How do hedge funds make money? This question could be answered through describing the wide set of strategies that constitute hedge funds or it can be addressed on a much higher or general level. At this higher level, the potential for making money can be broken into three categories, exploiting: biases, risk premiums or structural flaws.
- Alpha production from behavioral biases may come in a number of forms. Investors may be slow to react to new information. They may have anchored expectations. It could be an over-reaction to news. All of the behavior biases identified may lead to deviations from true value, and the smart hedge fund manager is able to identify and exploit these biases. This may be persistent or they may ebb and flows with market conditions.
- Exploiting risk premiums could be considered managing the wide set factor exposures identified in different asset classes. The excess returns are associated with taking on risk premium that are not measured in a benchmark. The hedge fund manager may be very good at switching between risk premiums which could be the basis for global macro and managed futures or the manager could just receive returns for taking on a unique set of risks.
- The hedge fund manager could be good at identifying structural changes or flaws in the marketplace which could lead to return opportunities. These excess returns could be from a change in regulations or a new law that may be temporary but will allow for excess returns. The excess returns could be from a capital constraint that allows profit to accrue because there is not even capital to arbitrage away opportunities.