The following article was written by Adinah Brown, content manager at Leverate.
Traders are always looking for tricks to give them an edge in the market. One way of doing this is by offsetting the risk of a trade by hedging it against market movements in the opposite direction. Consider it like an insurance policy so that if for example you were buying a house that happened to be located in an area that was prone to bush fires, you would most likely want to try and hedge that risk, by taking out home insurance that covered fire damage.
To every hedge there is a risk-reward tradeoff that is part and parcel, so that while a hedge does significantly reduce your exposure to risk, it does so at a cost. Likewise, with your house insurance policy, you would have to pay monthly or annual premiums, and if your house never gets engulfed in fire, you never get a payout.
Still, the nature of the beast is that hedging plays a vital part in many trades. However in this article we look at some of the more obscure and interesting techniques that hedge fund managers have used to protect their positions.
1. Life Insurance Policies – Morbid or otherwise, hedge fund managers have been known to invest in the life insurance policies of CEO’s, Presidents and industry leaders, so that should they die and their stocks fall flat with them, they know that they will still collect either way.
2. Bankruptcy Claims – There are fund managers who have specialized in purchasing the claims of bankrupt companies. The most well-known example of this are claims made by the victims of the Bernie Madoff scam in 2012. After Madoff claimed bankruptcy, hedge funds were able to buy these claims for pennies and then later collected in the dollars as trustees located funds for victims.
3. Catastrophe Bonds – Effectively hedging on risk itself, this is where insurance companies will sell off their risk to hedge funds, to reduce their own exposure to a specific type of catastrophe, be it hurricanes, earthquakes or floods in a defined location. Investors monetize by collecting the yield and hoping that god restrains his rage and fury, or at least focuses it on somewhere else.
4. Water Rights – In Western United States and Australia there is the practice of hedge funds investing in water rights. These are the only two locations where you can buy “shares” of water from river systems. Legally separated from land rights, the water claims are freely tradeable, have a yield component (where private owners can sell a portion of their annual allocation) and also incur capital appreciation.
5. Museum Art – Rather fancy a Picasso or a Rembrandt? Well, there are a limited number of hedge funds that have specialized in art investing. These hedge fund managers focus their efforts on “museum grade quality art” for which there is already an existing secondary market. Albeit, this strategy tends to be a preferred method of high-net-worth individuals because it tends to be less about the return on investment and more about being able to hold these “portfolio assets” on a large wall in their living room.
6. Pottery – Similar to museum art, pottery investors focus on buying museum-worthy pottery with significant historical value, such as vases made in the Ming-era in China. More than just an appreciation for an aesthetic, the theory behind it is that the value of Chinese art has been found to correlate to the number of wealthy Chinese citizens. So it becomes a way to invest in the Chinese economy without having to deal with its overly red-taped bureaucracy. Keep in mind forgery is prevalent!
7. Wine – Any wine buff will tell you that wine gets more valuable with age, but what fewer have realized is that this is an attractive feature for hedge fund managers. Expertized knowledge of the wine market, enables wine buffs to make an educated guess of which brand names are likely to appreciate in value over time. They seek out to buy wine wholesale and then sell those bottles at larger retail prices to investors. The challenge of course is restraining yourself from consuming your own hedge.
8. Single Malt Scotch – Same theory that applies to investing in wine, except scotch investors have seen a rapidly expanding market in China and India that is currently causing an acute under supply. 20 odd years ago, distilleries did not predict the economic growth in Asia and therefore significantly under produced. This short supply of aged, high quality scotch, has since created significant upward pressure for the unusual commodity.
9. Counting Ships – Less of a hedge and more of a risk management strategy. Large commodity funds will put representatives at major ports around the globe whose job it is to count the number of ships leaving and entering a port, whilst recording where they are going to and coming from, the commodities they are carrying and any other information they can glean. They do this for the purpose of understanding the supply and demand dynamics of those specific markets.
10. Film Financing – The big screen is big business, and not surprisingly several hedge funds have moved in to squeeze out their millions from the arena. To determine a movie’s hedging value they analyze metrics such as historical revenue generation, who are the key actors, producers and screenwriters along with the quality of the script. As is the nature of the industry, the fund managers throw fantastic parties for their investors and grab the opportunity to raise the sort of capital that you could expect when one rubs shoulders with A-class celebrities.