What does Hedge Fund do?

Return on financial asset can be broken down into two components: capital appreciation and cash flow.

Capital appreciation is the purchase (or decrease) in the price of an asset over the purchase price. Cash flow is the actual cash distribution to the owner.

Hedge fund involves shorting shares of the company and using leverage.

Another example is to buy Google while shorting Yahoo in equal dollar amount. Alternatively you can buy Singtel and short M1 at the same time.The point is by taking hedge position, you can significantly reduce your risk of holding your Google or Singtel position. The Google (long) and Yahoo (Short) trade is known as a pairs trade, where investor wishes to benefit from his expectation that one security will perform better than another while hedging out market risk. The best pairs are those in the same or similar industries or ones where one industry has a clear advantage over the others.

The idea is to have a hedge portfolio of a dozen or more pairs trades that are similarly contrived to profit from the relative performance between two securities. 

Directional trade involves using strategies which captures macro trends. Nonetheless, the Sharpe Ratio of directional strategies are often low. A Sharpe Ratio, the portfolio return divided by the variability of the return, greater than 1 is very good. It means that taking the risk of making your investment is better than holding cash, even when the returns of the risky investment have been adjusted for the risk taken.

Arbitrage is likely the least volatile of all hedge strategies, involving simultaneous buying and selling of a security at two different prices in two different markets, resulting in profits without risk. Arbitrage opportunities do not stick around for long. The knowledge of an arbitrage seeps into the intelligence of the market, and others begin to see and trade the same idea, making it less profitable over time and prehaps even a losing trade.

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