What Are Hedge Funds?

A Hedge fund is not a specific type of investment; it is a vehicle for investment. A hedge fund pools money from investors to invest in costly, high-risk, but high-reward securities and other opportunities. Unlike mutual funds, Hedge Funds are not heavily regulated. They have more leeway, allowing fund managers to pursue investments and strategies that could increase the risk of investment losses.

Hedge fund managers use a wide range of strategies, including trading esoteric assets and buying with borrowed money in an effort to achieve high investment returns for their clients. Hedge funds are considered risky investments accessible only to accredited investors, usually high net worth individuals (HNIs) and institutions who can afford the high fees and the risks involved.

Understanding the Hedge Fund

Initially, hedge funds solely focused on hedging or minimizing the risk of an investment. The managers of conventional investment funds would devote a portion of available assets to a hedged bet. That’s an investment in the opposite direction of a fund’s focus. The hedge fund helped in offsetting any losses in the core holdings. For example, if a fund manager invested a large portion in a cyclical sector that thrives in a booming economy like travel, they would devote another portion of the assets to stocks in a non-cyclical sector like power or food companies. In case of unexpected losses, the returns of the non-cyclical stocks would offset the losses in the cyclical stocks.

Nowadays, hedge funds aim to increase returns rather than decrease risks. Even though their focus has shifted, the name hedge fund stuck. Many hedge fund managers have taken the concept of hedge funds to an extreme. The funds have nothing to do with hedging, except for the few managers who stick to the original concept of hedge funds, commonly known as the classic long/short equities model.

The Securities and Exchange Commission does not regulate hedge funds strictly as it does mutual funds. This means that hedge funds often use riskier ways and riskier investment strategies. They often use leverage, which is borrowed money to buy assets to multiply their potential returns (at times, losses). Hedge funds also invest in derivatives like futures and options. They are free to invest in esoteric investments that conservative conventional (other) investors would not touch. The appeal of many hedge funds mainly revolves around the reputation of their managers, who are considered stars in this industry.

These money managers charge high fees, usually 1%-2% of assets and a performance fee of around 20% of the profits. These performance fees encourage the money managers to take high risks. The more the money they earn, the higher the profits for them and their clients. The fund managers are paid on pure profit management.

Types of Hedge Funds

There are several types of hedge funds. They are categorized depending on the strategies they employ, including macro, relative value, equity, activism, and distressed securities.

·       A macro hedge fund involves investing in bonds, stocks, and currencies. Fund managers invest with the hope of making profits from changes in macroeconomic variables like countries’ economic policies and global interest rates.

·       A relative-value fund involves taking advantage of spreads’ inefficiencies or price.

·       An equity hedge fund is country-specific or global. It involves investing in lucrative stocks while avoiding downturns. Fund managers do this by shorting overvalued stocks and stock indices.

Other hedge fund investment strategies employed by fund managers include emerging marketing, aggressive growth, income, value, and short selling.

The History of Hedge Funds

Alfred Winslow Jones, a renowned Australian investor and financial writer, launched the first hedge fund in 1949. Jones launched the hedge fund through his investment company, A.W. Jones & Co. He raised $100,000, of which $40,000 was from his own pocket. He set up a fund that aimed at minimizing the risks in long-term investment by short-selling other stocks.

Currently, this innovation is known as the classic long/short equities model. Jones enhanced the returns of his fund by employing leverage. He converted the fund from a general partnership to a limited partnership in 1952. He added a 20% incentive fee to compensate the managing manager. Jones earned a reputation as the father of the hedge fund because he was the first money manager to combine the use of leverage, short selling, and a compensation system based on performance.

Hedge funds outperformed most mutual funds in the 1960s. Initially, they were unknown to the public until a 1966 article; Fortune featured a fund that outperformed every mutual fund on the market. As the fund evolved, most hedge funds turned away from Jones’s strategy and embraced riskier strategies. These moves resulted in heavy losses in 1969-70 and many hedge fund closures during the bear market in 1973-74.

For more than two decades, the hedge fund industry didn’t grow much. However, in 1986, an article in Institutional Investor highlighted the double-digit performance of Julian Robertson’s Tiger Fund. Once again, hedge funds captured public attention. Many high-profile money managers abandoned the conventional mutual fund industry in the early 1990s and became hedge fund managers.

From the late 1990s up to the early 2000s, history repeated itself. Many high-profile hedge funds failed, including the Robertson’s Tiger Fund.

Hedge Fund Industry Today

The industry experienced a comeback, recording a growth of total assets under management from $2.2 trillion in 2012 to $ 3.6 trillion in 2019. The number of hedge funds has also grown. In 2002, the number stood at around 5,000, and by the end of 2015, it was 10,000. That number had exceeded 16,000 worldwide by 2019.

Common Hedge Fund Strategies

The most popular hedge fund strategies include:

1.      Long/Short Equity

This strategy involves exploiting potential profit opportunities. Managers take into consideration both potential upside and downside expected price moves. The strategy involves taking long positions in relatively underpriced stocks and selling short stocks considered overpriced.

2.      Merge Arbitrage

Also known as risk arb, merger arbitrage involves simultaneously buying and selling stock of merging companies, creating riskless profits. A merger arbitrageur weighs the likelihood of a merger not closing on time or not closing at all.

3.      Equity Market Neutral

With equity market neutral (EMN), a fund manager exploits the differences in stock prices by being long and short on an equal measure in closely related stocks. The stocks may be within the same industry, sector, or country. The stocks could be historically correlated or just share similar characteristics like market capitalization. Managers create EMN funds with the intent of producing positive returns, irrespective of whether the market is bullish or bearish.

4.      Global Macro

This strategy involves basing holdings mainly on the overall economic and political views of different countries and their macroeconomic principles. Holdings could include fixed income, long and short positions in equity, currency, futures markets, and commodities.

5.      Convertible Bond Arbitrage

Convertible bond arbitrage strategy simultaneously takes long and short positions in convertible bonds and underlying stock. The arbitrageur adopts this strategy, hoping to profit from the movement in the market by creating a hedge between long and short positions.

6.      Volatility Arbitrage

With this strategy, the hedge fund manager attempts to make a profit from the difference between the forecasted future price volatility of an asset like a stock and the implied volatility of options based on the asset. This strategy involves employing derivative contracts and other options.

Advantages of Hedge Funds

Despite the high investment risks of hedge fund investing, they provide some worthwhile benefits over conventional investment funds. Their common benefits include:

·       Managers employ creative strategies that can generate high returns in bond markets, and rising and falling equity.

·       There is a reduction in overall portfolio risk and market volatility in balanced portfolios.

·       There is potential for higher returns than for conventional investments.

·       Hedge funds embrace a variety of investment styles, giving many investors an opportunity to customize their investment strategy.

·       Gives hedge fund investors an opportunity to access some of the world’s most renowned and talented investment managers.

Disadvantages of Hedge Funds

Investing in hedge funds comes with the following risks:

·       Compared to mutual funds, hedge funds tend to be less liquid

·       Concentrated investment strategies adopted by managers expose investors to potentially huge losses

·       Investing in a hedge fund requires an investor to lock up money for several years

·       The use of borrowed money or leverage could lead to significant losses

Who Can Invest in Hedge Funds

Hedge fund investors must meet certain income and net worth requirements. Due to government regulations, only “accredited investors” can invest in these funds. An accredited investor could be a person or an entity. An individual investor must meet the following criteria:

·       Should have a personal income of $200,000 or more per year – if the investor is married, they must have a combined income of at least $300,000 with the spouse. The investor must have maintained this income level for two consecutive years and must have a reason to believe that they will maintain this income in the future.

·       The investor should also have a personal net worth of $1 million or higher, alone or with a spouse. This net worth excludes the investor’s primary residence.

For institutional investors and entities to be qualified investors, they must be:

·       A trust with a net worth of at least $5 million – the trust should have been formed for the purpose of investment and should be run by a sophisticated investor.

·       An entity in which all equity investors qualify as accredited investors in their own capacity/merit.

According to the U.S. Securities and Exchange Commission (SEC), sophisticated investors are persons with ample knowledge and experience, which enables them to make informed decisions regarding the potential risks of an investment.

Factors to Consider When Investing in Hedge Funds

Hedge funds are not subject to the federal rules that protect standard investors. This makes them riskier than other investment options. If you are considering investing in them, you should:

Be an accredited investor – You can only invest in hedge funds if you are an accredited investor. This means that you should have a minimum level of income or assets. Read and understand the fund prospectus – You should ensure that you read the fund prospectus and other materials to understand the level of risk involved. Ensure that the investment strategies and the risks involved are suitable for your investing goals, risk tolerance, and time horizons. Like with other investments, the higher the potential returns of a hedge fund, the higher the risks involved. Know how fund assets are valued – Hedge funds can hold hard-to-sell investments. The investments can also be difficult to value. Before you invest, ensure that you understand the valuation process, including how independent sources value the fund’s holdings. Understand the fees – Fees will have a significant impact on the return on your investment. Typically, hedge funds charge an asset management fee of 1-2% of assets and a 20% performance fee of the fund’s profits. Many managers take considerable risks to generate larger returns and, in turn, earn higher. Know the restrictions on your right to recoup your shares – With hedge funds, investors have limited opportunities to redeem or cash in their shares, usually four times a year or less. A lock-up period of one year or more applies, during which investors cannot cash in their shares. Choose a qualified fund manager –Ensure that you choose a fund manager who is qualified to manage your money. Before you invest, ensure that the fund manager has no disciplinary history within the securities industry. Gather information – Gather ample information and ask all the necessary questions. When investing in hedge funds, you are entrusting your money to another person. You have a right to know where your money is going, how it is being invested and how you can recover it.

The Bottom Line

Like mutual funds, hedge funds are pooled investment vehicles, guided by professional management firms. However, they operate with far less disclosure and aren’t regulated as much. They involve pursuing flexible and risky strategies to make higher profits for investors and higher gains for managers. Unlike mutual funds, hedge funds have higher minimum investment requirements. The majority of investors in hedge funds are high net-worth individuals. Therefore, hedge funds have earned the reputation of speculative luxury for wealthy investors.