Cheat Sheet:
Hedge fund managers use a combination of this tools:
Derivatives: Options, futures, and other investments that will help the hedge fund to increase or decrease its exposure in some parts of the economy.
Diversification: Investing in a wide range of assets to increment returns in case an asset is slacking, it can pick up the overall return.
Leverage: (for me this is the most important for hedge funds). This increases the potential return in the hedge fund but can also increase risk because the fund is borrowing money to make an investment. The borrowed money has to be repaid regardless of whatever happens in the economy. An example of a company that had high leverage ratio was Long Term Capital Management with a ratio of 250:1 (debt:assets).
Macro Investing: Betting on global trends, usually interest rates, currencies, and economic changes. An example is when George Soros bet against the pound in 1992 of 1.5 billion and made 1 billion out of his bet.
Short Selling: The investor is betting against a security because he is expecting the price will go down. The security is borrowed to be sold and it bought back after the price depreciates.
Questions recommended to ask a hedge fund manager:
What is your investment strategy? How do you plan to achieve alpha?
Who works on the fund? What is their education and experience? How much money do they have invested in the fund?
Who is your prime broker? Your administrative services firm? Your auditor?
What is your value at risk? How much of your borrowing is overnight? What are the fund's sources of risk?
Understanding the modern greeks:
Alpha: Investment return that is different than you would expect, given an investment's beta.
Beta: The amount of volatility in the overall market portfolio, it is measured with the overall market. Higher than 1 is considered riskier and lower than 1 is considered less risky, and negative the investment is moving in the opposite direction.
Delta: The percentage change in an investment.
Gamma: The rate of change in delta. Exposure to any change in prices, positive or negative.
Sigma: Standard deviation, the higher the standard deviation the greater is the investment risk.
