According to Harvard law, hedge funds caused the 2008 financial crisis. They create an impact on the economy by providing liquidity and improving price efficiency.
Thus, it’s important to understand how hedge funds operate. One main component of their operations is the advanced technology being used. What kind of technologies do hedge funds use exactly?
In order to create efficiency, hedge funds have moved from spreadsheets to using Artificial Intelligence for office operations, as well as digital and cloud enterprise resource planning (ERP) solutions.
Specific Technology for Hedge Funds to Increase Efficiency
- RPA or Robotic Process Automation
- Proper Website Build: Something as simple as building websites, especially interactive and user-friendly only one can increase client satisfaction and prospects percentages
- Recommendations to put on the site can be peer group analysis or basic investment statistics vs. actual benchmarks
- Web Meetings: Being able to be accessible globally for different types of clients benefits both the company and the workers. Platforms like Zoom and Microsoft Netmeeting can be affordable and require less maintenance. Online conference calls can also allow for schedule flexibility as it requires less time and travel expense for the workers
What Strategies Do Hedge Funds Use?
Hedge fund strategies are a range of instructions in order to make a profit with low risk. Here are some common hedge fund strategies:
- Convertible arbitrage: combines a bond with an equity option. Usually, this entails buying convertible bonds and the short sale of the same issuer’s ordinary shares.
- Long/short equity: requires knowing stock-picking tools well. Essentially, maintains long and short positions in equity and enquiry derivatives.
- Global macro: the general investment strategy making investment decisions based on broad political and economic outlooks of various countries. This strategy will use different instruments or assets as a function of the world economic situation: currencies, indices, yield curves, commodities, etc.
- Fixed-income arbitrage: seeks to exploit pricing differences in fixed-income securities. This strategy makes use of treasury securities, futures and rate swaps. The most common type of fixed-income arbitrage is swap-spread arbitrage.
- Merger arbitrage: involves taking opposing positions in two merging companies to take advantage of the price inefficiencies that occur before and after a merger. It looks at the risk that the merger deal will not close on time, or at all.
- Event-driven: related to arbitrage strategies, seeking to exploit pricing inflation and deflation that occurs in response to specific corporate events. Among these can include mergers and takeovers, reorganizations, restructuring, asset sales, spin-offs, bankruptcy, and other events creating inefficient stock pricing. One example of an Event-driven strategy is distressed securities.
- Emerging markets: a very high-risk strategy, because hedging instruments are not always available in this type of market. The manager invests in developing markets.
What Trading Tools Do Hedge Funds Use?
Hedge funds understand the complexity and technicalities of how to generate a profit in the market using the strategies above. Although hedge funds are diverse, most of the tools they use can be cateogrized into these main categories:
- Microeconomic and macroeconomic research with an outlook to drive out fundamental trends in the economy or financial markets, or to identify high-potential or struggling firms.
- Momentum or Day Trading focuses on short-term opportunities. Usually, this entails when there’s a breakout or big news such as Gamestop stocks. The only problem with these tools is that the risk is high and you’re unable to trade in big sizes.
- Arbitrage consists of taking advantage of unwarranted price spreads. However, arbitrage strategies are not that common anymore because there are fewer arbitrage opportunities due to the rise of high-frequency trading. One example is by buying convertible bonds that appear to be undervalued while shorting the underlying share.
- High-Frequency Trading is commonly used on Wall Street. They use mathematical formulas in order to search for new patterns and trade in order to trade, which is also why it’s called Quant trading; quant being short for quantitative.
- Derivatives are contracts that are derived from the price of the underlying security, they use this because it offers asymmetric risk. It’s also used frequently due to speculative reasons or to hedge against portfolio losses. Examples are futures, options and swaps.
What Analysis Do Hedge Funds Use?
Analyzing hedge funds is hard and difficult to evaluate, despite it becoming more recent over the years. Since the goal is to do better compared to your competition in the market, most of the analyzing is heavy on benchmarking. The analysis needs a reference point or benchmark. According to Harvard Business school, there are 4 performance metrics for analyzing hedge funds:
Beta is the measure of an asset or portfolio’s risk compared to the market’s risk. One way to obtain your desired beta level is to invest in the market as a whole, giving equal weight to riskier and safer investment options, and then invest a percentage of your capital to match your desired beta. eta lays the foundation for alpha
Alpha defines the difference between an asset or portfolio’s return and a benchmark’s return, relative to the amount of risk taken (beta).
It’s important because it gives context. It answers the question, “If the beta were equal to one, how much better or worse did this asset perform than the market?”
The Sharpe Ratio
This is the return percentage per unit of risk. Introduced by William Sharpe, it’s useful for directly comparing the performance of two assets or portfolios with different levels of risk.
To calculate the Sharpe of a pair of assets, use this formula: Sharpe Ratio = (Return of Asset – Risk-Free Return) / Standard Deviation of Asset’s Rate of Return
Information ratio is the excess return of an asset or portfolio divided by its “tracking error,” which is the standard deviation of the fund’s excess returns (or alpha).
The information ratio can be used to tell if the risk of trying to outperform the market is worth it. If your information ratio is high, your strategies are more likely to pay off.
Where Do Hedge Funds Buy Data?
One common way that hedge funds get data is through alternative datasets from satellites, cart transactions, web scraping, and many more. Common categories of alternative data are:
As the economy starts to rely heavily on technology, many hedge funds look online in order to view consumers and enterprising spending. This outlook provides insights and predicts of a company can win or close a sector. One example of this insight is conversion rate, which is an important transition data metric.
This data which is obtained by surveying people gains information from external markets- such as clients, supplies, or competitors. This type of data can monitor current positions, identify opportunities, or assess risk management issues.
Understanding the weather is important for forecasting agriculture prices. Before, the federal government controlled weather data. Specialized hedge funds in commodities will buy private independent weather data.
An example of this is the satellite imagery is used in the investment decision-making process to help forecast total rainfall, affecting agriculture prices
Hedge funds benefit from these images and data to make various decisions related to agriculture prices but also as well as travel, tourism and consumer spending.
To further deepen our understanding of alternative datasets, here are some examples from major categories:
- Web clicks
- URL Specific
Satellite or Geo Location
- GPS devices
- Weather satellites
- Cell towers
- Plastic cards
- POS terminals
A few products of the best hedge funds datasets are:
EPFR Global – Hedge Fund Flows
- What is used for? This product has 2 key use cases. EPFR Global recommends using the data for Hedge Funds and Quantitative Investing. Global businesses and organizations buy Alternative Data from EPFR Global to fuel their analytics and enrichment.
Knowsis Sentiment Quant Leading Indicators, Macro, Single Shares – Quant Hedge Fund Data
- What is used for? This product has 5 key use cases. Knowsis recommends using the data for Hedge Funds, Investing, ESG Investing, Alternative Investment, and Financial Services. Global businesses and organizations buy Alternative Data from Knowsis to fuel their analytics and enrichment.
RIMES ETF Fund Level data – Worldwide
- What is it used for? This product has 5 key use cases. RIMES Technologies recommends using the data for Hedge Funds, Risk Management, Asset Management, Investment Management, and Risk Analysis. Global businesses and organizations buy ETF Data from RIMES Technologies to fuel their analytics and enrichment.
EPFR Core Offerings – Fund Flows and Allocations Data
- What is used for? This product has 5 key use cases. EPFR Global recommends using the data for Hedge Funds, Alpha Generation, Quantitative Investing, Attribution Analysis, and Economic Analysis. Global businesses and organizations buy Short Interest Data from EPFR Global to fuel their analytics and enrichment.
FinPricing Inflation Linked Bond Curve Data Feed API – USA, UK, Canada, Australia, New Zealand
- What is used for? This product has 5 key use cases. FinPricing recommends using the data for Hedge Funds, Trading, Portfolio Construction, Portfolio Management, and Investment Management. Global businesses and organizations buy Bond Data from FinPricing to fuel their analytics and enrichment.
Reality Research Serenity Scores – quant REIT scores with 10+ years of alpha and outperformance
- What is used for? This product has 5 key use cases. Reality Research recommends using the data for Hedge Funds, Algorithmic Trading, Alpha Generation, Stock Selection, and Real Estate Intelligence. Global businesses and organizations buy Alternative Data from Reality Research to fuel their analytics and enrichment.
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