Hedge Funds and Institutional Investors

Suppose you have ever wondered who the real players are in Finance. In that case, it is undoubtedly not the overpaid day-traders in movies, nor the weekend casual investor scrolling through investment apps. There is an entire dimension of players behind the scenes, wielding tremendous influence over matchmaking, and all moving money most often in the billions, sometimes with caution, and sometimes with reckless abandon. 

Hedge funds and institutional investors are not simply participants; they are the market's architects. They can scale up in complexity and undertake simple projects, or they can provide the pillars of long-term capital.  They can influence prices, conduct trades, and set measures that may affect public policy.

Understanding the way they work is essential even for those not involved in Wall Street, so you can decipher some of the invisible factors behind the market's reactions you hear about in the news every single day.

What Is A Hedge Fund?

Essentially, a hedge fund is a private investment vehicle that pools money from accredited high-net-worth individuals, pension funds, and other larger and institutional traders. Hedge funds are far less regulated than mutual funds, so they have almost limitless investment strategies they can exercise; they can construct the aforementioned vehicle of long/short equities, which is betting stocks will go up, and will have to sell to close their investment, or they can short-sell (bet against) stock prices dropping, or invest in commodity, real estate and cryptocurrencies.

Hedge funds get their name from the firm's use of a "hedging" strategy to reduce risk. Still, ironically, many funds today employ a hedge strategy and take a hefty amount of risk to obtain greater returns. An investor's freedom to invest in almost anything can result in potentially outsized gains, but also potentially outsized losses. This is why they are generally reserved for sophisticated investors who can afford to take the risk.

What About the World of Institutional Investors?

Institutional investors are a wider-ranging category; they include pension funds, insurance companies, endowments, sovereign wealth funds, and yes, hedge funds. The defining characteristic of institutional investors is the scale; they manage large pools of capital, some in the hundreds of billions of dollars, and have access to investments and opportunities that an individual would rarely see.

While a hedge fund may be looking for quick returns, many institutional investors have a long-term investment horizon. A pension fund isn't looking for quarterly earnings; it is investing to ensure that retirees will have benefits in 20-30 years. As a result, their strategies often emphasize stability, steady growth, and diversification.

Key Differences Between Hedge Funds and Other Institutional Investors

Even though hedge funds are technically institutional investors, their approach and usages differ in ways that, in many respects, set them apart from other institutions. This includes:

• The Nature of Risk: Hedge Funds, in general, are willing to accept more risk if a higher return can be sought. Pension funds and insurance companies tend to be more conservative.

• The Ability to Take a Position: Hedge funds may take short-term positions, maybe days or weeks, while pension funds make decisions on investments for decades.

• The Regulatory Environment: Hedge funds operate in a less strict regulatory framework than entities like insurance companies that must comply with layers of regulation and oversight.

• Liquidity: Hedge funds typically have lock-up periods wherein you cannot withdraw your capital for a specific period. Compared to hedge funds, conventional institutional investors have more predictable liquidity needs.

Hedge Fund Strategies

One of the most interesting features of hedge funds is their unorthodox and often controversial approach to investing. Typical strategies include:

• Long/Short Equity: Going long on assumed stocks that will go up and shorting stocks that will, or are considered to, go down.

• Global Macro: Taking large bets based on major macro trends, such as interest rate movements or other political events.

• Event-Driven: Making money on stochastic events such as mergers and acquisitions, or in more dire cases, bankruptcies.

• Quantitative (Quant) Strategies: Relying on algorithms and data to seek and identify opportunities more quickly than a human can.

Hedge funds can flip-flop from one strategy to another relatively quickly; thus, they can react to market shocks more robustly and flexibly than other, less nimble institutions.

The Impact of Institutional Investors on The Market

Institutional investors, whether they are hedge funds, pension funds, or endowments, are some of the major players in the market. Their large trades can move prices dramatically, and sometimes create trends for smaller investors to follow. If you have a large pension fund that decides to move billions into renewable energy stocks, for example, that can create a rally across the entire renewable energy sector.

Institutional investors also have a stake in corporate governance. Large shareholders, with voting rights, can exert pressure on poor management, ineffective strategy, or poor environmental and social governance (or ESG). By doing so, institutional investors can influence not only markets but also companies within markets.

The Risks and Rewards

The rewards for hedge funds, if they are successful, can be immense. Legendary managers like George Soros and Ray Dalio have made billions for themselves and their investors by producing a call on market volatility before anyone else.

The risks are equally significant, and some funds can, and do, fail spectacularly and take a lot of money with them overnight. Institutional investors are organized so that long-term stability is as important as their activities in the markets.

Even though they invest in a diversified fund of funds, market shocks, changing asset allocation, and interest rates, as well as worldwide recessions and depressions, can create significant gaps. What they have is more hope to achieve a long-term horizon and more broadly diversified assets to work with.

Why Are They Important to Us

Even if you have never invested in a hedge fund (or a mutual fund for that matter), they are essential to us. A pension fund can perform in the investment market that is anywhere from good to bad. Still, your future retirement income is very likely to turn out very differently for millions of the same people.

An aggressive short position in a hedge fund against any company can quickly turn upside down once that business becomes liquidated or from a forced lay-off of workers.

Hedge funds, investment banks, and institutional investments follow a clear business direction with little or no concealment. The plays they make can play out further based on the plays of your potential investment, banking, and/or hedge concerns.

A hedge fund unwinding a prominent position will trigger selling. Conversely, if an institutional investor plays the long game in a lower going away acquisition, the price of the playing it buys for you will always trade-up as it sells it while the market decides where the next tier should go.

The Future of Hedge funds and institutional investors

The financial universe is changing quickly. Technology is changing fast. Data analytics is getting as fast as commerce. Artificial Intelligence is beginning to play important roles, are sometimes influenced, and more times written by the process of investing. Regulators are increasing scrutiny and establishing their landscape positioning in many regulated periods within any given turbulent market and environment.

As environmental, ethical (social), and governance (sustainability) investing becomes a more valid basis of operations in institutional investing, more pension plans and endowments are beginning to invest their funds towards environmental good, ethical investing, and related horror stories of environmental sustainability's conflated topic that yields billions.

As more hedge funds are willing to and have adapted to find the ability to grow profits and stocks, the public is all in on their global commitment to cleaner energy and ethical investing, and the opportunities relevant to those changes come out of our businesses.

Similar to Sid Martur, Tactical Investing applies concessional principles to permanent schemes, despite some physical correlation. There is no measure of return, despite the numerous low-cost index funds and ETFs achieving alpha compared to outperformance (including hedge funds), with no commitment to outperform the market in the future.

Final Thoughts

Hedge funds and institutional investors may not be operating their investment plans where they will play a bill to play every day eventually. Still, they are going to be operating where they need the least attention, whether you see them as essential market-makers defeating residuals, or giant and powerful gatekeepers that can defeat investments on regular retail play markets. Making sense of how they do exist will help you to consider the landscape of the real financial universe more realistically.

The next time you hear of some company's stock going up suddenly, or there is a change in corporate management, or something moves in some space market sense you have in this world of global shares and markets, do consider on some level, behind the curtain there could be a hedge fund or a back story about investment plans and institutional investor industry that is playing the better stocks, not the other way around. A stock price doesn't change for dumb if there are institutional investors behind the curtain helping it along.