Rich Bello walks through how long/short hedge funds work: generating alpha (beating a benchmark) and absolute returns in any market. Shorts act as insurance that can profit. Research analysts find ideas, portfolio managers build positions, and HR matters more than most realize.
Chapters
Foreign. Now we're going to move on to the investment process for our purposes. The information I'm going to share, while basically the same for most funds, is really the approach to the classic long, short equity hedge fund files, which is what most tiger cubs are, and that's my background. They tend to have a longer term investment horizon. The overall mission for a hedge fund is first to generate alpha, which is generally thought of as the return that the fund earns over a benchmark index. The actual calculation is a little bit more complex, but for our purposes this definition is sufficient. However, just beating the market, it isn't good enough for a great hedge fund. What if the market's down 10%? You're only down 6%, you have a 4% alpha, but you still lost money. Is that a good year? Some would say yes, even though you lost money. However, you can't eat negative returns. While you want to beat the market, you also want to be sure that you're generating positive returns regardless of the market's return. And that's what's referred to as absolute return. For instance, we didn't just look at shorts as a hedge. We viewed them as an insurance policy that paid us the premiums. We were right more than we were wrong on both the long side and the short side. Over time we'd make money. The other part of the mission is, of course, risk management, which we'll talk about a little bit later. So here is an overview of the entire investment process of a hedge fund. Specifically the research process, which is mainly the responsibility of the firm's research analyst. And then the portfolio management process, which is the responsibility, of course, of the portfolio manager. The first part of the process is human resources, which is necessary to get the right team in place depending on the maturity of the firm. This is a shared responsibility, but overall it's in the hands of the pm. We're not going to talk too much about human resources because while it's actually the most important part of the process, this is really a key function of any firm. I do a separate webinar on just the human resource process since it's so crucial. So feel free to reach out to us on a webinar on this or just some consulting on us if you'd like to go deeper.
