Ibrahim Sowunmi

Breakdown of Hedgefunds For Normies

A question with no obvious answer. The hedge fund industry is secretive and primers are made for people with a bit more industry expertise than the average SE/AE.

Here’s a high-level breakdown. Hedge funds can sit into five buckets. They are as follows:

  1. Style
  2. Asset Class
  3. Market Exposure
  4. Level of Diversification & “Involvement”
  5. Management Structure

Almost every hedge fund is a combination of the five.

Style

Systematic -> Hedge funds that hire quantitative analysts who then build algorithms. These then use strategy/trade “sweeps” across an entire market for hard-to-spot arbitrage, buying and selling an asset in different markets to take advantage of price inconsistencies. Discretionary -> Funds that develop a view on specific companies and carry out fundamental analysis (Researching the company, industry, economy, etc) before manually placing a position.

Asset Class

FICC -> Fixed Income + Commodities + Currencies There is a tendency for Hedge funds to take a mutually exclusive approach to FI vs CC vs Equities, unless discussing giants such as Citadel. The precedence among hedge funds is equities > Fixed income > Commodities + Currencies.

Market Exposure

Market neutral -> Similar levels of volume/leverage in long vs short positions. This means that the portfolio has minimal directional risk if the market crashes or rockets (all weather funds). Not market neutral -> There are a variety of strategies here.

Long only -> Buy undervalues companies (eg Berkshire Hathaway) Long-short -> Most of the time long, 70:30 - long:short split. Short -> Not a common strategy. Short positions incur high borrowing costs and opportunities are hard to spot as the market generally trends upwards.

Level of Diversification & “involvement”

Activist -> Hedge funds that have an active role in the company management. They tend not to acquire the whole company and just get minority stakes (5 - 10%), majority stakes are done by private equity firms. Passive -> Positions are under 5% of the market cap of a given company.

Management Structure

Single Manager -> Top dog calls the shots Pod Shop -> Multiple portfolio managers that all have their own books; if one is long & another short, positions may/may not net at the firm level.

This outlines the makeup of an average hedge fund. If you finance heads notice anything that doesn’t sound right let me know.