In recent decades, hedge funds have become one of the largest growth vehicles for aggressive investment partnerships. Since first emerging in the mid-20th century, they have mushroomed to more than 27,000 funds globally, with more than US$4 trillion in assets under management as of last year. While hedge funds are part of the financial asset management industry, they are not as tightly regulated as other segments.

What is a hedge fund?

A hedge fund is a financial instrument that allows investors to pool money and invest in various market opportunities. Unlike other investment vehicles, hedge funds are less regulated, aim for higher returns through riskier strategies, and typically require higher minimum investments.

They can invest in a far wider range of assets than other vehicles, including equities, fixed income securities, derivatives, and commodities. This flexibility allows hedge funds to pursue strategies tailored to different market conditions and investment objectives. They are usually structured as privately held investment partnerships.

Because of their wide investment scope, hedge funds are often active in commodity markets, particularly in 'futures' markets involving commodities like oil and grain. In recent times we have seen just how volatile these markets can be during periods of sociopolitical upheaval and global conflict. How does hedge fund activity affect such volatility? We should take a closer look at the futures market itself.

What are futures markets?

Futures are derivative financial contracts that oblige parties to buy or sell an asset at a predetermined future date and price. The buyer must buy, or the seller must sell, the asset at the agreed price, regardless of the market price at expiration date.

These underlying assets can include physical commodities and financial instruments, typically those in which the value will change according to market conditions and broader sociopolitical conditions. Futures contracts specify pricing and quantities and are traded on dedicated exchanges. They are often used for hedging, helping investors avoid losses from unfavourable price movements.

Hedge funds and futures markets

Hedge funds use various trading strategies in futures markets, which can significantly influence market dynamics. These may include identifying price trends, exploiting price differences between related contracts or markets, or taking speculative positions based on expected price movements.

Their substantial trading volumes and ability to move quickly can enhance market liquidity by increasing the number of buyers and sellers. However, during periods of market stress, concentrated positions or aggressive strategies may reduce liquidity and increase volatility. Some strategies, like trend-following or momentum trading, can amplify short-term price swings, while others may counteract volatility by taking contrarian positions.

How global conflicts influence futures and hedge investments

The connection between futures markets and geopolitical realties was shown clearly in 2022, when global grain prices surged after Russia withdrew from a deal allowing Ukrainian grain exports through the Black Sea, despite the war. The BBC reported that wheat futures on the Chicago Board of Trade immediately jumped 5.5%, with trading in corn and palm oil futures also rising.  

Ukraine and Russia together account for nearly a third of global wheat exports and are also among the top 3 global exporters of barley, maize, canola oil, and sunflower oil. Russia's move added significant volatility to grain prices and futures markets, driven by fears of supply disruption.

For many global hedge funds, such political volatility presents investment opportunities. These funds often take positions based on anticipated political or macroeconomic outcomes. Their strategies span a wide range of assets, including futures, currencies, index funds, bonds, and commodities.

Some hedge funds are structured to profit not only from accurate predictions but also from the volatility itself. A good example was the run-up to the 2016 Brexit vote, when the United Kingdom decided to leave the European Union (EU). Hedge funds confident in a 'Leave' outcome took long positions in safe-haven assets like gold and shorted EU stocks and the British pound. Others, uncertain of the outcome, positioned themselves to benefit from market turbulence regardless of the result.

How much should private investors be aware of?

For South African investors, volatility is a familiar feature of the local market. Hedge funds, offering flexibility and access to both conventional and alternative instruments like futures, bonds, and currencies, might well be attractive to those with an appetite for increased risk.

However, these are high-risk, high-reward investments. Get expert advice to assess your risk profile before making any decisions.