Ever wonder how hedge fund managers think and how they are sometimes able to generate explosive returns for their investors? You aren't alone. For years, hedge funds have retained a certain level of mystery about them and the way they operate; and for years, public companies and retail investors have tried to figure out the methods behind their (sometimes) apparent madness.

It's impossible to uncover and understand each and every hedge fund's strategy—after all, there are literally thousands of them out there. However, there are some constants when it comes to investment style, the methods of analysis used and how market trends are evaluated. (See also: A Brief History of the Hedge Fund.)

Cash Flow Is King

Hedge funds can come in all shapes and sizes. Some may place a heavy emphasis on arbitrage situations (like buyouts or stock offerings), while others focus on special situations. Others still may aim to be market neutral and profit in any environment, or employ complicated dual long/short investment strategies.

While many investors track metrics such as earnings per share (EPS), many hedge funds also tend to keep a very close eye on another key metric: cash flow.

Cash flow is important because bottom-line EPS can be manipulated or altered by one-time events, such as charges or tax benefits. Cash flow and the cash flow statement tracks money flow, so it can tell you if the company has generated a large sum from investments, or if it has taken in money from third parties, as well as how it's performing operationally. Because of the detail and the breakup of the cash flow statement into three parts (operations, investing and financing), it's considered to be a very valuable tool.

This statement can also tip off the investor if the company is having trouble paying its bills or provide a clue as to how much cash it might have on hand to repurchase shares, pay down debts or conduct another potentially value-enhancing transaction. (See also: The Essentials of Cash Flow.)

Run Trades Through Multiple Brokers or Conduct Arbitrage

When the average individual purchases or sells a stock, he or she tends to do so through one preferred broker. The transaction is generally simple and straightforward, but hedge funds, in their effort to squeeze out every possible gain, tend to run trades through multiple brokers, depending on which offers the best commission, the best execution or other services to assist the hedge fund.

Funds may also purchase a security on one exchange and sell it on another if it means a slightly larger gain (a basic form of arbitrage). Due to their larger size, many funds go the extra mile and may be able to pick up a couple of extra percentage points each year in returns by capitalizing on minute differences in price.

Hedge funds may also look for and try to seize upon mispricings within the market. For example, if a security's price on the New York Stock Exchange is trading out of sync with its corresponding futures contract on Chicago's exchange, a trader could simultaneously sell (short) the more expensive of the two and buy the other, thus profiting on the difference.

This willingness to push the envelope and wait for the biggest gains possible can easily tack on a couple of extra percentage points over a year's time as long as the potential positions truly do cancel each other out. (See also: Arbitrage Squeezes Profit From Market Inefficiency.)

Using Leverage and Derivatives

Hedge funds typically use leverage to magnify their returns. They may purchase securities on margin, or obtain loans and credit lines to fund even more purchases. The idea is to seize on or take advantage of an opportunity. The short version of the story goes that if the investment can generate a big enough return to cover interest costs and commissions (on borrowed funds), this kind of trading can be a highly effective strategy.

The downside is that when the market moves against the hedge fund and its leveraged positions, the result can be devastating. Under such conditions, the fund has to eat the losses plus the carrying cost of the loan. The well-known 1998 collapse of hedge fund Long-Term Capital Management occurred because of just this phenomenon. (See also: Massive Hedge Fund Failures and Hedge Funds' Higher Returns Come at a Price.)

Hedge funds may purchase options, which often trade for only a fraction of the share price. They may also use futures or forward contracts as a means of enhancing returns or mitigating risk. This willingness to leverage their positions with derivatives and take risks is what enables them to differentiate themselves from mutual funds and the average retail investor. This increased risk is also why investing in hedge funds is, with a few exceptions, reserved for high-net-worth and accredited investors, who are considered fully aware of (and perhaps more able to absorb) the risks involved.

Unique Knowledge From Good Sources

Many mutual funds tend to rely on information they obtain from brokerage firms or their own research sources and relationships they have with top management.

The downside to mutual funds, however, is that a fund may maintain many positions (sometimes in the hundreds), so their intimate knowledge of any one particular company may be somewhat limited.

Hedge funds—particularly those that maintain concentrated portfolios—often have the ability and willingness to get to know a company very well. In addition, they may tap multiple sell-side sources for information and cultivate relationships they've developed with top management, and even, in some cases, secondary and tertiary personnel, as well as perhaps distributors the company uses, ex-employees or a variety of other contacts. Because fund managers' personal profits are intimately tied to performance, their investment decisions are typically motivated by one thing—to make money for their investors.

Mutual funds cultivate somewhat similar relationships and do extensive due diligence for their portfolios as well. But hedge funds aren't held back by benchmark limitations or diversification rules. Therefore, at least theoretically, they may be able to spend more time per position; and again, the way hedge fund managers get paid is a strong motivator, which can align their interests directly with those of investors.

They Know When to Fold 'Em

Many retail investors seem to buy into a stock with one hope in mind: to watch the security's price climb in value. There's nothing wrong with wanting to make money, but very few investors consider their exit strategy, or at what price and under what conditions they'll consider selling.

Hedge funds are an entirely different animal. They often get involved in a stock with the intention of taking advantage of a particular event or events, such as the benefits reaped from the sale of an asset, a series of positive earnings releases, news of an accretive acquisition or some other catalyst.

However, once that event transpires, they often have the discipline to book their profits and move on to the next opportunity. This is important to note because having an exit strategy can amplify investment returns and help mitigate losses.

Mutual funds directors often keep an eye on the exit door as well, but a single position may only represent a fraction of a percent of a mutual fund's total holdings, so getting the absolute best execution on the way out may not be as important. So, because they often maintain fewer positions, hedge funds usually need to be on the ball at all times and be ready to book profits.

The Bottom Line

Although often mysterious in nature, hedge funds use or employ some tactics and strategies that are available to everyone. They do, however, often have a distinct advantage when it comes to industry contacts, leveraging investable assets, broker contacts and the ability to access pricing and trade information.

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