What Are Hedge Funds and How Do They Work?
Hedge funds are alternative investment tools that pool money from a limited number of qualified investors (limited partners). Professional hedge fund managers (General Partners) operate these funds. Hedge funds use various investment strategies and are often categorized by investment style.
Investors expect that the fund manager sticks to the agreed-upon hedge fund strategy. This means that it is the fund manager’s task to only invest in securities that match the fund’s goals.
The main goal of all hedge funds is to maximize returns while minimizing the risks. Hedge funds got their name from investors that were “hedging” by holding both long and short stocks to ensure they would profit despite market fluctuations. These days hedge funds can follow many different strategies. They can invest in anything, from real estate to patents, currencies, and many other types of assets.
Hedge funds are typically only open to qualified investors. They include high net-worth individuals with assets over $1 million or an annual income over $200,000 for the previous two years. They also include institutional investors, and investors with connections to the manager. Often fund managers themselves invest private equity in the fund they manage. Because hedge funds are open only to accredited investors, they are bound by fewer regulations than mutual funds or other investment funds.
Legally, hedge funds generally have the structure of either a Limited Partnership (LP) or a Limited Liability Company (LLC). A Limited Partnership is open to a limited number of investors who are responsible only for the amount of money they contribute to the fund. In an LLC, which is a corporate structure, the investors cannot be held personally responsible for any liability on the part of the company.
Hedge Fund History
In 1949 Alfred Jones established the first AIS (Alternative Investment Strategy) fund. Jones used 2 investment strategies that are still being used by fund managers today: Short selling and leverage.
The Investment Act of 1940 placed all kinds of regulations on investments. To circumvent some of these regulations, Jones limited the number of investors to 99 and set up the fund as a Limited Partnership.
Although the fund did well the first few years, his alternative investment strategy did not become popular until the late 60’s when Warren Buffet launched his own hedge fund following this strategy of short selling and leverage. Suddenly hedge funds became a popular investment vehicle for a select group of investors.
Investors started noticing that while the S&P 500 was not doing well, hedge funds were still making money on a yearly basis. Jones then decided to charge his clients a 20% performance fee which investors only had to pay if the fund made a profit.
In the last 2 decades, these funds have increased in popularity even though the hedge fund market has been blemished by several controversies.
In 2019 there were about 9,000 active hedge funds with approximately $3.2 trillion in different asset classes. While some of them still use the staple strategy of leverage and short selling, these days, hedge fund investors use hundreds of different investment strategies. However, not all of them are “hedged,” as Jones’ was. Recognized as the first modern investor to start a hedge fund, his business model that successfully dodged U.S regulation and his innovative investment strategy was the basis for the hedge fund industry today.
Several characteristics set hedge funds apart from more common investment avenues such as mutual funds. Here are its key characteristics :
• Little regulatory oversight: Hedge funds have very little regulatory oversight and do not have to register with the U.S. Securities and Exchange Commission) (SEC) in New York.
• Limited investor access to accredited and qualified investors: Those willing to invest in hedge funds often have to meet specific criteria. As a rule of thumb, their net worth has to be over $1 million, or they must have earned $200,000 every year for two years.
• A wider range of investments: Hedge funds can basically invest in anything like real estate, land, oil, currencies, or any other alternative assets. In contrast, mutual funds can only invest in stocks and bonds.
• Use of leverage: Fund managers often employ leverage or use borrowed money in layman terms to increase their earnings. This makes them vulnerable and can cause investors to lose a lot of money. This has happened repeatedly during several global financial crises.
• Higher fees: Investing in these types of funds is much more expensive than investing in traditional investment funds. Hedge funds do not only charge an expense ratio like other funds, but they also charge a performance fee.
This fee structure is called the “2 and 20”, and is also known as an asset management fee. This means that the hedge fund manager receives an annual fee equal to 2 % of the assets in the fund and an additional bonus equal to 20 % of the year’s profits.
Many funds have assets over $1 billion. If a $1 billion hedge fund loses money one year, the fund manager still gets the 2% AUM (Asset Under Management) fee. In this case that would be $20 Million! For this reason, the “2 and 20” fee structure has been often criticized in the past.
• Illiquidity: Most hedge funds have lock-up periods. This is a specific time period that investors cannot withdraw capital from the fund. This lock-up period gives the fund managers time to rebalance their investment portfolios and get rid of some of the illiquid funds if needed for the withdrawal. Hedge fund lock-ups are typically 30-90 days but could be as long as several years.
How Does a Hedge Fund Make Money?
The primary goal of a hedge fund, just like any other investment tool, is to maximize returns for investors while minimizing the risks. Let’s take a hypothetical scenario to explain this principle.
Say for example; an investor X puts in $100 million in a hedge fund named Great Returns, LLC. The contract states that X will receive 75% of any profits over 3% earned annually and the remaining 25% will go to Great Returns. The 3% is the stipulated hurdle rate that has to be crossed before profits can be distributed. Also, the firm is free to invest in any avenue it deems fit.
Now, Great Returns strikes gold with its choice of investments and earns a 100% profit of $100 million over X’s initial capital. As per the contract, the first 3% of profits earned – $3 million in this case – goes solely to investor X. Investor X also gets 75% of the remaining $97 million which equals $72.75 million. This makes the investor’s total earnings $75.75 million.
Great Returns, meanwhile, stakes its claims to 25% of the $97 million. This is the leftover profit after accounting for the 3% hurdle rate which belongs solely to the investor. This brings the firm’s earnings to $24.25 million for handling the investor’s money and helping him maximizing returns.
Types of Hedge Funds
The main goal of hedge funds is to minimize risk and maximize profits. The only thing that limits the type of investment in the fund is the agreement that the fund has with its investors. As long as the fund reaches the investors’ goals, they can select any type of investment. Thus, there are various types of hedge funds. Here are the most popular ones:
Global Macro: These funds make investments based on economic and political situations in different countries around the world with the hopes of cashing in on fluctuations in macroeconomic factors like interest rates, market policies, and global trade. These funds often include holdings in long and short positions in different equities such as stocks and bonds, currencies, futures, and fixed income.
Long/Short Equity: This is a strategy where the investment manager will buy long positions in equities that he believes are underpriced and at the same time will sell short positions in equities that he believes are overpriced.
Merger Arbitrage: This is an event-driven strategy as it gets its returns from a company merger or takeover. This can be a very risky strategy as there always is the risk of the merger not happening in a certain time frame. Moreover. it might not happen at all due to certain conditions not being met or regulations prohibiting the merger.
Distressed: Contrary to what their name might suggest, these funds are not in trouble themselves. They help companies that are in financial trouble turn around their business by purchasing the company’s bonds at a steep discount of their face value with the hope that the company will do better in the future which will result in the appreciation of the purchased bonds.
Funds of Funds (FOF): These types of hedge funds use a passive investing strategy. This means that there is no active trading going on. The money in these funds gets simply invested in other hedge funds such as equity fund FOFs, and ETF FOFs. Then, their performance is monitored on a regular basis. These types of funds are less risky as they are more diversified.
Hedge Fund Advantages
1. These funds utilize aggressive investment strategies with the possibility of very high returns.
2. Because of the different investment strategies they use, they can generate returns in up and down markets. This reduces the risk and volatility for the hedge fund.
3. Hedge Funds have fewer regulations and restrictions imposed on them than other types of funds. Thus they enjoy higher flexibility when it comes to areas of asset allocation and the use of different investment strategies.
4. Because of the various types of investment available to them, financers have the opportunity to explore new avenues and strategies. This is not possible with traditional funds.
5. Professional experienced hedge fund managers with sound financial judgment manage these funds. They often invest a large chunk of their own money in the funds as well. Therefore, they are very motivated as they will benefit if the fund performs well in the market.
Hedge Fund Limitations
1. They are not open to the general public and require a very high minimum investment amount. Thus, only high net-worth individuals and institutional investors can invest in hedge funds.
2. The fees levied by the fund managing firms are much higher than mutual funds or other traditional investment methods. There is a “2 and 20” fee structure. 2% is the management fee and 20% is the performance fee.
3. Most hedge funds have a minimum one-year lockdown period. Even after that period is over, withdrawals can only be done at specified intervals, usually quarterly or bi-annually.
4. Losses can be very large due to aggressive investment strategies and concentrated investments.
5. Hedge funds usually require a very large minimum investment amount.
How To Pick a Hedge Fund?
There is an enormous number of hedge funds available to qualified investors, and it isn’t easy to select a fund. Investors should do a lot of market research and due diligence before deciding which fund to invest in.
First, the investor has to decide on the level of risk they want to take, and what their expected return should be. Then they need to decide if the fund is in line with their vision. Consulting a seasoned adviser might be a good idea if the investor has no experience in the hedge fund market.
Absolute factors, such as the fund fees, and the fund’s historical performance should also be considered. In addition, relative factors such as the firm’s and fund manager’s reputation should also be taken into consideration when selecting a hedge fund.
As hedge funds are private investment vehicles that are only open to qualified investors, they are only loosely regulated. As long as they are transparent about their intentions and strategies to investors they can do pretty much anything. This makes hedge funds an inherently risky investment option. Therefore, it isn’t surprising that hedge funds have been involved in some of the worst financial catastrophes over the years. However, the flexibility enjoyed by this investment vehicle has witnessed capable wealth managers produce some jaw-dropping long-term returns. This has led to the sustained popularity of this financial instrument.