The comprehensive guide below will tell you everything you need to know about a hedge fund including its history, strategy, how it works and alot more!
Are you someone who is looking to seek active returns? Have you been wondering how people end up making money from hedge funds?
If your answer is yes to both of the above questions, then this comprehensive guide is for you!
With the developments in the world of finance, it is very important to understand your risks and returns before investing in anything. Therefore, always check out every fund you plan to invest in, and also the alternative options.
So buckle up, because it is time to learn everything about a hedge fund!
What is a Hedge Fund?
A hedge fund is considered as ‘alternative investments’, that is, an investment in any class of asset except the following: stocks, bonds, and cash. It uses a pool of funds that employ different strategies to produce active returns (returns you give out of active management of portfolio) and alpha (excess returns earned, above the benchmark return).
Hedge funds are like a partnership between a funds manager and the investor. The funds manager (also known as a general partner) is responsible for managing the portfolio and controlling the investment strategy to carry out trading activities, whereas the investor (also known as a limited partner) works as a silent partner. Thus, together, they make use of different strategies to invest in a wide range of financial products.
However, this type of investment is generally only accessible to authorized investors.
History of Hedge Funds
Beginning of Hedge Funds
After the Investment Company Act of 1940 which regulated the investment funds, in 1949, Alfred Winslow Jones created the very first hedge fund strategy. He pursued the strategy of buying the assets he believed would perform well against the market, and sold the ones he expected to decrease. As a result, he described his funds as being “hedged” against the market movements. Eventually, Alfred went on to introduce a 20% performance fee when he created the first hedge fund product in 1952.
Initial Rise in Hedge Funds
In the late 1960’s, there was a rise in hedge funds. Over the past 5 years, Alfred had outperformed the best mutual fund, even after taking the fees into account. The achievement was featured in Fortune magazine, and after this many new hedge funds were established. This included Quantum Fund which were advised by George Soros through his company Soros Fund Management. Therefore, with this, the number of hedge funds started growing.
First Crash of Hedge Funds
However, when there was a recession from 1969-1970 after which the stock market crashed during 1973-1974, the world saw the first hedge fund crash. Thus, as the industry struggled due to heavy losses, many hedge funds were forced to shut down, and even Alfred’s funds suffered a loss of over 10%.
The Revival of Hedge Funds
It wasn’t until the late 1980’s that the hedge funds began increasing again. As the hedge funds strategies began to expand, the market generated huge returns for investors. During that same time period, Julian Robertson launched ‘Tiger Fund’ with $8 million, and turned it into $22 million in the late 1990s. Even though it was still one of the earliest funds, it was generating immense results.
Later continuing in the 1990s, many dominant funds were launched, amazing funds managers emerged, and most importantly, new strategies were discovered. The hedge funds were now covering a range of asset classes and different styles of investment.
Later in the 21st Century
By the early 2000’s, the hedge funds industry had gained popularity around the world and by 2008, the industry held almost $2 trillion in assets under management (AUM). However, when the 2007-2008 financial crisis hit the world, it resulted in heavy losses. The investors were forced to withdraw assets, and as a consequence, AUM declined.
The hedge funds bounced back in the industry in 2011, when the industry asset reached $2 trillion. During this time, 61% of the worldwide investment in hedge funds came from institutional sources. And even though there were greater regulations now after The Dodd-Frank Wall Street Reform and Consumer Protection Act was put into effect, the hedge funds still performed well.
Later during the first few months in 2012, the industry reached a high record of $2.13 trillion in assets under management and jumped to $3.1 trillion by July 2017.
Today, the hedge fund industry has matured and is increasingly popular. Now the fund managers can have several billions of dollars in AUM and the industry has consolidated larger firms such as Citadel, Elliot, Millennium, Bridgewater, and others.
The table below shows the asset under management in hedge funds in 2020 according to different regions:
|Region||Hedge Funds Asset Under Management|
|North America||$2,783 billion|
|Asia Pacific||$121 billion|
|Rest of the World||$30 billion|
Characteristics of a Hedge Fund
Investment in hedge funds are often illiquid, that is, they cannot be easily converted to cash. This is because hedge fund managers often put a limitation on investors taking out their money. For example, they might require investors to keep their money in for at least a year, a time known as “lock-up period”. As a result, it is a long term investment since your money might be locked for a few years.
2. Requirement of accredited investors
Qualified investors are a requirement when it comes to investing in hedge funds. Meaning, the investors need to meet a certain criteria in terms of their net worth (generally it should exceed over $1 million) or else they won’t be qualified to invest.
3. Usage of aggressive investment strategies
An aggressive investment strategy is when the portfolio aims to maximize returns (higher than expected) by taking a relatively higher risk. As a result, these strategies are different from typical investments since they make use of versatile investment vehicles that can make use of leverage, derivatives, short selling, etc.
4. Wider investment range
Unlike mutual funds, which are usually limited to stocks and bonds, hedge funds have a wide range of investments available. This includes investing in anything including real estate, derivatives contracts, currencies, different commodities and other alternative investments. Therefore, due to this wide range, hedge funds have an advantage in terms of greater available options for investment.
5. Biased performance data
People often come across good numbers in hedge funds, indicating they have performed really well. But what most people don’t realise is that hedge funds managers don’t have to report their performance numbers to anyone but their investor, and as a result, whatever number is mostly available is biased towards good performance.
There are two important types of biases to consider when we are analysing hedge funds data: selection bias and survivorship bias.
This is when hedge funds managers themselves drop non performers from the list when presenting performance and only “select” the best performers.
This situation occurs when only the best performers are able to survive and the non performing funds are eventually out of the list. Therefore, the hedge funds manager drops the non performers and only reports the “surviving” ones, which at the same time are also the best performers.
6. Employment of leverage
Hedge funds often make use of borrowed money to boost their returns by leveraging a broker’s money to make larger investments. While this may maximize more than expected returns, it also magnifies the risk associated which can lead to a lot of loss. Thus, if the situation hits an unexpected turn, like during the Great Recession (2007-2009), then as a result, hedge funds suffer more due to increased exposure as they employ high levels of leverage.
Different Strategies of A Hedge Fund
To further solve the question about ‘what is a hedge fund’, we need to look at the different strategies it is divided in based on a set of principles. The different strategies employed by hedge funds are based on a contribution of the following elements:
- Hedge fund’s approach to market
- Instruments used
- Market sector it specializes in
- Method to select investment
- Diversification percentage
Here is a list of 9 most common hedge funds strategies:
This is one of the most popular strategies of hedge funds. It aims to make profit from economic and political changes around the world by making bets. The bet can cover a variety of assets and instruments including shares, bonds, and currencies.
The Global Macro strategy is developed by investment managers after analyzing various economic variables and their impact on the world. Thus, they make use of macroeconomics analysis and look at the “bigger picture”. Even though this strategy is flexible, the timings of implementation matters the most and if the timing is right, the strategy will generate great returns.
Techniques like systematic analysis, quantitative and fundamental approaches, long and short-term holding periods are often applied in this strategy.
Moreover, the strategy is divided into two approaches: discretionary trading where investment managers are responsible for identifying and carrying out investments and systematic trading where the execution is based on a mathematical model.
This type of strategy basically consists of short selling, where investors will invest in such a way that they will make a profit if the value of the asset falls. So basically, it means to sell the asset that is most likely to fall.
To implement this strategy, the funds manager must have all the details regarding a particular asset and find anything that indicates that a particular company will not perform well.
Long/Short Equity Strategy
The first hedge fund launched used a long/short strategy. In this case, the funds manager will buy the stock they feel is underpriced and sell the ones that are overpriced. Therefore, they will maintain a “long and short position” through pair trading and go long and short on two competing companies in the same industry based on their valuation. As a result, the investor will make money no matter what happens in the overall market if the company whose stock is underpriced performs well.
Since the strategy can be broadly diversified, it’s a less risky one. However, the funds manager can choose to focus on specific sectors.
Market Neutral Strategy
In this strategy, the hedge fund will make a profit no matter what happens in the overall market, by pairing long and short positions. Thus, since longs and shorts will have equal market value, managers can get full return based on their stock selection and avoid some form of market risk entirely. Also, even if the market moves in any direction, the gains and losses will offset each other.
Merger Arbitrage Strategy
Here in order to create a “riskless” profit, fund managers will buy and sell stocks of two merging companies simultaneously. Since there will be uncertainty about whether the deal will be completed or not and if it is completed, whether it will be on time or not, the stock of that target company will be underpriced. And eventually, once the deal is complete, the merger arbitrage can take advantage of the inefficiencies and make profit from the difference after selling the stock.
This type of hedge fund strategy makes use of “hybrid” securities where it combines a bond with an equity option. So basically, it typically includes a long position on bonds and short position on equity (which can be either common stock or shares). As a result, profit occurs when there is a pricing error made during the conversion.
So if a convertible bond is underpriced, the arbitrageur will take a long position in the convertible bonds and a short position in the stock. But if the convertible bond is overpriced, then the arbitrageur will take a short position on the convertible bond. Thus, the strategy works when there is volatility in the market.
Capital Structure Arbitrage Strategy
Over here, the underpriced security of a firm is bought and the overpriced security is sold. It includes going long in one security and going short in another. Thus, profit is made due to the inefficiency in the firm’s capital structure.
Fixed Income Arbitrage
This particular hedge fund strategy attempts to engage in government bonds arbitrage since they are risk free as the risk of default is eliminated. It aims to take advantage of the difference in interest rates between varying government securities.
However, the strategy often provides small profits and can cause huge losses at times.
Strategies like event driven only work when the economic activity in the country is performing well. This includes strong business activities that indicate that the economy is going towards a boom.
Thus, in this strategy, fund managers maintain positions or buy funds in companies that are in distress. The distress can be in any form, like, the company may be involved with mergers, it may be restructuring itself, or might be involved in other capital structure adjustments.
If the company has not filed for bankruptcy in such a scenario, the fund manager might short sell equity, betting the shares will fall. However, if the company is already bankrupt, then a subordinated debt is entitled when the company restores profitability in order to get hold of a better hedge.
In addition to that, the strategy requires some risk and a lot of patience as a company might take months or even years to restore profitability.
Performance of Hedge Funds
Hedge funds are known to produce “risk adjusted returns”. A risk adjusted return is basically a calculation of the profit from an investment, or the potential profit after taking into account a specific degree of risk, that must be there in order to achieve the returns. The risk over here is measured by comparing it to the risk of government securities, because these securities have risk free return since the default risk is non-existent.
Over the past 10 years, the performance of hedge funds has weakened comparatively. The average return of a hedge fund was 11.02% in 2020, which is greater than the average return of 2019 which was 10.07%. Thus, even though the average returns have fallen since 2009, the statistic has recently elevated.
Hedge Funds VS Other Funds
Let us now compare hedge funds with two other popular investments:
Hedge Funds VS Mutual Funds
Both, hedge funds and mutual funds, are pooled funds that are managed by a fund manager using capital from multiple investors. However, while mutual funds are offered to the public and available for daily trading, hedge funds are only available for accredited investors since they are private investments as discussed above.
Hedge funds often make use of high risk strategies, such short selling and leverage. On the other hand, mutual funds are less risky, and as a result, have limited potential returns.
In the case of a mutual fund, fund managers don’t take a “performance fee” from the profit, whereas hedge fund managers typically require a 20% performance fee which they take from the profit as mentioned above.
Last, but not least, since hedge funds take a greater risk, they are more likely to perform better and bring greater returns. Whereas, mutual funds tend to not perform as well as hedge funds in terms of returns.
Hedge Funds VS Private Equity
Both, hedge funds and private equity, pay their manager management fees and performance fees. (for details on each type of fee click here). Next, they both contain the requirement of accredited investors, that is, it is appealing to high net worth investors.
However, the difference arises in the time horizon of each. Since, hedge funds are pooled investments, they tend to invest in assets that provide good returns within a short time period. Whereas, private equity means directly investing in companies, due to which these funds are not looking for short term returns, but in fact, look for long term investment and return.
Even though both types of investments tend to offset their risk through safer investment, yet when compared, hedge funds are more riskier than private equity because they focus on higher returns in a short time span.
In addition to that, the structure of both differ as well. While hedge funds are open ended funds with no restriction, private equity is close ended investment.
Risk Associated with Hedge Funds
Different types of investment come with different risks attached. The following are the 3 basic risks attached to consider when investing in hedge funds:
1. Investment risk
This is the risk of losing some, or all of your investment. Since hedge funds are not regulated, they use certain strategies that result in exposure to excessive risk. Thus, there is always a certain level of investment risk that is not expected by the investors.
Here are 3 of the main investment risk:
2. Style Drift:
This occurs when the funds manager changes his/her stated strategy in order to avoid a loss in the declining market. While this may seem like a smart move, the fact that investment was made considering the manager’s expertise in that specific stated strategy, may create a chaos and not end up in the favour of neither the investor, nor the funds manager.
3. Overall market risk
It is not easy to maintain a balance with the overall market risk. As a result, an adverse economic condition can create a wide spread between the positions that may negatively affect the performance of the funds.
Since hedge funds often make use of leverage, even the smallest fluctuation in the expected performance of a fund can be risky for the fund managers as it may affect the returns of the fund.
5. Fraud risk
Due to the lack of regulation, fraud risk has greater chances to occur in the hedge fund industry. This means that often fund managers opt for unethical behaviour for their own interest. Thus, there are chances that a fund manager might hold on to huge sums of money just to avail a luxury lifestyle for themselves. As a result, it is very important to know your funds manager and stay up to date with what is going on.
6. Operational risk
This type of risk is attached with operational inefficiencies that tags along when there is inefficient profit earned as compared to operational costs. This inefficiency is a result of the lack of policies, and procedures implemented in the activities of a hedge fund, that eventually exposes the investment to operational risk.
Fees of Hedge Funds
The fee structure of hedge funds constitutes of two main key components:
This is the fee charged by the fund manager for operating the investment vehicle. It is an annual fee that is charged over a period of 12 months. It is typically 2% of the investment or 2% of the net asset value. However, lately, the fee structure has seen to be decreased to an average of 1.50%.
This sort of fee behaves kind of like a reward for performing well. Thus, the greater the positive returns, the more the fund manager will earn. The performance fee is typically 20% of the funds profits, but lately has been decreased to an average of 19%.
To further understand, consider the following example:
If you invest $100, 2% ($2 in this case) will go as management fees. Now $98 is left. After investing, and making profit, if by assumption the funds manager makes $110, this means a profit of $10. Thus, if the performance fees will be 20% of the profit, then the funds manager will get another $2. In the end, you will receive $108, and consequently make a profit of $8.
Top 5 must read books to learn more about what is a hedge fund
- Top Hedge Fund Investors: Stories, Strategies, and Advice by Cathleen Rittereiser and Lawrence Kochard
- Definitive Strategies and Techniques by IMCA
- Hedge Fund Market Wizards by Jack D. Schwager
- The Hedge Fund Book: A Training Manual for Professionals and Capital-Raising Executives by Richard Wilson
- Market-Neutral Investing: Long/Short Hedge Fund Strategies by Joseph Nicholas
So therefore, as we can now fully understand ‘what is a hedge fund’, we can deduce that this type of investment has its own features, that help us determine its pros and cons and eventually assists us in deciding on whether we should or should not be a part of the hedge funds industry.