Investopedia

 

What Is a Bear Market?

A bear market is when a market experiences prolonged price declines. It typically describes a condition in which securities prices fall 20% or more from recent highs amid widespread pessimism and negative investor sentiment. Bear markets are often associated with declines in an overall market or index like the S&P 500, but individual securities or commodities can also be considered to be in a bear market if they experience a decline of 20% or more over a sustained period of time—typically two months or more. Bear markets also may accompany general economic downturns such as a recession.¹

Bear markets may be contrasted with upward-trending bull markets.

KEY TAKEAWAYS

• Bear markets occur when prices in a market decline by more than 20%, often accompanied by negative investor sentiment and declining economic prospects.¹
• Bear markets can be cyclical or longer-term. The former lasts for several weeks or a couple of months and the latter can last for several years or even decades.
• Short selling, put options, and inverse ETFs are some of the ways in which investors can make money during a bear market as prices fall.

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What's a Bear Market? InvestoTrivia

Understanding Bear Markets

Stock prices generally reflect future expectations of cash flows and profits from companies. As growth prospects wane, and expectations are dashed, prices of stocks can decline. Herd behavior, fear, and a rush to protect downside losses can lead to prolonged periods of depressed asset prices.

One definition of a bear market says markets are in bear territory when stocks, on average, fall at least 20% off their high. But 20% is an arbitrary number, just as a 10% decline is an arbitrary benchmark for a correction. Another definition of a bear market is when investors are more risk-averse than risk-seeking. This kind of bear market can last for months or years as investors shun speculation in favor of boring, sure bets.

The causes of a bear market often vary, but in general, a weak or slowing or sluggish economy will bring with it a bear market. The signs of a weak or slowing economy are typically low employment, low disposable income, weak productivity and a drop in business profits. In addition, any intervention by the government in the economy can also trigger a bear market.

For example, changes in the tax rate or in the federal funds rate can lead to a bear market. Similarly, a drop in investor confidence may also signal the onset of a bear market. When investors believe something is about to happen, they will take action—in this case, selling off shares to avoid losses. 

Bear markets can last for multiple years or just several weeks. A secular bear market can last anywhere from 10 to 20 years and is characterized by below average returns on a sustained basis. There may be rallies within secular bear markets where stocks or indexes rally for a period, but the gains are not sustained, and prices revert to lower levels. A cyclical bear market, on the other hand, can last anywhere from a few weeks to several months.

The U.S. major market indexes were close to bear market territory on December 24, 2018, falling just shy of a 20% drawdown. More recently, major indexes including the S&P 500 and Dow Jones Industrial Average fell sharply into bear market territory between March 11–12, 2020. Prior to that, the last prolonged bear market in the United States occurred between 2007 and 2009 during the Financial Crisis and lasted for roughly 17 months. The S&P 500 lost 50% of its value during that time.

In February 2020, global stocks entered a sudden bear market in the wake of the global coronavirus pandemic, sending the DJIA down 38% from its all-time high on February 12 (29,568.77) to a low on March 23 (18,213.65) in just over one month. Though the S&P 500 and the Nasdaq 100 both made new highs by August, the DJIA failed to do so.

History and duration of bear markets.

Phases of a Bear Market

Bear markets usually have four different phases.

1.    The first phase is characterized by high prices and high investor sentiment. Towards the end of this phase, investors begin to drop out of the markets and take in profits.

2.    In the second phase, stock prices begin to fall sharply, trading activity and corporate profits begin to drop, and economic indicators, that may have once been positive, start to become below average. Some investors begin to panic as sentiment starts to fall. This is referred to as capitulation.

3.    The third phase shows speculators start to enter the market, consequently raising some prices and trading volume.

4.    In the fourth and last phase, stock prices continue to drop, but slowly. As low prices and good news starts to attract investors again, bear markets start to lead to bull markets.

"Bear" and "Bull"

The bear market phenomenon is thought to get its name from the way in which a bear attacks its prey—swiping its paws downward. This is why markets with falling stock prices are called bear markets. Just like the bear market, the bull market may be named after the way in which the bull attacks by thrusting its horns up into the air.

Bear Markets vs. Corrections

A bear market should not be confused with a correction, which is a short-term trend that has a duration of fewer than two months. While corrections offer a good time for value investors to find an entry point into stock markets, bear markets rarely provide suitable points of entry. This barrier is because it is almost impossible to determine a bear market's bottom. Trying to recoup losses can be an uphill battle unless investors are short sellers or use other strategies to make gains in falling markets.

Between 1900 and 2018, there were 33 bear markets, averaging one every 3.5 years. One of the most recent bear markets coincided with the global financial crisis occurring between October 2007 and March 2009. During that time the Dow Jones Industrial Average (DJIA) declined 54%.

Short Selling in Bear Markets

Investors can make gains in a bear market by short selling. This technique involves selling borrowed shares and buying them back at lower prices. It is an extremely risky trade and can cause heavy losses if it does not work out. A short seller must borrow the shares from a broker before a short sell order is placed. The short seller’s profit and loss amount is the difference between the price where the shares were sold and the price where they were bought back, referred to as "covered."

For example, an investor shorts 100 shares of a stock at $94. The price falls and the shares are covered at $84. The investor pockets a profit of $10 x 100 = $1,000. If the stock trades higher unexpectedly, the investor is forced to buy back the shares at a premium, causing heavy losses. 

Puts and Inverse ETFs in Bear Markets

A put option gives the owner the freedom, but not the responsibility, to sell a stock at a specific price on, or before, a certain date. Put options can be used to speculate on falling stock prices, and hedge against falling prices to protect long-only portfolios. Investors must have options privileges in their accounts to make such trades. Outside of a bear market, buying puts is generally safer than short selling.

Inverse ETFs are designed to change values in the opposite direction of the index they track. For example, the inverse ETF for the S&P 500 would increase by 1% if the S&P 500 index decreased by 1%. There are many leveraged inverse ETFs that magnify the returns of the index they track by two and three times. Like options, inverse ETFs can be used to speculate or protect portfolios.

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Tips For Retiring In A Bear Market

Real World Examples of Bear Markets

The ballooning housing mortgage default crisis caught up with the stock market in October 2007. Back then, the S&P 500 had touched a high of 1565.15 October 9. By March 5, 2009, it had crashed to 682.55 as the extent and ramifications of housing mortgage defaults on the overall economy became clear. The U.S. major market indexes were again close to bear market territory on December 24, 2018, falling just shy of a 20% drawdown.

Most recently, the Dow Jones Industrial Average went into a bear market on March 11, 2020, and the S&P 500 entered a bear market on March 12, 2020. This followed the longest bull market on record for the index, which started in March 2009. Stocks were driven down by the effects of the coronavirus and falling oil prices due to the split between Saudi Arabia and Russia. During this period, the Dow Jones fell sharply from all-time highs close to 30,000 to lows below 19,000 in a matter of weeks.

Other examples include the aftermath of the bursting of the dot com bubble in March 2000, which wiped out approximately 49% of the S&P 500's value and lasted until October 2002; and the Great Depression which began with the stock market collapse of October 28-29, 1929.

 

 

Derivative

• What Is a Derivative?
• The Basics of a Derivative
• Common Forms of Derivatives
• Advantages of Derivatives
• Downside of Derivatives
• Real World Example of Derivatives
• Frequently Asked Questions

What Is a Derivative?

A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties, and the derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest rates, and market indexes. These assets are commonly purchased through brokerages.

(See how your broker compares with Investopedia list of the best online brokers).

 Melissa Ling {Copyright} Investopedia, 2019.

Derivatives can trade over-the-counter (OTC) or on an exchange. OTC derivatives constitute a greater proportion of the derivatives market. OTC-traded derivatives, generally have a greater possibility of counterparty risk. Counterparty risk is the danger that one of the parties involved in the transaction might default. These parties trade between two private parties and are unregulated.

Conversely, derivatives that are exchange-traded are standardized and more heavily regulated.

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Derivative: My Favorite Financial Term

The Basics of a Derivative

Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings. Their value comes from the fluctuations of the values of the underlying asset.

Originally, derivatives were used to ensure balanced exchange rates for goods traded internationally. With the differing values of national currencies, international traders needed a system to account for differences. Today, derivatives are based upon a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.

For example, imagine a European investor, whose investment accounts are all denominated in euros (EUR). This investor purchases shares of a U.S. company through a U.S. exchange using U.S. dollars (USD). Now the investor is exposed to exchange-rate risk while holding that stock. Exchange-rate risk the threat that the value of the euro will increase in relation to the USD. If the value of the euro rises, any profits the investor realizes upon selling the stock become less valuable when they are converted into euros.

To hedge this risk, the investor could purchase a currency derivative to lock in a specific exchange rate. Derivatives that could be used to hedge this kind of risk include currency futures and currency swaps.

A speculator who expects the euro to appreciate compared to the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have a holding or portfolio presence in the underlying asset.

KEY TAKEAWAYS

• Derivatives are securities that derive their value from an underlying asset or benchmark.
• Common derivatives include futures contracts, forwards, options, and swaps.
• Most derivatives are not traded on exchanges and are used by institutions to hedge risk or speculate on price changes in the underlying asset.
• Exchange-traded derivatives like futures or stock options are standardized and eliminate or reduce many of the risks of over-the-counter derivatives
• Derivatives are usually leveraged instruments, which increases their potential risks and rewards.

Common Forms of Derivatives

There are many different types of derivatives that can be used for risk management, for speculation, and to leverage a position. Derivatives is a growing marketplace and offer products to fit nearly any need or risk tolerance.

Futures

Futures contracts—also known simply as futures—are an agreement between two parties for the purchase and delivery of an asset at an agreed upon price at a future date. Futures trade on an exchange, and the contracts are standardized. Traders will use a futures contract to hedge their risk or speculate on the price of an underlying asset. The parties involved in the futures transaction are obligated to fulfill a commitment to buy or sell the underlying asset.

For example, say that Nov. 6, 2019, Company-A buys a futures contract for oil at a price of $62.22 per barrel that expires Dec. 19, 2019. The company does this because it needs oil in December and is concerned that the price will rise before the company needs to buy. Buying an oil futures contract hedges the company's risk because the seller on the other side of the contract is obligated to deliver oil to Company-A for $62.22 per barrel once the contract has expired. Assume oil prices rise to $80 per barrel by Dec. 19, 2019. Company-A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits.

In this example, it is possible that both the futures buyer and seller were hedging risk. Company-A needed oil in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures contract. The seller could be an oil company that was concerned about falling oil prices and wanted to eliminate that risk by selling or "shorting" a futures contract that fixed the price it would get in December.

It is also possible that the seller or buyer—or both—of the oil futures parties were speculators with the opposite opinion about the direction of December oil. If the parties involved in the futures contract were speculators, it is unlikely that either of them would want to make arrangements for delivery of several barrels of crude oil. Speculators can end their obligation to purchase or deliver the underlying commodity by closing—unwinding—their contract before expiration with an offsetting contract.

For example, the futures contract for West Texas Intermediate (WTI) oil trades on the CME represents 1,000 barrels of oil. If the price of oil rose from $62.22 to $80 per barrel, the trader with the long position—the buyer—in the futures contract would have profited $17,780 [($80 - $62.22) X 1,000 = $17,780]. The trader with the short position—the seller—in the contract would have a loss of $17,780.

Not all futures contracts are settled at expiration by delivering the underlying asset. Many derivatives are cash-settled, which means that the gain or loss in the trade is simply an accounting cash flow to the trader's brokerage account. Futures contracts that are cash settled include many interest rate futures, stock index futures, and more unusual instruments like volatility futures or weather futures.

Forwards

Forward contracts—known simply as forwards—are similar to futures, but do not trade on an exchange, only over-the-counter. When a forward contract is created, the buyer and seller may have customized the terms, size and settlement process for the derivative. As OTC products, forward contracts carry a greater degree of counterparty risk for both buyers and sellers.

Counterparty risks are a kind of credit risk in that the buyer or seller may not be able to live up to the obligations outlined in the contract. If one party of the contract becomes insolvent, the other party may have no recourse and could lose the value of its position. Once created, the parties in a forward contract can offset their position with other counterparties, which can increase the potential for counterparty risks as more traders become involved in the same contract.

Swaps

Swaps are another common type of derivative, often used to exchange one kind of cash flow with another. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.

Imagine that Company XYZ has borrowed $1,000,000 and pays a variable rate of interest on the loan that is currently 6%. XYZ may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while the company has this variable rate risk.

Assume that XYZ creates a swap with Company QRS, which is willing to exchange the payments owed on the variable rate loan for the payments owed on a fixed rate loan of 7%. That means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will pay XYZ 6% interest on the same principal. At the beginning of the swap, XYZ will just pay QRS the 1% difference between the two swap rates.

If interest rates fall so that the variable rate on the original loan is now 5%, Company XYZ will have to pay Company QRS the 2% difference on the loan. If interest rates rise to 8%, then QRS would have to pay XYZ the 1% difference between the two swap rates. Regardless of how interest rates change, the swap has achieved XYZ's original objective of turning a variable rate loan into a fixed rate loan.

Swaps can also be constructed to exchange currency exchange rate risk or the risk of default on a loan or cash flows from other business activities. Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative—a bit too popular. In the past. It was the counterparty risk of swaps like this that eventually spiraled into the credit crisis of 2008.

Options

An options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that, with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation—futures are obligations. As with futures, options may be used to hedge or speculate on the price of the underlying asset.

Imagine an investor owns 100 shares of a stock worth $50 per share they believe the stock's value will rise in the future. However, this investor is concerned about potential risks and decides to hedge their position with an option. The investor could buy a put option that gives them the right to sell 100 shares of the underlying stock for $50 per share—known as the strike price—until a specific day in the future—known as the expiration date.

Assume that the stock falls in value to $40 per share by expiration and the put option buyer decides to exercise their option and sell the stock for the original strike price of $50 per share. If the put option cost the investor $200 to purchase, then they have only lost the cost of the option because the strike price was equal to the price of the stock when they originally bought the put. A strategy like this is called a protective put because it hedges the stock's downside risk.

Alternatively, assume an investor does not own the stock that is currently worth $50 per share. However, they believe that the stock will rise in value over the next month. This investor could buy a call option that gives them the right to buy the stock for $50 before or at expiration. Assume that this call option cost $200 and the stock rose to $60 before expiration. The call buyer can now exercise their option and buy a stock worth $60 per share for the $50 strike price, which is an initial profit of $10 per share. A call option represents 100 shares, so the real profit is $1,000 less the cost of the option—the premium—and any brokerage commission fees.

In both examples, the put and call option sellers are obligated to fulfill their side of the contract if the call or put option buyer chooses to exercise the contract. However, if a stock's price is above the strike price at expiration, the put will be worthless and the seller—the option writer—gets to keep the premium as the option expires. If the stock's price is below the strike price at expiration, the call will be worthless and the call seller will keep the premium. Some options can be exercised before expiration. These are known as American-style options, but their use and early exercise are rare.

Advantages of Derivatives

As the above examples illustrate, derivatives can be a useful tool for businesses and investors alike. They provide a way to lock in prices, hedge against unfavorable movements in rates, and mitigate risks—often for a limited cost. In addition, derivatives can often be purchased on margin—that is, with borrowed funds—which makes them even less expensive.

Downside of Derivatives

On the downside, derivatives are difficult to value because they are based on the price of another asset. The risks for OTC derivatives include counter-party risks that are difficult to predict or value as well. Most derivatives are also sensitive to changes in the amount of time to expiration, the cost of holding the underlying asset, and interest rates. These variables make it difficult to perfectly match the value of a derivative with the underlying asset.

Pros

·         Lock in prices

·         Hedge against risk

·         Can be leveraged

·         Diversify portfolio

Cons

·         Hard to value

·         Subject to counterparty default (if OTC)

·         Complex to understand

·         Sensitive to supply and demand factors

Also, since the derivative itself has no intrinsic value—its value comes only from the underlying asset—it is vulnerable to market sentiment and market risk. It is possible for supply and demand factors to cause a derivative's price and its liquidity to rise and fall, regardless of what is happening with the price of the underlying asset.

Finally, derivatives are usually leveraged instruments, and using leverage cuts both ways. While it can increase the rate of return it also makes losses mount more quickly.

Real World Example of Derivatives

Many derivative instruments are leveraged. That means a small amount of capital is required to have an interest in a large amount of value in the underlying asset.

For example, an investor who expects the S&P 500 Index to rise in value could buy a futures contract based on that venerable equity index of the largest U.S. publicly traded companies. The notional value of a futures contract on the S&P 500 is $250,000.

Frequently Asked Questions

What are derivatives?

Derivatives are securities whose value is dependent on—or “derived from”—an underlying asset. For example, an oil futures contract is a type of derivative whose value is based on the market price of oil. Derivatives have become increasingly popular in recent decades, with the total value of derivatives outstanding currently estimated at over $600 trillion.

What are some examples of derivatives?

Common examples of derivatives include futures contracts, options contracts, and credit default swaps. Beyond these, there is a vast quantity of derivative contracts tailored to meet the needs of a diverse range of counterparties. In fact, since many derivatives are traded over the counter (OTC), they can in principle be infinitely customized.

What are the main benefits and risks of derivatives?

Derivatives can be a very convenient way to achieve financial goals. For example, a company that wants to hedge against its exposure to commodities can do so by buying or selling energy derivatives such as crude oil futures. Similarly, a company could hedge its currency risk by purchasing currency forward contracts. Derivatives can also help investors leverage their positions, such as by buying equities through stock options rather than shares. The main drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact that complicated webs of derivative contracts can lead to systemic risks.

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Bull Market

By 

ADAM HAYES

 

 

Reviewed by 

GORDON SCOTT

 

 

Updated Feb 24, 2021

What is a Bull Market?

A bull market is the condition of a financial market in which prices are rising or are expected to rise. The term "bull market" is most often used to refer to the stock market but can be applied to anything that is traded, such as bonds, real estate, currencies, and commodities.

Because prices of securities rise and fall essentially continuously during trading, the term "bull market" is typically reserved for extended periods in which a large portion of security prices are rising. Bull markets tend to last for months or even years.

KEY TAKEAWAYS

• A bull market is a period of time in financial markets when the price of an asset or security rises continuously.
• The commonly accepted definition of a bull market is when stock prices rise by 20% after two declines of 20% each.
• Traders employ a variety of strategies, such as increased buy and hold and retracement, to profit off bull markets.

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Bull Market

Understanding Bull Markets

Bull markets are characterized by optimism, investor confidence, and expectations that strong results should continue for an extended period of time. It is difficult to predict consistently when the trends in the market might change. Part of the difficulty is that psychological effects and speculation may sometimes play a large role in the markets.

There is no specific and universal metric used to identify a bull market. Nonetheless, perhaps the most common definition of a bull market is a situation in which stock prices rise by 20%, usually after a drop of 20% and before a second 20% decline. Since bull markets are difficult to predict, analysts can typically only recognize this phenomenon after it has happened. A notable bull market in recent history was the period between 2003 and 2007. During this time, the S&P 500 increased by a significant margin after a previous decline; as the 2008 financial crisis took effect, major declines occurred again after the bull market run.

Characteristics of a Bull Market

Bull markets generally take place when the economy is strengthening or when it is already strong. They tend to happen in line with strong gross domestic product (GDP) and a drop in unemployment and will often coincide with a rise in corporate profits. Investor confidence will also tend to climb throughout a bull market period. The overall demand for stocks will be positive, along with the overall tone of the market. In addition, there will be a general increase in the amount of IPO activity during bull markets.

Notably, some of the factors above are more easily quantifiable than others. While corporate profits and unemployment are quantifiable, it can be more difficult to gauge the general tone of market commentary, for instance. Supply and demand for securities will seesaw: supply will be weak while demand will be strong. Investors will be eager to buy securities, while few will be willing to sell. In a bull market, investors are more willing to take part in the (stock) market in order to gain profits.

Bull vs. Bear Markets

The opposite of a bull market is a bear market, which is characterized by falling prices and typically shrouded in pessimism. The commonly held belief about the origin of these terms suggests that the use of "bull" and "bear" to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air, while a bear swipes its paws downward. These actions are metaphors for the movement of a market. If the trend is up, it's a bull market. If the trend is down, it's a bear market.

Bull and bear markets often coincide with the economic cycle, which consists of four phases: expansion, peak, contraction, and trough. The onset of a bull market is often a leading indicator of economic expansion. Because public sentiment about future economic conditions drives stock prices, the market frequently rises even before broader economic measures, such as gross domestic product (GDP) growth, begin to tick up. Likewise, bear markets usually set in before economic contraction takes hold. A look back at a typical U.S. recession reveals a falling stock market several months ahead of GDP decline.

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Market Mentalities: Bulls Vs. Bears

How to Take Advantage of a Bull Market

Investors who want to benefit from a bull market should buy early in order to take advantage of rising prices and sell them when they’ve reached their peak. Although it is hard to determine when the bottom and peak will take place, most losses will be minimal and are usually temporary. Below, we'll explore several prominent strategies investors utilize during bull market periods. However, because it is difficult to assess the state of the market as it exists currently, these strategies involve at least some degree of risk as well.

Buy and Hold

One of the most basic strategies in investing is the process of buying a particular security and holding onto it, potentially to sell it at a later date. This strategy necessarily involves confidence on the part of the investor: why hold onto a security unless you expect its price to rise? For this reason, the optimism that comes along with bull markets helps to fuel the buy and hold approach.

Increased Buy and Hold

Increased buy and hold is a variation on the straightforward buy and hold strategy, and it involves additional risk. The premise behind the increased buy and hold approach is that an investor will continue to add to his or her holdings in a particular security so long as it continues to increase in price. One common method for increasing holdings suggests that an investor will buy an additional fixed quantity of shares for every increase in stock price of a pre-set amount.

Retracement Additions

A retracement is a brief period in which the general trend in a security's price is reversed. Even during a bull market, it's unlikely that stock prices will only ascend. Rather, there are likely to be shorter periods of time in which small dips occur as well, even as the general trend continues upward. Some investors watch for retracements within a bull market and move to buy during these periods. The thinking behind this strategy is that, presuming that the bull market continues, the price of the security in question will quickly move back up, retroactively providing the investor with a discounted purchase price.

Full Swing Trading

Perhaps the most aggressive way of attempting to capitalize on a bull market is the process known as full swing trading. Investors utilizing this strategy will take very active roles, using short-selling and other techniques to attempt to squeeze out maximum gains as shifts occur within the context of a larger bull market.

Bull Market Example

The most prolific bull market in modern American history started at the end of the stagflation era in 1982 and concluded during the dotcom bust in 2000. During this secular bull market—a term that denotes a bull market lasting many years—the Dow Jones Industrial Average (DJIA) averaged 16.8% annual returns. The NASDAQ, a tech-heavy exchange, increased its value five-fold between 1995 and 2000, rising from 1,000 to over 5,000. A protracted bear market followed the 1982-2000 bull market. From 2000 to 2009, the market struggled to establish footing and delivered average annual returns of -6.2%. However, 2009 saw the start of a more than ten-year bull market run. Analysts believe that the last bull market started on March 9, 2009, and was mainly led by an upswing in technology stocks.

Frequently Asked Questions

Why is it called a "bull" market when prices go up?

The actual origin of the term "bull" is subject to debate. The terms "bear" (for down markets) and "bull" (for up markets) are thought by some to derive from the way in which each animal attacks its opponents. That is, a bull will thrust its horns up into the air, while a bear will swipe down. These actions were then related metaphorically to the movement of a market. If the trend was up, it was considered a bull market. If the trend was down, it was a bear market. Others point to Shakespeare's plays, which make reference to battles involving bulls and bears. In Macbeth, the ill-fated titular character says his enemies have tethered him to a stake but "bear-like, I must fight the course." In Much Ado About Nothing, the bull is a savage but noble beast. Several other explanations also exist.

Are we in a bull market now?

Generically, a bull market exists if the market has risen 20% or more above its near-term lows. Since the dramatic market sell-off during the 2008-09 financial crisis, the stock market has shown a resilient bull market, rising significantly, and reaching new all-time highs more than ten years after that market crash (despite some sharp pullbacks along the way).

Why do stock prices rise in a bull market?

Bull markets often exist side-by-side a healthy, robust, and growing economy. Stock prices are informed by future expectations of profits and the ability of firms to generate cash flows. A strong production economy, high employment, and rising GDP all suggest profits will continue to grow, and this is reflected in rising stock prices. Low interest rates and low corporate tax rates also are positive for corporate profitability.

Why do bull markets sometimes falter and become bear markets?

When the economy hits a rough patch, for instance in the face of recession or spike in unemployment, it becomes difficult to sustain rising stock prices. Moreover, recessions are often accompanied by a negative turn in investor and consumer sentiment, where market psychology becomes more concerned with fear or reducing risk than greed or risk-taking.

Equity

By 

JASON FERNANDO

 

 

Reviewed by 

KHADIJA KHARTIT

 

 

Updated Feb 27, 2021

What Is Equity?

Equity, typically referred to as shareholders' equity (or owners' equity for privately held companies), represents the amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company's debt was paid off in the case of liquidation. In the case of acquisition, it is the value of company sale minus any liabilities owed by the company not transferred with the sale.

In addition, shareholder equity can represent the book value of a company. Equity can sometimes be offered as payment-in-kind. It also represents the pro-rata ownership of a company's shares.

Equity can be found on a company's balance sheet and is one of the most common pieces of data employed by analysts to assess the financial health of a company.

KEY TAKEAWAYS

• Equity represents the value that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company's debts were paid off.
• We can also think of equity as a degree of residual ownership in a firm or asset after subtracting all debts associated with that asset.
• Equity represents the shareholders’ stake in the company, identified on a company's balance sheet.
• The calculation of equity is a company's total assets minus its total liabilities, and is used in several key financial ratios such as ROE.

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Equity

Formula and Calculation for Shareholder Equity

The following formula and calculation can be used to determine the equity of a firm, which is derived from the accounting equation:

\text{Shareholders' Equity} = \text{Total Assets} - \text{Total Liabilities}Shareholders’ Equity=Total Assets−Total Liabilities

This information can be found on the balance sheet, where these four steps should be followed:

1.    Locate the company's total assets on the balance sheet for the period.

2.    Locate total liabilities, which should be listed separately on the balance sheet.

3.    Subtract total liabilities from total assets to arrive at shareholder equity.

4.    Note that total assets will equal the sum of liabilities and total equity.

Shareholder equity can also be expressed as a company's share capital and retained earnings less the value of treasury shares. This method, however, is less common. Though both methods yield the same figure, the use of total assets and total liabilities is more illustrative of a company's financial health.

Understanding Shareholder Equity 

By comparing concrete numbers reflecting everything the company owns and everything it owes, the "assets-minus-liabilities" shareholder equity equation paints a clear picture of a company's finances, which can be easily interpreted by investors and analysts. Equity is used as capital raised by a company, which is then used to purchase assets, invest in projects, and fund operations. A firm typically can raise capital by issuing debt (in the form of a loan or via bonds) or equity (by selling stock). Investors typically seek out equity investments as it provides greater opportunity to share in the profits and growth of a firm.

Equity is important because it represents the value of an investor’s stake in a company, represented by their proportion of the company's shares. Owning stock in a company gives shareholders the potential for capital gains as well as dividends. Owning equity will also give shareholders the right to vote on corporate actions and in any elections for the board of directors. These equity ownership benefits promote shareholders' ongoing interest in the company.

Shareholder equity can be either negative or positive. If positive, the company has enough assets to cover its liabilities. If negative, the company's liabilities exceed its assets; if prolonged, this is considered balance sheet insolvency. Typically, investors view companies with negative shareholder equity as risky or unsafe investments. Shareholder equity alone is not a definitive indicator of a company's financial health; used in conjunction with other tools and metrics, the investor can accurately analyze the health of an organization.

Components of Shareholder Equity

Retained earnings are part of shareholder equity and are the percentage of net earnings that were not paid to shareholders as dividends. Think of retained earnings as savings since it represents a cumulative total of profits that have been saved and put aside or retained for future use. Retained earnings grow larger over time as the company continues to reinvest a portion of its income.

At some point, the amount of accumulated retained earnings can exceed the amount of equity capital contributed by stockholders. Retained earnings are usually the largest component of stockholders’ equity for companies that have been operating for many years.

Treasury shares or stock (not to be confused with U.S.Treasury bills) represent stock that the company has bought back from existing shareholders. Companies may do a repurchase when management cannot deploy all the available equity capital in ways that might deliver the best returns. Shares bought back by companies become treasury shares, and their dollar value is noted in an account called treasury stock, a contra account to the accounts of investor capital and retained earnings. Companies can reissue treasury shares back to stockholders when companies need to raise money.

Many view stockholders' equity as representing a company's net assets—its net value, so to speak, would be the amount shareholders would receive if the company liquidated all its assets and repaid all its debts.

Example of Shareholder Equity

Using a historical example, below is a portion of Exxon Mobil Corporation's (XOM) balance sheet as of September 30, 2018:¹

• Total assets were $354,628 (highlighted in green).
• Total liabilities were $157,797 (1st highlighted red area).
• Total equity was $196,831 (2nd highlighted red area).

The accounting equation whereby assets = liabilities + shareholder equity is calculated as follows:

Shareholder equity = $354,628, (total assets) - $157,797 (total liabilities) = $196,831

Image by Sabrina Jiang © Investopedia 2020

Other Forms of Equity

The concept of equity has applications beyond just evaluating companies. We can more generally think of equity as a degree of ownership in any asset after subtracting all debts associated with that asset.

Below are several common variations on equity:

• A stock or any other security representing an ownership interest in a company.
• On a company's balance sheet, the amount of the funds contributed by the owners or shareholders plus the retained earnings (or losses). One may also call this stockholders' equity or shareholders' equity.
• In margin trading, the value of securities in a margin account minus what the account holder borrowed from the brokerage.
• In real estate, the difference between the property's current fair market value and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying any liens. Also referred to as “real property value.”
• When a business goes bankrupt and has to liquidate, equity is the amount of money remaining after the business repays its creditors. This is most often called “ownership equity,” also known as risk capital or “liable capital.”

Private Equity 

When an investment is publicly traded, the market value of equity is readily available by looking at the company's share price and its market capitalization. For private entitles, the market mechanism does not exist and so other forms of valuation must be done to estimate value.

Private equity generally refers to such an evaluation of companies that are not publicly traded. The accounting equation still applies where stated equity on the balance sheet is what is left over when subtracting liabilities from assets, arriving at an estimate of book value. Privately held companies can then seek investors by selling off shares directly in private placements. These private equity investors can include institutions like pension funds, university endowments, and insurance companies, or accredited individuals.

Private equity is often sold to funds and investors that specialize in direct investments in private companies or that engage in leveraged buyouts (LBOs) of public companies. In an LBO transaction, a company receives a loan from a private equity firm to fund the acquisition of a division or another company. Cash flows or the assets of the company being acquired usually secure the loan. Mezzanine debt is a private loan, usually provided by a commercial bank or a mezzanine venture capital firm. Mezzanine transactions often involve a mix of debt and equity in the form of a subordinated loan or warrants, common stock, or preferred stock.

Private equity comes into play at different points along a company's life cycle. Typically, a young company with no revenue or earnings can't afford to borrow, so it must get capital from friends and family or individual "angel investors." Venture capitalists enter the picture when the company has finally created its product or service and is ready to bring it to market. Some of the largest, most successful corporations in the tech sector, like Google, Apple, Facebook, and Amazon—or what is referred to as BigTechs or GAFAM—all began with venture capital funding.

Venture capitalists (VCs) provide most private equity financing in return for an early minority stake. Sometimes, a venture capitalist will take a seat on the board of directors for its portfolio companies, ensuring an active role in guiding the company. Venture capitalists look to hit big early on and exit investments within five to seven years. An LBO is one of the most common types of private equity financing and might occur as a company matures.

A final type of private equity is a Private Investment in a Public Company (PIPE). A PIPE is a private investment firm's, a mutual fund's, or another qualified investors' purchase, of stock in a company at a discount to the current market value (CMV) per share, to raise capital.

Unlike shareholder equity, private equity is not accessible for the average individual. Only "accredited" investors, those with a net worth of at least $1 million, can take part in private equity or venture capital partnerships. Such endeavors might require the use of form 4, depending on their scale. For investors who have don't meet this marker, there is the option of exchange-traded funds (ETFs) that focus on investing in private companies.

Equity Begins at Home 

Home equity is roughly comparable to the value contained in home ownership. The amount of equity one has in their residence represents how much of the home that they own outright by subtracting from it the mortgage debt owed. Equity on a property or home stems from payments made against a mortgage, including a down payment, and from increases in property value.

Home equity is often an individual’s greatest source of collateral, and the owner can use it to get a home-equity loan, which some call a second mortgage or a home-equity line of credit. Taking money out of a property or borrowing money against it is an equity takeout.

For example, let’s say Sam owns a home with a mortgage on it. The house has a current market value of $175,000 and the mortgage owed totals $100,000. Sam has $75,000 worth of equity in the home or $175,000 (asset total) - $100,000 (liability total).

Brand Equity 

When determining an asset's equity, particularly for larger corporations, it is important to note these assets may include both tangible assets, like property, and intangible assets, like the company’s reputation and brand identity. Through years of advertising and development of a customer base, a company’s brand can come to have an inherent value. Some call this value “brand equity,” which measures the value of a brand relative to a generic or store-brand version of a product.

For example, many soft-drink lovers will reach for a Coke before buying a store-brand cola because they prefer the taste, or are more familiar with the flavor. If a 2-liter bottle of store-brand cola costs $1 and a 2-liter bottle of Coke costs $2, then the Coca-Cola has brand equity of $1.

There is also such a thing as negative brand equity, which is when people will pay more for a generic or store-brand product than they will for a particular brand name. Negative brand equity is rare and can occur because of bad publicity, such as a product recall or a disaster.

Equity vs. Return on Equity

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholder equity. Because shareholder equity is equal to a company’s assets minus its debt, ROE could be thought of as the return on net assets. ROE is considered a measure of how effectively management is using a company’s assets to create profits.

Equity, as we have seen, has various meanings but usually represents ownership in an asset or a company such as stockholders owning equity in a company. ROE is a financial metric that measures how much profit is generated from a company’s shareholder equity.

Frequently Asked Questions

What exactly is equity?

Equity is an important concept in finance that has different specific meanings depending on the context. Perhaps the most common type of equity is “shareholders’ equity," which is calculated by taking a company’s total assets and subtracting its total liabilities.

Shareholders’ equity is, therefore, essentially the net worth of a corporation. If the company were to liquidate, shareholders’ equity is the amount of money that would theoretically be received by its shareholders.

What are some other terms used to describe equity?

Other terms that are sometimes used to describe this concept include shareholders’ equity, book value, and net asset value. Depending on the context, the precise meanings of these terms may differ, but generally speaking, they refer to the value of an investment that would be left over after paying off all of the liabilities associated with that investment. This term is also used in real estate investing to refer to the difference between a property’s fair market value and the outstanding value of its mortgage loan.

How is equity used by investors?

Equity is a very important concept for investors. For instance, in looking at a company, an investor might use shareholders’ equity as a benchmark for determining whether a particular purchase price is expensive. If that company has historically traded at a price to book value of 1.5, for instance, then an investor might think twice before paying more than that valuation unless they feel the company’s prospects have fundamentally improved. On the other hand, an investor might feel comfortable buying shares in a relatively weak business as long as the price they pay is sufficiently low relative to its equity.

Hedge

By 

LUCAS DOWNEY

 

 

Reviewed by 

GORDON SCOTT

 

 

Updated Feb 3, 2021

What Is a Hedge?

A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.

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Hedge

KEY TAKEAWAYS

• Hedging is a strategy that tries to limit risks in financial assets.
• Popular hedging techniques involve taking offsetting positions in derivatives that correspond to an existing position.
• Other types of hedges can be constructed via other means like diversification. An example could be investing in both cyclical and counter-cyclical stocks.

How a Hedge Works

Hedging is somewhat analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding—to hedge it, in other words—by taking out flood insurance. In this example, you cannot prevent a flood, but you can plan ahead of time to mitigate the dangers in the event that a flood did occur.

There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn't free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policyholder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.

In the investment world, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their exposure to risks. In order to appropriately hedge in the investment world, one must use various instruments in a strategic fashion to offset the risk of adverse price movements in the market. The best way to do this is to make another investment in a targeted and controlled way. Of course, the parallels with the insurance example above are limited: in the case of flood insurance, the policy holder would be completely compensated for her loss, perhaps less a deductible. In the investment space, hedging is both more complex and an imperfect science.

A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected; "basis" refers to the discrepancy.

How Does Hedging Work?

The most common way of hedging in the investment world is through derivatives. Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indices or interest rates. Derivatives can be effective hedges against their underlying assets, since the relationship between the two is more or less clearly defined. It’s possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.

For example, if Morty buys 100 shares of Stock plc (STOCK) at $10 per share, he might hedge his investment by buying an American put option with a strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8 any time in the next year. Let's assume he pays $1 for the option, or $100 in premium. If one year later STOCK is trading at $12, Morty will not exercise the option and will be out $100. He's unlikely to fret, though, since his unrealized gain is $100 ($100 including the price of the put). If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell his shares for $8, for a loss of $300 ($300 including the price of the put). Without the option, he stood to lose his entire investment.

The effectiveness of a derivative hedge is expressed in terms of delta, sometimes called the "hedge ratio." Delta is the amount the price of a derivative moves per $1 movement in the price of the underlying asset.

Fortunately, the various kinds of options and futures contracts allow investors to hedge against almost any investment, including those involving stocks, interest rates, currencies, commodities, and more.

The specific hedging strategy, as well as the pricing of hedging instruments, is likely to depend upon the downside risk of the underlying security against which the investor would like to hedge. Generally, the greater the downside risk, the greater the cost of the hedge. Downside risk tends to increase with higher levels of volatility and over time; an option which expires after a longer period and which is linked to a more volatile security will thus be more expensive as a means of hedging. In the STOCK example above, the higher the strike price, the more expensive the put option will be, but the more price protection it will offer as well. These variables can be adjusted to create a less expensive option which offers less protection, or a more expensive one which provides greater protection. Still, at a certain point, it becomes inadvisable to purchase additional price protection from the perspective of cost effectiveness.

Hedging Through Diversification

Using derivatives to hedge an investment enables for precise calculations of risk, but requires a measure of sophistication and often quite a bit of capital. Derivatives are not the only way to hedge, however. Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge, albeit a somewhat crude one. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends.

This strategy has its trade offs: If wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring counter-cyclical stocks, which might fall as capital flows to more exciting places. It also has its risks: There is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis, or for unrelated reasons, such as Mexico's suspension of mining production due to COVID-19 which drove up the price of silver.¹² 

Spread Hedging

In the index space, moderate price declines are quite common, and they are also highly unpredictable. Investors focusing in this area may be more concerned with moderate declines than with more severe ones. In these cases, a bear put spread is a common hedging strategy.

In this type of spread, the index investor buys a put which has a higher strike price. Next, she sells a put with a lower strike price but the same expiration date. Depending upon the way that the index behaves, the investor thus has a degree of price protection equal to the difference between the two strike prices (minus the cost). While this is likely to be a moderate amount of protection, it is often sufficient to cover a brief downturn in the index.

Risks of Hedging

Hedging is a technique utilized to reduce risk, but it’s important to keep in mind that nearly every hedging practice will have its own downsides. First, as indicated above, hedging is imperfect and is not a guarantee of future success, nor does it ensure that any losses will be mitigated. Rather, investors should think of hedging in terms of pros and cons. Do the benefits of a particular strategy outweigh the added expense it requires? Because hedging will rarely if ever result in an investor making money, it’s worth remembering that a successful hedge is one that only prevents losses.

Hedging and the Everyday Investor

For most investors, hedging will never come into play in their financial activities. Many investors are unlikely to trade a derivative contract at any point. Part of the reason for this is that investors with a long-term strategy, such as those individuals saving for retirement, tend to ignore the day-to-day fluctuations of a given security. In these cases, short-term fluctuations are not critical because an investment will likely grow with the overall market.

For investors who fall into the buy-and-hold category, there may seem to be little to no reason to learn about hedging at all. Still, because large companies and investment funds tend to engage in hedging practices on a regular basis, and because these investors might follow or even be involved with these larger financial entities, it’s useful to have an understanding of what hedging entails so as to better be able to track and comprehend the actions of these larger players.

Hedge Fund

By 

JASON FERNANDO

 

 

Reviewed by 

BRIAN BARNIER

 

 

Updated Jan 24, 2021

What Is a Hedge Fund?

Hedge funds are alternative investments using pooled funds that employ different strategies to earn active returns, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles.¹

KEY TAKEAWAYS

• Hedge funds are actively managed alternative investments that may also utilize non-traditional investment strategies or asset classes.
• Hedge funds are more expensive compared to conventional investment funds, and will often restrict investment to high net-worth or other sophisticated investors.
• The number of hedge funds has had an exceptional growth curve in the last 20 years and has also been associated with several controversies.
• While the performance of hedge funds as beating the market was lauded in the 1990s and early 2000s, since the financial crisis, many hedge funds have underperformed (especially after fees and taxes).

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Introduction To Hedge Funds

Understanding Hedge Funds

Each hedge fund is constructed to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and thus are often classified according to investment style. There is substantial diversity in risk attributes and investments among styles.

Legally, hedge funds are most often set up as private investment limited partnerships that are open to a limited number of accredited investors and require a large initial minimum investment. Investments in hedge funds are illiquid as they often require investors to keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.

The History of the Hedge Fund 

A former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co. launched the first hedge fund in 1949. It was while writing an article about current investment trends for Fortune in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance returns.²

In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner. As the first money manager to combine short selling, the use of leverage shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.²

Hedge funds went on to dramatically outperform most mutual funds in the 1960s and gained further popularity when a 1966 article in Fortune highlighted an obscure investment that outperformed every mutual fund on the market by double-digit figures over the previous year and by high double-digits over the previous five years.³²

However, as hedge fund trends evolved, in an effort to maximize returns, many funds turned away from Jones' strategy, which focused on stock picking coupled with hedging and chose instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74.³

The industry was relatively quiet for more than two decades until a 1986 article in Institutional Investor touted the double-digit performance of Julian Robertson's Tiger Fund. With a high-flying hedge fund once again capturing the public's attention with its stellar performance, investors flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic strategies, including currency trading and derivatives such as futures and options.³

High-profile money managers deserted the traditional mutual fund industry in droves in the early 1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds, including Robertson's, failed in spectacular fashion.⁴ Since that era, the hedge fund industry has grown substantially. Today the hedge fund industry is massive—total assets under management in the industry are valued at more than $3.2 trillion according to the 2018 Preqin Global Hedge Fund Report. Based on statistics from research firm Barclays hedge, the total number of assets under management for hedge funds jumped by 2335% between 1997 and 2018.

The number of operating hedge funds has grown as well, at least in some periods. There were around 2,000 hedge funds in 2002. Estimates vary about the number of hedge funds operating today. This number had crossed 10,000 by the end of 2015. However, losses and underperformance led to liquidations. By the end of 2017, there were 9,754 hedge funds according to research firm Hedge Fund Research. According to Statistica, by 2019, the number of funds worldwide had reached 11,088; 5581 were in North America.⁵

Key Characteristics of Hedge Funds

They're only open to "accredited" or qualified investors

Hedge funds are only allowed to take money from "qualified" investors—individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. As such, the Securities and Exchange Commission deems qualified investors suitable enough to handle the potential risks that come from a wider investment mandate.⁶ 

They offer wider investment latitude than other funds

A hedge fund's investment universe is limited only by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds and are usually long-only.

They often employ leverage

Hedge funds will often use borrowed money to amplify their returns and also allow them to take aggressive short positions, depending on the fund's strategy. As we saw during the financial crisis of 2008, leverage can also wipe out hedge funds.

2-and-20 fee structure

Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as "Two and Twenty"—a 2% asset management fee and then a 20% cut of any gains generated.⁷

Special Considerations

There are more specific characteristics that define a hedge fund, but basically, because they are private investment vehicles that only allow wealthy individuals to invest, hedge funds can pretty much do what they want as long as they disclose the strategy upfront to investors. This wide latitude may sound very risky, and at times it can be. Some of the most spectacular financial blow-ups have involved hedge funds. That said, this flexibility afforded to hedge funds has led to some of the most talented money managers producing some amazing long-term returns.

It is important to note that "hedging" is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market. (Mutual funds generally don't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk." In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

Below are some of the unique risks of hedge funds:

•   Concentrated investment strategy exposes hedge funds to potentially huge losses.
•   Hedge funds typically require investors to lock up money for a period of years.
•   Use of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss.

Hedge Fund Manager Pay Structure 

Hedge fund managers are notorious for their typical 2 and 20 pay structure whereby the fund manager receives 2% of assets and 20% of profits each year.¹ It's the 2% that gets the criticism, and it's not difficult to see why. Even if a hedge fund manager loses money, they still gets 2% of assets. For example, a manager overseeing a $1 billion fund could pocket $20 million a year in compensation without lifting a finger. 

That said, there are mechanisms put in place to help protect those who invest in hedge funds. Often times, fee limitations such as high-water marks are employed to prevent portfolio managers from getting paid on the same returns twice. Fee caps may also be in place to prevent managers from taking on excess risk.

How to Pick a Hedge Fund 

With so many hedge funds in the investment universe, it is important that investors know what they are looking for in order to streamline the due diligence process and make timely and appropriate decisions. 

When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each. These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the top five highest-performing funds in a particular category.

For a list of the biggest hedge funds in the world read, "What are the Biggest Hedge Funds in the World?"

Fund Absolute Performance Guidelines

The first guideline an investor should set when selecting a fund is the annualized rate of return. Let's say that we want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that underperform the index over long time periods, and it could be adjusted based on the performance of the index over time. 

This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and several others. But if these aren't the types of funds the investor is looking for, then they must also establish a guideline for standard deviation. Once again, we will use the WGBI to calculate the standard deviation for the index over the previous five years. Let's assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can also be eliminated from further consideration.

Unfortunately, high returns do not necessarily help to identify an attractive fund. In some cases, a hedge fund may have employed a strategy that was in favor, which drove performance to be higher than normal for its category. Therefore, once certain funds have been identified as high-return performers, it is important to identify the fund's strategy and compare its returns to other funds in the same category. To do this, an investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the 50th percentile as the guideline for filtering funds. 

Now an investor has two guidelines that all funds need to meet for further consideration. However, applying these two guidelines still leaves too many funds to evaluate in a reasonable amount of time. Additional guidelines need to be established, but the additional guidelines will not necessarily apply across the remaining universe of funds. For example, the guidelines for a merger arbitrage fund will differ from those for a long-short market-neutral fund.

Fund Relative Performance Guidelines

To facilitate the investor's search for high-quality funds that not only meet the initial return and risk guidelines but also meet strategy-specific guidelines, the next step is to establish a set of relative guidelines. Relative performance metrics should always be based on specific categories or strategies. For example, it would not be fair to compare a leveraged global macro fund with a market-neutral, long/short equity fund.

To establish guidelines for a specific strategy, an investor can use an analytical software package (such as Morningstar) to first identify a universe of funds using similar strategies. Then, a peer analysis will reveal many statistics, broken down into quartiles or deciles, for that universe.

The threshold for each guideline may be the result for each metric that meets or exceeds the 50th percentile. An investor can loosen the guidelines by using the 60th percentile or tighten the guideline by using the 40th percentile. Using the 50th percentile across all the metrics usually filters out all but a few hedge funds for additional consideration. In addition, establishing the guidelines this way allows for flexibility to adjust the guidelines as the economic environment may impact the absolute returns for some strategies.

Factors used by some advocates of hedge funds include:

• Five-year annualized returns
• Standard deviation
• Rolling standard deviation
• Months to recovery/maximum drawdown
• Downside deviation

These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis.

Other Fund Consideration Guidelines

An investor may also want to consider other guidelines that can either further reduce the number of funds to analyze or to identify funds that meet additional criteria that may be relevant to the investor. Some examples of other guidelines include:

• Fund Size/Firm Size: The guideline for size may be a minimum or maximum depending on the investor's preference. For example, institutional investors often invest such large amounts that a fund or firm must have a minimum size to accommodate a large investment. For other investors, a fund that is too big may face future challenges using the same strategy to match past successes. Such might be the case for hedge funds that invest in the small-cap equity space. 
• Track Record: If an investor wants a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate any new funds. However, sometimes a fund manager will leave to start their own fund and although the fund is new, the manager's performance can be tracked for a much longer time period. 
• Minimum Investment: This criterion is very important for smaller investors as many funds have minimums that can make it difficult to diversify properly. The fund's minimum investment can also give an indication of the types of investors in the fund. Larger minimums may indicate a higher proportion of institutional investors, while low minimums may indicate a larger number of individual investors.
• Redemption Terms: These terms have implications for liquidity and become very important when an overall portfolio is highly illiquid. Longer lock-up periods are more difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges during the portfolio-management process. A guideline may be implemented to eliminate funds that have lockups when a portfolio is already illiquid, while this guideline may be relaxed when a portfolio has adequate liquidity.

Taxing Hedge Fund Profits

When a domestic U.S. hedge fund returns profits to its investors, the money is subject to capital gains tax. The short-term capital gains rate applies to profits on investments held for less than one year, and it is the same as the investor's tax rate on ordinary income. For investments held for more than one year, the rate is not more than 15% for most taxpayers, but it can go as high as 20% in high tax brackets. This tax applies to both U.S. and foreign investors.⁸

An offshore hedge fund is established outside of the United States, usually in a low-tax or tax-free country. It accepts investments from foreign investors and tax-exempt U.S. entities. These investors do not incur any U.S. tax liability on the distributed profits.⁹

Ways Hedge Funds Avoid Taxes

Many hedge funds are structured to take advantage of carried interest. Under this structure, a fund is treated as a partnership. The founders and fund managers are the general partners, while the investors are the limited partners. The founders also own the management company that runs the hedge fund. The managers earn the 20% performance fee of the carried interest as the general partner of the fund.⁹

Hedge fund managers are compensated with this carried interest; their income from the fund is taxed as a return on investments as opposed to a salary or compensation for services rendered. The incentive fee is taxed at the long-term capital gains rate of 20% as opposed to ordinary income tax rates, where the top rate is 39.6%. This represents significant tax savings for hedge fund managers.⁹

This business arrangement has its critics, who say that the structure is a loophole that allows hedge funds to avoid paying taxes. The carried interest rule has not yet been overturned despite multiple attempts in Congress. It became a topical issue during the 2016 primary election. And President Biden's tax plan includes eliminating the carried interest provision.

Many prominent hedge funds use reinsurance businesses in Bermuda as another way to reduce their tax liabilities. Bermuda does not charge a corporate income tax, so hedge funds set up their own reinsurance companies in Bermuda. The hedge funds then send money to the reinsurance companies in Bermuda. These reinsurers, in turn, invest those funds back into the hedge funds. Any profits from the hedge funds go to the reinsurers in Bermuda, where they owe no corporate income tax. The profits from the hedge fund investments grow without any tax liability. Taxes are only owed once the investors sell their stakes in the reinsurers.¹⁰

The business in Bermuda must be an insurance business. Any other type of business would likely incur penalties from the U.S. Internal Revenue Service (IRS) for passive foreign investment companies. The IRS defines insurance as an active business. To qualify as an active business, the reinsurance company cannot have a pool of capital that is much larger than what it needs to back the insurance that it sells. It is unclear what this standard is, as it has not yet been defined by the IRS.¹¹

Hedge Fund Controversies 

A number of hedge funds have been implicated in insider trading scandals since 2008. One of the most high-profile insider trading cases involves the Galleon Group managed by Raj Rajaratnam.

The Galleon Group managed over $7 billion at its peak before being forced to close in 2009. The firm was founded in 1997 by Raj Rajaratnam. In 2009, federal prosecutors charged Rajaratnam with multiple counts of fraud and insider trading. He was convicted on 14 charges in 2011 and began serving an 11-year sentence. Many Galleon Group employees were also convicted in the scandal.¹²

Rajaratnam was caught obtaining insider information from Rajat Gupta, a board member of Goldman Sachs. Before the news was made public, Gupta allegedly passed on information that Warren Buffett was making an investment in Goldman Sachs in September 2008 at the height of the financial crisis. Rajaratnam was able to buy substantial amounts of Goldman Sachs stock and make a hefty profit on those shares in one day.¹²

Rajaratnam was also convicted on other insider trading charges. Throughout his tenure as a fund manager, he cultivated a group of industry insiders to gain access to material information.

Regulations for Hedge Funds

Hedge funds are so big and powerful that the SEC is starting to pay closer attention, particularly because breaches such as insider trading and fraud seem to be occurring much more frequently. However, a recent act has actually loosened the way that hedge funds can market their vehicles to investors. 

In March 2012, the Jumpstart Our Business Startups Act (JOBS Act) was signed into law. The basic premise of the JOBS Act was to encourage funding of small businesses in the U.S. by easing securities regulation. The JOBS Act also had a major impact on hedge funds: In September 2013, the ban on hedge fund advertising was lifted. In a 4-to-1 vote, the SEC approved a motion to allow hedge funds and other firms that create private offerings to advertise to whomever they want, although they still can only accept investments from accredited investors. Hedge funds are often key suppliers of capital to startups and small businesses because of their wide investment latitude. Giving hedge funds the opportunity to solicit capital would in effect help the growth of small businesses by increasing the pool of available investment capital.

Hedge fund advertising entails offering the fund's investment products to accredited investors or financial intermediaries through print, television, and the internet. A hedge fund that wants to solicit (advertise to) investors must file a “Form D” with the SEC at least 15 days before it starts advertising. Because hedge fund advertising was strictly prohibited prior to lifting this ban, the SEC is very interested in how advertising is being used by private issuers, so it has made changes to Form D filings. Funds that make public solicitations will also need to file an amended Form D within 30 days of the offering’s termination. Failure to follow these rules will likely result in a ban from creating additional securities for a year or more.

Post-2008: Chasing the S&P

Since the 2008 crisis, the hedge fund world has entered into another period of less-than-stellar returns. Many funds that had previously enjoyed double-digit returns during an average year have seen their profits diminish significantly. In many cases, funds have failed to match the returns of the S&P 500. For investors considering where to place their money, this becomes an increasingly easy decision: why suffer the high fees and initial investments, the added risk, and the withdrawal limitations of hedge funds if a safer, simpler investment like a mutual fund can produce returns that are the same or, in some cases, even stronger?

There are many reasons why hedge funds have struggled in recent years. These reasons run the gauntlet from geopolitical tensions around the globe to an over-reliance among many funds on particular sectors, including technology, and interest rate hikes by the Fed. Many prominent fund managers have made highly-publicized bad bets which have cost them not only monetarily but in terms of their reputations as savvy fund leaders, too.

David Einhorn is an example of this approach. Einhorn's firm Greenlight Capital bet against Allied Capital early on and Lehman Brothers during the financial crisis. Those high-profile bets were successful and earned Einhorn the reputation of a shrewd investor.

However, the firm posted losses of 34 percent, its worst year ever, in 2018 on the back of shorts against Amazon, which recently became the second trillion dollar company after Apple, and holdings in General Motors, which posted a less-than-stellar 2018.

Notably, the overall size of the hedge fund industry (in terms of assets under management) has not declined significantly during this period and has continued to grow. There are new hedge funds launching all the time, even as several of the past 10 years have seen record numbers of hedge fund closures.

In the midst of growing pressures, some hedge funds are reevaluating aspects of their organization, including the "Two and Twenty" fee structure. According to data from Hedge Fund Research, the last quarter of 2016 saw the average management fee fall to 1.48%, while the average incentive fee fell to 17.4%. In this sense, the average hedge fund is still much more costly than, say, an index or mutual fund, but the fact that the fee structure is changing on average is notable.

Major Hedge Funds

In mid-2018, data provider HFM Absolute Return created a ranked list of hedge funds according to total AUM. This list of top hedge funds includes some companies which hold more in AUM in other areas besides a hedge fund arm. Nonetheless, the ranking factors in only the hedge fund operations at each firm.

Paul Singer's Elliott Management Corporation held $35 billion in AUM as of the survey. Founded in 1977, the fund is occasionally described as a "vulture fund," as roughly one-third of its assets are focused on distressed securities, including debt for bankrupt countries. Regardless, the strategy has proven successful for multiple decades.

Founded in 2001 by David Siegel and John Overdeck, New York's Two Sigma Investments is near the top of the list of hedge funds by AUM, with more than $37 billion in managed assets. The firm was designed to not rely on a single investment strategy, allowing it to be flexible along with shifts in the market.

One of the most popular hedge funds in the world is James H. Simon's Renaissance Technologies. The fund, with $57 billion in AUM, was launched in 1982, but it has revolutionized its strategy along with changes in technology in recent years. Now, Renaissance is known for systematic trading based on computer models and quantitative algorithms. Thanks to these approaches, Renaissance has been able to provide investors with consistently strong returns, even in spite of recent turbulence in the hedge fund space more broadly.

AQR Capital Investments is the second-largest hedge fund in the world, overseeing just under $90 billion in AUM as of the time of HFM's survey. Based in Greenwich, Connecticut, AQR is known for utilizing both traditional and alternative investment strategies.

Ray Dalio's Bridgewater Associates remains the largest hedge fund in the world, with just under $125 billion in AUM as of mid-2018. The Connecticut-based fund employs about 1700 people and focuses on a global macro investing strategy. Bridgewater counts foundations, endowments, and even foreign governments and central banks among its clientele.

Frequently Asked Questions

What is a hedge fund?

A hedge fund is a type of investment vehicle that caters to high-net-worth individuals, institutional investors, and other accredited investors. The term “hedge” is used because hedge funds originally focused on strategies that hedged the risks faced by investors, such as by simultaneously buying and shorting shares in a long-short equity strategy. Today, hedge funds offer a very wide range of strategies across practically all available asset classes, including real estate, derivatives, and non-traditional investments such as fine art and wine.

How do hedge funds compare to other investment vehicles?

As a type of actively-managed investment fund, hedge funds are similar to other investment vehicles such as mutual funds, venture capital funds, and joint ventures. However, hedge funds are known for a few defining characteristics. First, they are more lightly regulated than competing products such as mutual funds or exchange-traded funds (ETFs), providing them with virtually unlimited flexibility in terms of the strategies and objectives they can pursue. Second, hedge funds have the reputation for being more expensive than other vehicles, with many hedge funds utilizing the “2 and 20” fee structure.

Why do people invest in hedge funds?

Because of their diversity, hedge funds can help investors accomplish a wide variety of investment objectives. For example, an investor might be attracted to a particular hedge fund because of the reputation of its managers, the specific assets in which the fund is invested, or the unique strategy that it employs. In some cases, the techniques used by hedge funds—such as combining leverage with complex derivative transactions—may not even be permitted by regulators if it were pursued by a mutual fund or another type of investment vehicle.

Stock

By 

ADAM HAYES

 

 

Reviewed by 

GORDON SCOTT

 

 

Updated Mar 15, 2021

TABLE OF CONTENTS

• What Is a Stock?
• Understanding Stocks
• Stockholders & Equity Ownership
• Common vs. Preferred Stock
• Stocks vs. Bonds
• Frequently Asked Questions

What Is a Stock?

A stock (also known as equity) is a security that represents the ownership of a fraction of a corporation. This entitles the owner of the stock to a proportion of the corporation's assets and profits equal to how much stock they own. Units of stock are called "shares."

Stocks are bought and sold predominantly on stock exchanges, though there can be private sales as well, and are the foundation of many individual investors' portfolios. These transactions have to conform to government regulations which are meant to protect investors from fraudulent practices. Historically, they have outperformed most other investments over the long run.¹ These investments can be purchased from most online stock brokers. Stock investment differs greatly from real estate investment.

KEY TAKEAWAYS

• A stock is a form of security that indicates the holder has proportionate ownership in the issuing corporation.
• Corporations issue (sell) stock to raise funds to operate their businesses. There are two main types of stock: common and preferred.
• Stocks are bought and sold predominantly on stock exchanges, though there can be private sales as well, and they are the foundation of nearly every portfolio.
• Historically, they have outperformed most other investments over the long run.¹

Understanding Stocks

Corporations issue (sell) stock to raise funds to operate their businesses. The holder of stock (a shareholder) has now bought a piece of the corporation and, depending on the type of shares held, may have a claim to a part of its assets and earnings. In other words, a shareholder is now an owner of the issuing company. Ownership is determined by the number of shares a person owns relative to the number of outstanding shares. For example, if a company has 1,000 shares of stock outstanding and one person owns 100 shares, that person would own and have claim to 10% of the company's assets and earnings.²

Stock holders do not own corporations; they own shares issued by corporations. But corporations are a special type of organization because the law treats them as legal persons. In other words, corporations file taxes, can borrow, can own property, can be sued, etc. The idea that a corporation is a “person” means that the corporation owns its own assets. A corporate office full of chairs and tables belongs to the corporation, and not to the shareholders.³

This distinction is important because corporate property is legally separated from the property of shareholders, which limits the liability of both the corporation and the shareholder. If the corporation goes bankrupt, a judge may order all of its assets sold – but your personal assets are not at risk. The court cannot even force you to sell your shares, although the value of your shares will have fallen drastically. Likewise, if a major shareholder goes bankrupt, she cannot sell the company’s assets to pay off her creditors.⁴

Stockholders and Equity Ownership

What shareholders actually own are shares issued by the corporation; and the corporation owns the assets held by a firm. So if you own 33% of the shares of a company, it is incorrect to assert that you own one-third of that company; it is instead correct to state that you own 100% of one-third of the company’s shares. Shareholders cannot do as they please with a corporation or its assets. A shareholder can’t walk out with a chair because the corporation owns that chair, not the shareholder. This is known as the “separation of ownership and control.”

Owning stock gives you the right to vote in shareholder meetings, receive dividends (which are the company’s profits) if and when they are distributed, and it gives you the right to sell your shares to somebody else.

If you own a majority of shares, your voting power increases so that you can indirectly control the direction of a company by appointing its board of directors.⁵ This becomes most apparent when one company buys another: the acquiring company doesn’t go around buying up the building, the chairs, the employees; it buys up all the shares. The board of directors is responsible for increasing the value of the corporation, and often does so by hiring professional managers, or officers, such as the Chief Executive Officer, or CEO.

For most ordinary shareholders, not being able to manage the company isn't such a big deal. The importance of being a shareholder is that you are entitled to a portion of the company's profits, which, as we will see, is the foundation of a stock’s value. The more shares you own, the larger the portion of the profits you get. Many stocks, however, do not pay out dividends, and instead reinvest profits back into growing the company. These retained earnings, however, are still reflected in the value of a stock.

Common vs. Preferred Stock

There are two main types of stock: common and preferred. Common stock usually entitles the owner to vote at shareholders' meetings and to receive any dividends paid out by the corporation. Preferred stockholders generally do not have voting rights, though they have a higher claim on assets and earnings than the common stockholders. For example, owners of preferred stock (such as Larry Page) receive dividends before common shareholders and have priority in the event that a company goes bankrupt and is liquidated.²

The first common stock ever issued was by the Dutch East India Company in 1602.⁶

Companies can issue new shares whenever there is a need to raise additional cash. This process dilutes the ownership and rights of existing shareholders (provided they do not buy any of the new offerings). Corporations can also engage in stock buy-backs which would benefit existing shareholders as it would cause their shares to appreciate in value.

Stocks vs. Bonds

Stocks are issued by companies to raise capital, paid-up or share, in order to grow the business or undertake new projects. There are important distinctions between whether somebody buys shares directly from the company when it issues them (in the primary market) or from another shareholder (on the secondary market). When the corporation issues shares, it does so in return for money.

Bonds are fundamentally different from stocks in a number of ways. First, bondholders are creditors to the corporation, and are entitled to interest as well as repayment of principal. Creditors are given legal priority over other stakeholders in the event of a bankruptcy and will be made whole first if a company is forced to sell assets in order to repay them. Shareholders, on the other hand, are last in line and often receive nothing, or mere pennies on the dollar, in the event of bankruptcy. This implies that stocks are inherently riskier investments that bonds.²

Frequently Asked Questions

What is a stock?

A stock is a type of security that entitles the holder a fraction of ownership in a company. Through the ownership of this stock, the holder may be granted a portion of a company’s earnings, distributed as dividends. Broadly speaking, there are two main types of stocks, common and preferred. Common stockholders have the right to receive dividends and vote in shareholder meetings, while preferred shareholders have limited or no voting rights. Preferred stockholders typically receive higher dividend payouts, and in the event of a liquidation, a greater claim on assets than common stockholders.

How do you buy a stock?

Most often, stocks are bought and sold on stock exchanges, such as the Nasdaq or the New York Stock Exchange (NYSE). After a company goes public through an initial public offering (IPO), their stock becomes available for investors to buy and sell on an exchange. Typically, investors will use a brokerage account to purchase stock on the exchange, which will list the purchasing price (the bid) or the selling price (the offer). The price of the stock is influenced by supply and demand factors in the market, among other variables.

What is the difference between a stock and a bond?

When a company raises capital by issuing stock, it entitles the holder a share of ownership in the company. By contrast, when a company raises funds for the business by selling bonds, these bonds represent loans from the bondholder to the company. Bonds have terms that require the company or entity to pay back the principal along with interest rates in exchange for this loan. In addition, bondholders are granted priority over stockholders in the event of a bankruptcy, while stockholders typically fall last in line in claim to assets.