Feb 16, 2022

Consultant here, trying to understand how HFs ‘hedge’: For example, do L/S equity funds buy quality retailers and short the low quality ones (as a means of doubling down)? Or, idk if their thesis is that Russia will invade Ukraine, do they buy Gold/Oil and hedge with buying some high quality Russian stocks as insurance in case they don’t invade etc. would appreciate any guidance HF pros can provide on how they go about hedging

Region

Hedging means many different things to different people. And the definition of HF is now so broad that many aren’t really “hedging” (in the standard definition, I.e. event driven fund isn’t really hedging).

But in your first example of going long one retailer vs another, you aren’t really “doubling down” you are reducing a lot of your risk to the market and that sector. As an example, the overall market (or sector) could fall a lot, but if your long falls less than your short, you make money. You are making a specific bet; that company A will do better than company B (but not whether they will go up or down, which would be driven by many other things like the overall growth of the economy, etc). The same can be said for “hedging” other risks (I.e., maybe I’m not trying to bet on growth, etc I can look for ways of removing that risk).

What an insightful reply, thank you sir! With regards to the ratio of the long/short, I'm assuming it is more art than science (1:1 \$ ratio etc.)?

What an insightful reply, thank you sir! With regards to the ratio of the long/short, I'm assuming it is more art than science (1:1 \$ ratio etc.)?

No, there are very precise mathematical formulas that specify the ideal hedge ratio. The ratio is not static, and you're supposed to adjust it slightly every day based on the changing prices. But even though the formulas are mathematically precise and widely known, people often tend to blow up on it anyway (I was at a bank in 2008 that correctly predicted the subprime housing crash, and we had the mathematically provably correct hedge ratio in place ***given the information known at the time*** but then the situation deteriorated so fast that we weren't able to adjust our ratio and even though we were mathematically right about everything, we still lost nine billion dollars).

For different type of funds, the approach varies. And as far as I understand, the hedging is often non-linear and it doesn't mean that the risk can be hedged completely. In other words, they choose the risk they want to take and hedge the risk they don't like. Here is a simple example. The price of a commodity at city A is higher than the price at city B. You assume that this spread will be eliminated by the arbitrage activities and thus you go short at city A and long at city B. Now, the directional risk is hedged since, no matter which way the price goes, u profit as long as the spread goes away.

However, sometimes they choose to take a lot of directional risks like putting on some big bets based on macroeconomic judgment that is purely discretionary. Or betting on the mean reversion of market(statistical arbitrage) with a high leverage to amplify the profit. They simply don't hedge.

Probably a silly question but if we went long in one sector and short in another would that count as hedging? e.g if we went long tech and short retail would that be a hedged trade? Or is that a more directional bet?

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