Hedge Funds & Probability

by Dennis Hartman

A hedge fund is an investment product that uses money from fund owners to invest in a wide range of securities, using many different investment techniques and strategies. The term hedge fund comes from the fact that hedge funds attempt to hedge against the risks of a down market, making investments that will pay off even when traditional investments do not. However, hedge funds involve many uses of probability that prospective buyers need to be aware of before they commit.

Range of Risks

The probability that a hedge fund will perform as expected varies widely from one fund to another. Each hedge fund manager has the freedom to buy and sell assets at will, without input from investors. Fund managers employ strategies such as short sales, which involve selling securities in hopes of buying them back later after prices fall, along with traditional investment techniques to control risk. This means that investors must look at recent statistics to determine the probability that a specific fund will make money in the future, the likelihood of a loss and the potential for large gains.

Returns Probabilities

In general, if the probability that a fund will deliver a positive return is high, the biggest risk investors will face is making less than they would have with other types of investments. Hedge funds are generally expensive in terms of fees and management costs. This means that an investor needs to make more than a conventional investment that costs less, such as a mutual fund or a bond portfolio, would earn over the same time period to make the probability of gains for a hedge fund pay off.

Probability Metrics

Independent financial advisors and economic analysts provide probability metrics for hedge funds using complex algorithms that synthesize recent data for the fund itself and more general market trends. These metrics show how likely a hedge fund is to grow when the markets it invests in do not, and the probability that investors will realize gains of a certain level by a certain time. For example, some financial analysts provide probability figures that forecast high water marks for hedge funds. These marks represent the point at which funds stop growing and investors should sell.

Effects of Regulation

Hedge funds face relatively little regulation compared to other types of investments. This means that investors can't count on the same probabilities that they would with other, more highly regulated investments. Hedge funds are both less consistent and more flexible, which provides an advantage or a drawback based on the investor's expectations and the fund manager's individual performance. With some exceptions, most hedge funds guard against loss. However, elements of luck and strategy outside the realm of measurable probability play roles in determining which funds earn the most.