
3 Recommended Hedge Fund Strategies to Use in Your Portfolio
Now I’m going to reveal those three hedge fund strategies to use in your portfolio but first though, I want to personally invite you to get The Daily Bow-Tie, my daily market newsletter with all the important news, stock market trends and what to watch…all delivered straight to your inbox the night before so you have time to plan. It’s your opportunity to be a smarter investor in less than 5 minutes a day.
This is something completely new this year and I love being able to share those daily market updates and trends with you in the community. It’s completely free, look for the link in the video description below so you don’t miss out.
Now there are two ways Main Street investors can get in on these types of hedge fund investments. One is to invest in exchange traded funds set up using the hedge fund strategies like the RPAR Risk Parity ETF, ticker RPAR, or the IG Merger Arbitrage Fund, ticker MNA. Both have beaten the market return over the last year and more importantly, they did it with less volatility, less risk compared to the market.
The other way, and the way I like better because it puts you in control of your investments is to mimic the hedge fund strategies themselves. So let’s look at three ways hedge funds invest, three strategies you can use in your portfolio; event-driven, relative value strategies and market neutral.
Our first hedge fund strategy is called relative value and it’s going to be the easiest to understand for most investors. It’s also the most popular type of hedge fund, accounting for about a third of global hedge fund assets.
The relative value is a long-short strategy based on fundamental research and valuation. The analyst researches an industry or sector of stocks that should do well against the broader economic background. Then they pick two stocks, one that’s prices cheaply and another that is relatively more expensive. They buy the cheap stock and sell the expensive.
Now there’s a lot more than just the definition there; first it’s important to look at that broader economic picture so you’re picking stocks from an industry or a sector that will do well. Because in truth, most hedge funds don’t perfectly hedge their longs with shorts. Most will only do like a 30% hedge, for example if they buy $100 of the long stock then they only sell short $30 of the other stock.
This is because since the market rises over time, you want to be net long and if you are picking an industry that will benefit broadly from the economy then all the stocks should do well.
And there are other ways you can create these pair trades. You can pick stocks from different sectors, industries…I’ve even seen people pick stocks from different geographies. For example, if you thought the economic growth in the U.S. was going to beat Latin America; maybe you go long a U.S. stock while shorting an ADR from a company based in Chile or Brazil.
Again, the idea here is you win in any situation. If both stocks go up, the better company with a cheaper valuation should do better. If both go down then your stronger stock, the one that’s already cheap and has the good financials, shouldn’t go down as much as the risker, more expensive stock.
Our next hedge fund strategy is called event-driven because you’re focused on a specific corporate or geopolitical event.
This is where you build a narrative around a specific event that may be coming up whether it’s a potential bankruptcy, acquisition announcement or an earnings report…anything with the potential to really move a stock.
The most common event-driven strategy is called merger arbitrage, where the investor is taking a long and short position after an acquisition deal has been announced. Most of the time the investor is going long, or buying, shares of the target company and selling short shares of the acquiring company.
The strategy is normally because the market doesn’t price the deal fully into the shares even after the announcement, so if the analyst thinks the target company will be acquired, they can benefit as the shares reach that target price.
Another event driven strategy is buying the debt of companies that have either filed bankruptcy already or have been knocked down significantly in their debt ratings. Because a lot of institutional bond investors have to dump bonds under a certain rating, the price falls hard on a downgrade, especially if the rating falls into non-investment status. If the hedge fund thinks the company will ultimately be able to pull out of its bad finances, the debt can be extremely cheap to buy and a solid return.
The third hedge fund strategy and one of my favorites is called market neutral.
The goal of the market neutral strategy is to produce returns regardless of market direction, you make money whether the market goes up or down.
There are two ways you can do this, with that traditional long-short strategy we talked about where you buy one stock and sell another from the same industry or group of stocks. Whereas in the first strategy, maybe we didn’t fully hedge our position, we went $100 long and only $30 short. In the market neutral strategy, you would completely cover you longs with your shorts by dollar amount to remove more risk.
Another strategy is using options for a short position on the market itself. So maybe you buy individual stocks but then buy put options on the S&P 500 fund, ticker SPY. This way, you benefit on the individual stocks but you’re hedged to make money on the puts if the overall market falls.
Those three hedge fund strategies mentioned in the video include relative value, event-driven and market neutral. All three can be great additions to your portfolio and will make you get higher returns with less risk.