Let's talk all about hedge funds in a way that's easy to understand!
Think of a hedge fund as
a special kind of investment fund that gathers money from different investors. It uses some
smart and sometimes tricky ways to try and make more money and protect investments from
market ups and downs.
Here’s a detailed look at hedge funds:
What are Hedge Funds?
A hedge fund is a type of investment fund where many people pool their money together.
These funds invest in things like stocks, bonds, and other liquid assets. What makes them
different from regular investment options like mutual funds is their ability to use more
complex methods, such as:
● Short selling: This is when they borrow something, sell it, and hope its price drops
so they can buy it back cheaper and return it, making a profit.
● Leverage: This means borrowing money to make even bigger investments, which
can increase both potential gains and losses.
● Derivative instruments: These are financial tools whose value comes from other
assets.
In the United States, hedge funds are only for institutional investors (like big organizations)
and very wealthy individuals, not for the average person. They are considered "alternative
investments" and are different from mutual funds and ETFs because they use more complex
techniques and leverage. Also, unlike private equity funds, hedge funds usually invest in
assets that can be easily bought and sold (liquid assets) and typically let investors put
money in or take it out regularly. While there isn't one strict definition, these features help us
understand what a "hedge fund" is.
A Bit of History and How They've Grown
The idea of "hedging" – which means putting limits on risk – has been around for a long
time. Early hedge funds tried to protect specific investments from big market changes by
"shorting" similar assets. The very first hedge fund structure was created in 1949 by Alfred
W. Jones, who also came up with the name "hedged fund". He used "hedged" to describe
how he managed investment risk due to market changes. Jones also started the popular fee
structure where hedge funds charge a 2% management fee and a 20% performance fee on
gains.
In the 1970s, many hedge funds closed down because of heavy losses during recessions.
But they started getting noticed again in the late 1980s and really grew in the 1990s, partly
because of the rising stock market and the idea that they could offer better-than-average
returns. During this time, they expanded their strategies beyond just buying and selling
stocks to include things like credit arbitrage and fixed income. Big institutional investors, like
pension funds, started putting more of their money into hedge funds.
By 2008, the global hedge fund industry managed about $1.93 trillion. However, the 2008
financial crisis hit them hard, causing many to limit withdrawals and leading to a drop in their
popularity and total assets. But they bounced back, reaching almost $2 trillion by April 2011
and a record high of $2.13 trillion in April 2012. As of 2021, their total assets were around
$3.8 trillion. Today, the industry is maturing, with larger firms becoming more prominent, and
more funds closing than opening. In July 2017, assets under management hit a record $3.1
trillion.
How Hedge Funds Make Money (Fees) and How Managers Get Paid
Hedge fund management firms usually charge two main types of fees:
1. Management Fee: This is a percentage of the total money in the fund, usually
around 2% per year, though it can range from 1% to 4%. This fee helps cover the
fund manager's operating costs. It's usually paid monthly or quarterly.
2. Performance Fee: This is typically 20% of the profits the fund makes in a year,
though it can be anywhere from 10% to 50%. This fee is meant to encourage
managers to make good profits. Some people, like Warren Buffett, have criticized this
fee because managers share in the profits but not the losses, which might encourage
risky behavior.
Most performance fees include a "high water mark," which means the manager only gets
paid a performance fee if the fund's value goes above its highest previous point after any
losses have been recovered. This stops managers from earning fees for simply volatile
performance. Sometimes, funds might also have a "hurdle rate," meaning the manager only
gets a performance fee if the fund's returns are better than a certain benchmark, like LIBOR
or a fixed percentage. A "soft" hurdle means the fee applies to all returns if the hurdle is
cleared, while a "hard" hurdle only applies to returns above the hurdle rate. This ensures
managers are rewarded for returns that beat what investors could get elsewhere.
Occasionally, hedge funds also charge a "redemption fee" if investors take out their money
too soon (e.g., within a year) or if they withdraw more than a certain percentage of their initial
investment. This fee aims to discourage short-term investing and is usually kept by the fund
and shared among all investors, unlike the other fees.
Hedge fund management firms are often owned by their portfolio managers, so the profits
from performance fees (and any extra management fees) go to these owners. Top hedge
fund managers can earn huge amounts of money, sometimes up to $4 billion in a good year,
because they often invest a lot of their own money in the funds. In fact, the top 25 hedge
fund managers often earn more than all 500 CEOs in the S&P 500 combined. However,
most hedge fund managers earn much less. For example, in 2011, the average earnings for
the 25 highest-paid US hedge fund managers was $576 million, while the average for all
hedge fund investment professionals was about $690,786.
Different Ways Hedge Funds Invest (Strategies)
Hedge fund strategies are generally grouped into four main categories, plus some others:
1. Global Macro: These funds make big bets in stock, bond, or currency markets based
on their predictions of major global economic events. Managers use "big picture"
economic analysis to find opportunities to profit from expected price changes. These
strategies offer a lot of flexibility because they can use leverage and invest in many
different markets. Global macro strategies can be "discretionary" (managers pick
investments) or "systematic" (computer models pick investments). They can also
follow trends or try to profit from trend reversals. Sub-strategies include trading in
diversified markets ("systematic diversified") or specializing in specific sectors like
currency ("systematic currency"). Commodity Trading Advisors (CTAs), which trade
futures or options in commodity markets, are also part of this.
2. Directional: These strategies try to profit from market movements, trends, or
inconsistencies when choosing investments across different markets. They have a
greater exposure to overall market swings than "market neutral" strategies. A
common example is long/short equity, where they buy stocks they think will go up
("long") and sell borrowed stocks they think will go down ("short"), often using options
to balance risks. Sub-strategies include:
○ Emerging markets: Focusing on fast-growing economies like China and
India.
○ Sector funds: Specializing in specific industries such as technology or
healthcare.
○ Fundamental growth: Investing in companies expected to grow earnings
faster than the market.
○ Fundamental value: Investing in companies they believe are undervalued.
○ Quantitative directional: Using computer models and financial signal
processing for stock trading.
○ Short bias: Primarily using short positions to profit from falling stock prices.
3. Event-Driven: These strategies look for investment opportunities related to specific
corporate events. This includes things like company mergers, acquisitions,
bankruptcies, or restructurings. Managers try to profit from price differences that
happen before or after these events. Big investors like hedge funds are more likely to
use these strategies because they have the resources to analyze such complex
events.
○ Distressed securities: Investing in the bonds or loans of companies in
severe financial trouble or facing bankruptcy, often buying them at a discount.
○ Risk arbitrage (or merger arbitrage): Buying and selling stocks of
companies involved in a merger or acquisition to profit from price differences.
The "risk" comes from the chance the deal might not happen.
○ Special situations: Identifying upcoming events (like spin-offs, stock
buybacks, or asset sales) that will significantly change a company's stock
value.
○ Other event-driven strategies include credit arbitrage (corporate bonds),
activist strategies (taking large stakes to influence company management),
and legal catalyst strategies (companies in major lawsuits).
4. Relative Value: These strategies try to profit from small price differences between
related securities. The idea is that these differences might exist because of
mispricing compared to other related securities or the overall market. Managers use
math, technical analysis, or fundamental research to find these discrepancies. This is
often called "market neutral" because these strategies usually have very little
exposure to the overall market's direction. Sub-strategies include:
○ Fixed income arbitrage: Profiting from pricing differences between related
fixed-income securities.
○ Equity market neutral: Buying and selling stocks within the same sector or
industry to profit from price differences, while "hedging" against broader
market movements.
○ Convertible arbitrage: Profiting from differences between convertible bonds
and the stocks they can be converted into.
○ Statistical arbitrage: Using complex math models to find pricing differences
between securities.
○ Volatility arbitrage: Profiting from changes in how much an asset's price
moves, rather than the price itself.
5. Miscellaneous Strategies: Some strategies don't fit neatly into the main four
categories. These include:
○ Fund of hedge funds: A hedge fund that invests in many other
single-manager hedge funds.
○ Multi-manager: A fund where money is split among several sub-managers,
each using their own strategy.
○ Multi-strategy: A single fund that uses a mix of different investment
strategies.
○ 130-30 funds: Equity funds that are 130% "long" (invested normally) and
30% "short" (selling borrowed shares), resulting in a net 100% long position.
○ Risk parity: Spreading risk across many different types of assets and using
leverage to maximize gains.
○ AI-driven: Using advanced machine learning and big data to make
investment decisions.
How Hedge Funds Handle Risk
While "hedging" sounds like it reduces all risk, it's important to know that while it can lower
some risks, it often introduces others, like operational or model risks. So, risk can be
reduced, but not completely removed. However, research has shown that hedge funds can
be less volatile than stock market investments for some strategies because they use
hedging techniques.
Hedge fund managers often use detailed strategies to manage risk and protect the fund and
its investors. Large hedge funds are known for having very advanced risk management
practices. Funds that make many quick trades often have comprehensive risk management
systems, and it's common for them to have independent risk officers who aren't involved in
trading but assess and manage risks.
They use various ways to measure risk, considering the fund's leverage, how easily assets
can be bought/sold (liquidity), and its investment strategy. Beyond just looking at market
risks, investors also check for "operational due diligence" to see if there's a risk of errors or
fraud that could cause losses.
Transparency and Regulation's Role in Risk: Because hedge funds are private, they don't
have to share as much information publicly, which can make them seem less transparent.
There's also a common idea that they face less regulatory oversight than other investment
funds. However, new rules passed in the US and Europe after the 2008 financial crisis have
made hedge fund managers report more information, leading to more transparency. Also, big
institutional investors are pushing for better risk management and more transparency, often
leading funds to share details about their valuation methods, investment positions, and
leverage.
Risks Similar to Other Investments: Hedge funds share some risks with other
investments, such as:
● Liquidity risk: This is about how easily an asset can be converted to cash. Like
private equity funds, hedge funds often have "lock-up periods" when investors can't
take their money out.
● Manager risk: Risks that come from how the fund is managed. This includes "style
drift," where a manager moves away from their area of expertise. Other factors are
valuation risk (if asset values are wrong), capacity risk (too much money in one
strategy can hurt performance), and concentration risk (too much exposure to one
investment or sector). These risks can be managed with clear controls, limits on how
funds are allocated, and set exposure limits.
Many investment funds use leverage, which means borrowing money or using derivatives to
make investments bigger than the actual capital. While this can boost potential returns, it
also increases the possibility of bigger losses. Hedge funds that use a lot of leverage usually
have strong risk management practices. Interestingly, hedge fund leverage is generally lower
than that of investment banks. Fund managers also have a stronger reason to manage risk
well if they have their own money invested in the fund.
How Hedge Funds Are Set Up (Structure)
A hedge fund is usually set up as an offshore corporation, limited partnership, or limited
liability company. It's managed by an investment manager, which is a separate organization
from the fund itself. These managers often get help from various service providers:
● Prime Broker: These are often parts of big investment banks. They help with trading,
provide leverage, lend money for short periods, and lend securities for strategies like
long/short equities. They can also hold the fund's assets and help with trade
execution.
● Administrator: Administrators are usually in charge of figuring out the fund's value
(called Net Asset Value or NAV). This is very important because it's the price at which
investors buy and sell shares in the fund. They also handle investor subscriptions
and withdrawals. In the US, hedge funds don't have to hire an administrator, and the
investment manager can do these tasks. However, many funds use outside auditors
to increase transparency.
● Auditor: This is an independent accounting firm that checks the fund's financial
statements thoroughly, usually once a year. They can also confirm the fund's NAV
and assets under management (AUM).
● Distributor: This person or company helps market the fund to potential investors.
Many hedge funds don't have a separate distributor, and the investment manager
handles the marketing themselves, though they might use "placement agents" or
broker-dealers too.
Where Funds and Managers Are Located (Domicile and Taxation): The legal setup of a
hedge fund, including where it's based and its legal type, is often chosen based on what's
best for investors' taxes and regulations. Many hedge funds are set up in offshore financial
centers (like the Cayman Islands, Luxembourg, or Bermuda) to avoid certain taxes for
foreign and tax-exempt investors. These offshore funds usually don't pay US capital gains
tax, but their investors still pay taxes in their home countries on any gains. US tax-exempt
investors (like pension plans) often use offshore hedge funds to keep their tax-exempt
status.
The investment managers, however, are usually located "onshore," meaning in major
financial centers. The United States is the biggest center, with US-based funds managing
about 70% of global assets in 2011. New York City and Connecticut are key locations for US
hedge fund managers. London used to be Europe's main hub, but some funds have moved
to other European cities or even back to New York after Brexit. Asia has seen increased
interest in hedge funds, especially in Japan, Hong Kong, and Singapore.
Legal Structures: US hedge funds for US-based, taxable investors are generally set up as
limited partnerships or limited liability companies. This helps avoid paying taxes both at the
fund level and again at the investor level. Offshore corporate funds are common for non-US
investors.
"Side Pockets": This is a way a fund can separate assets that are hard to sell or value
reliably. When an investment is "side-pocketed," its value is calculated separately. Investors
typically can't redeem these side-pocketed investments easily. Profits or losses from these
assets are only shared with investors who were in the fund when the asset was put into the
side pocket. This practice was common during the 2008 financial crisis to handle illiquid
assets but can be unpopular with investors.
How Hedge Funds Are Regulated
Hedge funds have to follow the laws and regulations where they are located. Unlike mutual
funds, US hedge funds are usually exempt from many standard registration and reporting
rules because they only take money from "accredited investors" (very wealthy or
experienced investors). However, after the 2008 financial crisis, new regulations were
passed in the US (Dodd-Frank Wall Street Reform Act) and Europe (Alternative Investment
Fund Managers Directive - AIFMD) to increase government oversight and require more
reporting.
● United States: Hedge funds in the US are subject to rules for reporting and
record-keeping. Many also fall under the Commodity Futures Trading Commission.
Historically, hedge funds were exempt from mandatory registration with the SEC if
they only sold to accredited investors. However, rules have changed over time:
○ In 2004, the SEC started requiring hedge fund advisers managing over $25
million and with more than 14 investors to register. This rule was later
overturned in court but led to other rules to increase oversight.
○ The Dodd-Frank Wall Street Reform Act (2010) made big changes. It
requires SEC registration for advisers managing private funds with more than
$150 million in assets. Registered managers must file reports with the SEC
about their assets and trading. This increased the number of hedge funds
under government supervision. The "Volcker Rule" within Dodd-Frank also
limits banks' relationships with hedge funds.
● Europe: In the EU, hedge funds are mainly regulated through their managers. In the
UK, managers must be authorized by the Financial Conduct Authority (FCA). The
EU's Alternative Investment Fund Managers Directive (AIFMD) requires all EU
hedge fund managers to register with national regulators and provide more frequent
information. It also sets rules for how managers are paid, potentially affecting
bonuses.
● Offshore Centers: Some hedge funds are set up in places like the Cayman Islands,
Dublin, or Singapore, which have different rules about investors, client privacy, and
manager independence.
The hedge fund industry has also tried to regulate itself. In 2007, top managers created the
"Hedge Fund Standards" to promote transparency and good governance. The Hedge Fund
Standards Board works to maintain these standards.
How Hedge Funds Perform
It can be hard to get performance data for individual hedge funds because they aren't usually
required to publicly report their results. However, some estimates suggest that hedge funds,
on average, have returned about 11.4% per year, which is 6.7% more than the overall
market before fees. One study found that between 2000 and 2009, hedge funds did better
than other investments and were less volatile, especially during that very volatile period. But
more recently, from about 2009 to 2016, hedge fund performance has generally been lower
than the market.
Performance is measured by comparing returns to risk using tools like the Sharpe ratio.
However, these traditional measures don't always fully capture the complexities of hedge
fund returns, leading to new ways of measuring performance.
There's a debate about whether the growth of the hedge fund industry has "diluted" the skill
(alpha) of managers. Some argue that more trading means fewer easy market opportunities,
and that more managers entering the field might mean less talent available.
Hedge Fund Indices: Unlike stock market indices, hedge fund indices are more complicated
because hedge funds aren't traded publicly and don't have to publish returns.
● Non-investable indices: These try to show the general performance of a group of
hedge funds based on databases. But they have biases: funds might only report
good results (self-selection bias), or when bad funds close, the average performance
looks better than it was (survivorship bias). Also, when a fund is added, its past good
results might be added, making history look better than it was ("instant history bias"
or "backfill bias").
● Investable indices: These try to create a product that investors can actually buy,
similar to a "fund of hedge funds". However, to make the index "investable" and
liquid, hedge funds must agree to certain terms, which means many successful
managers who don't need to agree to such terms won't be included.
● Hedge fund replication (clone indices): This newer approach uses math to create
a model of how hedge fund returns relate to other financial assets, then builds an
investable portfolio of those assets. While they can be representative, their history is
still too short to know how successful they'll be.
Closures: In 2016, there were more hedge fund closures than during the 2009 recession.
Many big public pension funds, like CalPERS, pulled their money because the funds'
performance wasn't worth the high fees. Also, the number of new hedge funds launched in
2016 was lower than before the 2008 crisis.
Big Debates and Issues (Controversies)
Hedge funds are often part of public discussions and controversies:
● Systemic Risk: This is the risk that a problem in one part of the financial system
could spread and cause instability across the whole system. Some groups, like the
European Central Bank, have said hedge funds pose systemic risks. The failure of
the Long-Term Capital Management (LTCM) hedge fund in 1998 raised worries about
whether one fund's failure could bring down other banks. However, many in the
financial industry disagree, saying hedge funds are generally "small enough to fail"
and don't use enough leverage to cause widespread harm if one fails. The head of
the Federal Reserve Board, Ben Bernanke, even said in 2009 that he didn't think any
single hedge fund would become "systemically critical". The concern remains that if
many hedge funds make the same bad trades and use a lot of leverage, it could lead
to forced selling of assets in a crisis, which could create systemic risk. Also, their
close ties with prime brokers (investment banks) can be a two-way street: a failing
bank can freeze hedge fund assets, as Lehman Brothers did in 2008.
● Transparency: Hedge funds are set up to avoid most direct regulation and don't
have to publicly share their investment activities, unlike mutual funds. While investors
in a hedge fund might get more detailed reports directly from the manager, this high
level of disclosure isn't available to the general public, leading to their reputation for
secrecy. Some funds are very private even with their own investors. Much of the data
available about hedge funds is reported by the funds themselves and isn't always
checked by others. Studies have shown big differences in reported information
between databases. This lack of independent checking has, in some cases,
contributed to fraud. For example, the Bernard Madoff Ponzi scheme, which was
incorrectly described as a hedge fund, highlighted the dangers of unverified financial
documents. After the Madoff case, the SEC added an audit requirement for hedge
funds.
● Links with Analysts: There have been concerns about the connections between
hedge funds and financial analysts. For example, a US Senate investigation in 2006
looked into whether hedge funds were getting special, early information from analysts
that wasn't available to the public.
● Value in a Portfolio: Hedge funds can be attractive because they sometimes don't
move in the same direction as traditional investments like stocks, which can help
reduce overall portfolio risk. However, there are reasons not to put a large portion of
assets into hedge funds:
○ Each hedge fund is very unique, making it hard to predict its returns or risks.
○ Their correlation with other assets (meaning how much they move together)
tends to increase during stressful market times, making them less useful for
diversification when you need it most.
○ The high fees they charge can significantly reduce actual returns. Some
studies have suggested that hedge funds are good for diversifying investment
portfolios, but this is debated. For example, one calculation showed that an
ideal portfolio wouldn't include hedge funds if performance fees were
considered, but it would if there were no performance fees. Also, hedge funds
tend to perform poorly during stock market downturns, when investors most
need some part of their portfolio to do well.
This should give you a good, comprehensive overview of what hedge funds are all about!
