What Is a Hedge Fund?
A hedge fund is a limited partnership of private investors whose money is pooled and managed by professional fund managers. These managers use a wide range of strategies, including leverage (borrowed money) and the trading of non-traditional assets, to earn above-average investment returns.
A hedge fund investment is often considered a risky, alternative investment choice and usually requires a high minimum investment or net worth. Hedge funds typically target wealthy investors.
Key Takeaways
- Hedge funds are actively managed funds focused on alternative investments that commonly use risky investment strategies.
- A hedge fund investment typically requires accredited investors and a high minimum investment or net worth.
- Hedge funds charge higher fees than conventional investment funds.
- The strategies used by hedge funds depend on the fund manager and relate to equity, fixed-income, and event-driven investment goals.
- A hedge fund investor's investment usually is locked up for a year before they may sell shares and withdraw funds.
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Understanding Hedge Funds
Hedging Their Bets
The term "hedge fund" refers to an investment instrument with pooled funds that is managed to outperform average market returns. The fund manager often hedges the fund's positions to protect them from market risk.
They do so by investing a portion of the fund's assets in securities whose prices move in the opposite direction of the fund's core holdings. Theoretically, should the prices of the core holdings move down, the prices of the securities acting as a hedge should move up. As a result, the hedge can offset any losses in the core holdings.
For example, a hedge fund that focuses on a cyclical sector, such as travel, may invest a portion of its assets in a non-cyclical sector such as energy, aiming to use the positive returns of the non-cyclical stocks to offset any losses in cyclical stocks.
Risk
Hedge funds use risky strategies, leverage, and derivative securitiessuch as options and futures. Therefore, an investor in a hedge fund is commonly regarded as an accredited investor. This means that they meet a required minimum level of income or assets. Typical investors are institutional investors, such as pension funds and insurance companies, and wealthy individuals.
Investments in hedge funds are consideredilliquidas funds often require investors to keep their money in the fund for at least one year, a time known as thelock-up period.Withdrawalsmay also only happen at certain intervals such as quarterly or bi-annually.
Types of Hedge Funds
Four common types of hedge funds are:
- Global macro hedge funds: These are actively managed funds that attempt to profit from broad market swings caused by political or economic events.
- Equity hedge funds: These may be global or specific to one country, investing in lucrative stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices.
- Relative value hedge funds: These funds seek to exploit temporary differences in the prices of related securities, taking advantage of price or spread inefficiencies.
- Activist hedge funds: These aim to invest in businesses and take actions that boost the stock price such as demanding that companies cut costs, restructure assets, or change the board of directors.
The appeal of many hedge funds lies in the reputations of their managers, which stand out in the closed world of hedge fund investing.
Common Hedge Fund Strategies
Hedge fund strategies cover a broad range of risk tolerance and investment philosophies. They involve a large selection of investments, including debt and equity securities, commodities, currencies, derivatives, and real estate.
Common hedge fund strategies are classified according to theinvestment style of the fund's manager and include equity, fixed-income, and event-driven investment goals.
- A long/short hedge fund strategy is an extension of pairs trading, by which investors go long and short on two competing companies in the same industry based on their relative valuations.
- A fixed-income hedge fund strategy gives investors solid returns, with minimal monthly volatility and aims for capital preservation; it takes both long and short positions in fixed-income securities.
- An event-driven hedge fund strategy takes advantage of temporary stock mispricing, spawned by corporate events like restructurings, mergers and acquisitions, bankruptcy, or takeovers.
Examples of Hedge Funds
The most notable hedge funds, based on assets under management (AUM), include:
- Bridgewater Associates: Founded in New York in 1975 and headquartered in Westport, Conn., global leader, with more than $124 billion in AUM.
- Renaissance Technologies: Founded in 1982 and headquartered in East Satauket, N.Y., with mathematical- and statistical-based investment strategies, and over $106 billion in AUM.
- AQR Capital Management: Founded in 1998 and headquartered in Greenwich, Conn., with applied quantitative research investment strategies, and over $94.5 billion in AUM.
Hedge Fund Compensation
Australian investor Alfred Winslow Jones is credited with launching the first hedge fund in 1949 through his company,A.W. Jones & Co. Raising $100,000, he designed a fund that aimed to minimize the risk in long-term stock investing byshort-selling, now referred to as the long/short equitiesmodel.
In 1952, Jones converted his fund to alimited partnership,added a 20%incentive feeas compensation for the managing partner, and became the firstmoney managerto combine short selling, the use of leverage, and a compensation system based on performance.
Today, hedge funds employ a standard "2 and 20" fee system, which refers to a 2% management fee and a 20% performance fee.
The management fee is based on the net asset value of each investor's shares, so an investment of $1 million garners a $20,000 management fee that year to cover the operations of the hedge and compensate the fund manager.
The performance fee is commonly 20% of profits. If an investment of $1 million increases to $1.2 million in one year, $40,000 is the fee owed to the fund.
Hedge Fund vs. Mutual Fund
Hedge funds are not as strictly regulated by the Securities and Exchange Commission (SEC) as mutual funds are.
Mutual funds are a practical, cost-efficient way to build a diversified portfolio of stocks, bonds, or short-term investments. They are available to the general public and average investor.
Hedge funds normally will only accept money from accredited investors who include individuals with an annual income that exceeds $200,000 or a net worth exceeding $1 million, excluding their primary residence. These investors are considered suitable to handle the potential risks that hedge funds are permitted to take.
A hedge fund can invest in land,real estate, stocks,derivatives, and currencies while mutual funds use stocks or bonds as their instruments for long-term investment strategies.
Unlike mutual funds where an investor can elect to sell shares at any time, hedge funds typically limit opportunities to redeem shares and often impose a locked period of one year before shares can be cashed in.
Hedge funds employ the 2% management fee and 20% performance fee structure. In 2022, the average expense ratio across all mutual funds and exchange-traded funds was 0.37%.
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What to Consider Before Investing
As investors conduct research to identify hedge funds that meet their investment goals, they often consider the fund or firm's size, the track record and longevity of the fund, the minimum investment required to participate, and the redemption terms of the fund. Hedge funds operate in many countries, including the U.S., United Kingdom, Hong Kong, Canada, and France.
According to the SEC, investors should also do the following when deciding whether or not to invest in a hedge fund:
- Read the hedge fund’s documents and agreements which contain information about investing in the fund, the strategies of the fund, the location of the fund, and the risks anticipated by the investment.
- Understand the level of risk involved in the fund’s investment strategies and whether they equate with your personal investing goals, time horizons, and risk tolerance.
- Determine if the fund is using leverage or speculative investment techniques which will typically invest both the investors’ capital and the borrowed money to make investments.
- Evaluate potential conflicts of interest disclosed by hedge fund managers and research the background and reputation of the hedge fund managers.
- Understand how a fund’s assets are valued as hedge funds may invest in highly illiquid securities and valuations of fund assets will affect the fees that the manager charges.
- Understand how a fund's performance is determined and whether it reflects cash or assets received by the fund as opposed to the manager’s estimate of the change in the value.
- Understand any limitations to time restrictions imposed to redeem shares.
What Tools Do Investors Use to Compare the Performance of Hedge Funds?
Investors look at the annualized rate of return to compare funds and to reveal funds with high expected returns. To establish guidelines for a specific strategy, an investor can use an analytical software package such as Morningstar to identify a universe of funds using similar strategies.
How Do Hedge Funds Compare to Other Investments?
Hedge funds, mutual funds, and exchange-traded funds (ETFs) all pool money contributed by many investors and attempt to earn a profit for themselves and their clients.
Hedge funds are actively managed by professional managers who buy and sell certain investments with the stated goal of exceeding the returns of the markets, or some sector or index of the markets. They take the greatest risks while trying to achieve these returns. In addition, hedge funds are more loosely regulated than competing investments, and they can invest in options and derivatives as well as esoteric investments that mutual funds cannot invest in.
Why Do People Invest in Hedge Funds?
A wealthy individual who can afford to diversify into a hedge fund might be attracted to the high-performance reputation of its manager, the specific assets in which the fund is invested, or the unique strategy that it employs.
The Bottom Line
Hedge fund investing is considered a risky alternative investment choice and requires that investors can make a large minimum investment or have a high net worth. Hedge fund strategies involve investing in debt and equity securities, commodities, currencies, derivatives, and real estate.
Hedge funds are loosely regulated by the SEC and earn money from the 2% management fee and 20% performance fee structure.
