Once a niche investment vehicle for the ultra-rich, the hedge fund industry has grown to more than $3.2 trillion in assets under management. Today there are numerous strategies that hedge funds employ, ranging from the simple to the very complex. Hedge funds are also purposefully opaque, so knowing exactly what's on its balance sheet is difficult to ascertain. Often hedge funds operate as a "black box," with little disclosure to investors or the outside public. In addition to a lack of transparency, hedge funds often utilize leverage and derivatives to achieve their goals, making their balance sheets even murkier. (See also: The Multiple Strategies of Hedge Funds.)

In order not to guess at what a modern-day hedge fund's balance sheet looks like, it's useful to go back to their roots: the equity market-neutral long-short fund. Established in 1949, this still frequently used strategy became the world's first hedge fund. (See also A Brief History of the Hedge Fund.)

The Equity Market-Neutral Long-Short Fund

As its name suggests, this strategy both buys and sells short stocks in a manner such that the overall portfolio is relieved of all systematic market risk, and its beta is zero. As a result, the portfolio is immune to the movements and direction of the overall stock market, and any alpha (excess return) generated is solely due to the portfolio manager's ability to buy undervalued stocks and sell overvalued ones.

The buys and sales are not arbitrary. They're instead chosen to cancel the betas of the positions. For example, in the airline sector, XYZ Airlines might be undervalued and ABC Airways overvalued. If the beta of each stock was equal, the fund would buy and sell equal quantities respectively. If ABC had a beta twice as large as XYZ, the fund would sell half as many ABC shares as it buys in XYZ to neutralize the net beta. (See also: Getting Positive Results with Market-Neutral Funds.)

Example of a Hedge Fund Balance Sheet

A balance sheet is a financial statement that shows a snapshot of a company or fund's assets and liabilities. The balance sheet functions under the accounting formula Assets = Liabilities + Owners' Equity. (See also: 5 Tips for Reading a Balance Sheet.)

In the case of our hedge fund, assets are long stock positions and cash. Shares that have been sold short would appear on the balance sheet as liabilities (and the cash generated from those sales as assets). Equity is what is left after subtracting liabilities from assets. Below is a hypothetical example of a balance sheet for a typical equity market-neutral long-short hedge fund:

Assets

 

 

Liabilities

 

 

 

 

 

 

Long stocks

250

 

Short stocks (borrow)

250

Cash (from short sales)

250

 

 

 

Other cash

50

 

 

 

 

 

 

Equity

300

Total assets:

550

 

Total liabilities + equity:

550

In the simplified example above, market neutrality is achieved using equal dollar amounts of long and short positions. In reality, this may not be the case, so long as the effect is a portfolio beta of zero.

One other thing to notice is that in such a strategy, two alphas can be earned: one from the asset selection that produces the long positions and the second from the short positions. Because of this, such a fund may use both a long index and a short index as its benchmark. Other market-neutral hedge funds may use an absolute return for a benchmark; for example, it may be a return objective of 5% annually or 200 basis points greater than the risk-free rate.

The Bottom Line

Hedge funds can be difficult to understand because it is hard to get information on them. However, once you know the basic mechanism of hedging, some of the mystery disappears. It should be said that hedge funds are a high-risk investment, generally favored by those who can afford to lose money but want a chance to get better returns than the general market.