One of my final term (!) MBA classes is "Hedge Funds," which takes a look at those investment vehicles of mystery and intrigue (though the whole aim of the class is to prove that HF are not so mysterious - we shall see). As part of the class, we have to keep a mock portfolio of futures trades, so I will do an ongoing (short) post this term looking at a few of the long/short* trades we are making, and why.*If you are wondering what the difference is between long and short, and confused about what a hedge fund actually is (you are not alone!), see the bottom of this post for a few term definitions.
Of course, all the usual caveats apply - this is just for fun, so please don't sell your house, car, and trusty dog to cash out and invest in what I'm posting. But it can be fun to play with 'fake' money! (So far we are up a couple grand this week). What the heck, use all that free time and build your own portfolio!
Trades:
Our investment strategy this week was macro, meaning taking a look at broad-sweeping world events and making investment decisions based on them. For these trades, we are focusing on commodities on the CME (again, see terms) and decided on two plays:
Trade 1: Long on Gold
Ininitially I was actually against this trade, though so far this week it has been profitable. Gold is one of those "safe havens" people pour into during times of economic pessimism and uncertainty. It has had an incredible run over the last few years (not surprising given how our economy has stunk - see the graph below), and remains appealing to many as a protection against inflation. After all, if inflation hits, your $20 bill will buy less at the store, but that gold brick will just rise in value.
My resistance to going long was that a) gold has already had a huge run-up (so it may be over-bought and nearing a bubble) and b) it's a risky play - there is so much economic volatility/uncertainty (political and otherwise) that who the heck knows what will happen. My teammates argued that even if the economy improves, inflation will still be a huge concern given the amount of money the Fed has printed (see my Fed / Taylor Rule post for more inflation thoughts), so gold could still rise in value even if the economy improves. So far, they are right - we'll see how long we have the courage to hold on to the position.
The price of gold over the last 5 years:
Trade 2: Short on Brazilian Real (BRL)
While emerging markets like Brazil have shown periods of explosive growth in the past, my group and I were particularly concerned that Brazil has peaked past its top periods of growth. Specifically, Brazil is putting in place increasingly stifling investment rules, making it difficult for international firms to do business in Brazil (in fact, one of my teammate's firms recently closed down their Brazil offices due to regulations that were becoming so burdensome that it no longer made sense to have a footprint in the country). Lack of competition and increased state-controlled presence in business have also contributed to lower growth, as well as the looming specter of high inflation, which Brazil has frequently battled in the past (with mixed success.)
Technically, you can't bet against a country - so in this case we went short an FX future for BRL/USD.
Not to toot our own horn (though obviously I am), we made the short play on Jan 15th, and the Economist came out with an interesting article on troubling Brazilian economic news on the 19th:
http://www.economist.com/news/americas/21569706-more-inflation-less-growth-wrong-numbers
Thoughts?
That's it for the past week - though now on to a few definitions...
Terms:
CME: Chicago Mercantile Exchange, the main home of futures/derivatives trading.
Futures: A type of derivative (option); specifically, the right to buy something at a future date at a set price. Say pork bellies (nod, Trading Places) are selling for $2/lb (I'm completely making up units here) and you think the price will go up to $5/lb. Therefore you want to go long a futures position (giving you the right to buy pork bellies at $2 in, say, 6 months), then you get to resell your pork that you got to buy for $2/lb to those poor suckers who didn't buy futures and are now paying market price $5/lb. Of course, guess incorrectly on which way the market is moving, and you'll lose money. Farmers are classic examples - they use agriculture futures to help protect themselves against price movements. Of course, you can't actually trade pork bellies anymore, but you get the drift.
FX: The trade of currencies (i.e. foreign currency exchange rates/Forex). You are making a bet on whether the exchange rate for a certain currency will go up/down versus a second currency.
Hedge Fund: An investment group typically set up as a Limited Partnership. The investment manager is the General Partner, and the investors are Limited Partners (which must number less than 100). The investment manager uses money that the limited partners contribute to invest in any number of strategies, such as macro (making bets based on global trends), fixed income (bonds), distressed (companies in bankruptcy), fund of funds (investing in lots of other hedge funds), emerging markets (Brazil, China, etc), and so on. There is typically a high minimum investment, since the HF can have no more than 100 limited partners, and the investment manager makes money both from management fees (set fees charged to the investors) and performance fees (sort of like a bonus, these are a % of profits and where most of the money is made).
Of course, HF may or may not be hedged; the true meaning of a "hedge" is offsetting positions to minimize risk (such as being both long on corn futures and short on corn futures so that you're not hurt no matter the movement). But, NO ONE is perfectly hedged. A, it is impossible (most trades are too complex to find perfectly offsetting trades). B, by definition you couldn't make money if you had no risk. Actually, to quote my professor, "The only way to be perfectly hedged is to be dead."
Long: Buying something, essentially betting that the price will go up. For example, to go long a stock or a future, you simply buy a share of stock, or buy a futures contract.
Short: Borrowing and then selling a position, essentially betting that the price will go down. This is easiest to explain with stocks. IBM closed on Friday at $194.47. To go short means that you borrow the stock from someone and sell it on the open market, hoping that the price will go down (say to $190). Once the price hits $190, you buy the stock at $190, and return the shares to the lender. The lender is no better or worse off (well, they may have charged you a small fee to borrow), while you made $4.47 per share (i.e. the $194.47 you received from selling, less the $190 cost to repurchase).
Of course, if the price had gone up, your losses could theoretically be infinite - say an act of God occurs and the stock shoots up to $5,000 a share. Unlikely, but you're still on the hook to buy the shares and return them, so you'll lose $4805.53 (i.e. the $194.47 you earned from selling the stock, less the $5,000 you had to shell out to repurchase).
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