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Table of Contents
What a hedge fund is
A hedge fund is a private investment pool which collects money from a limited number of wealthy or professional investors and which employs a variety of techniques in an effort to profit from the investments. The fund's managers seek to make money from all sorts of market conditions, and not just when the market is on the rise. Compared to the funds that regular average-Joe investors put their retirement money in, hedge funds offer more flexibility, higher fees and a certain amount of mystery. Let's shed some light on that mystery.
It sounds ridiculous, but let us begin our discussion with the very first definition. To hedge means to protect oneself against a loss, in the same way that one buys an insurance policy. The first hedge fund was created by a sociologist and a journalist, Alfred Winslow Jones, in 1949. He short sold stocks that he expected to depreciate and went long in those that he anticipated to rise. Thus, his hedge fund protected him against falls in the general market. However, the name remained, despite the fact that most funds today perform more diverse operations than just hedging.
Here is a typical fund structure. There is a manager, usually a firm, which makes all the investment decisions, and implements the business plan. They then have their investors, who are the ones who put the money in, and are partners in the fund. Most funds are set up as limited partnerships, meaning that the manager is the general partner, and the investors are limited partners. The investors will share in the gains and losses, but don't make investment decisions.
Who can invest, and how they are regulated
One of the main differences between hedge funds and mutual funds is that hedge funds are available to a select group of people, whereas mutual funds are available to the masses. Hedge Funds are therefore only available to those considered to have a certain level of sophistication knowledge, such as accredited investors in the U.S., and pension funds, endowments, and insurance companies in general Institutions. It is considered that such sophisticated investors will have the necessary assets to be able to withstand any losses that may arise.
In the United States, the requirements for accreditation are based primarily on income or wealth. As of the date of this writing, a person must have either a certain level of income (for two consecutive years) or net Worth (excluding the value of his or her primary residence) in order to qualify. Exceptions can be made for those who possess certain types of professional credentials. The relevant authorities can provide information on these levels and exceptions.
Hedge funds are lightly regulated forms of mutual funds, but they are not as lawless as it seems. For instance, managers are required to register as investment advisers, to file reports with regulators, and to follow restrictions on fraud and insider trading. The only difference is that they are generally subject to fewer restrictions on investments and reporting to the public, which makes them more free to follow their strategy, and more dangerous as well.
The main strategies
Speaking of the strategies, there are a variety of them, and one of the most famous is the long-short equity. In fact, it is similar to what Jones was doing. The manager implements the long-short equity strategy by purchasing (going long) on stocks expected to rise and selling (shorting) those anticipated to fall. Thus, short selling involves selling shares of stock that the seller does not own and is temporarily borrowed with the expectation of buying them back later at a lower price. Consequently, the fund can profit from both rising and falling stock prices.
Another type is global macro. Macro managers focus on macroeconomic trends and factors such as interests rates, inflation, exchange rates, and political events, and then take big positions in individual countries or markets. As a result of a famous trade against the British pound in 1992, a small group of investors made a huge profit. Macro funds are highly versatile and can take positions in any market, from bonds and currencies to commodities and stock indexes.
Event-driven funds concentrate on different types of corporate events such as mergers and acquisitions, bankruptcies, and restructurings. Managers of these funds try to take advantage of market inefficiencies surrounding these events. For example, merger arbitrage funds buy the stock of the target company involved in a merger, acquisition, or takeover since its price tends to be lower than the offer price, but still has a significant risk of default. On the other hand, distressed securities funds specialize in purchasing securities of firms that are in financial distress and take actions to improve the situation and sell the securities at a higher price.
Relative value and arbitrage strategies are typically related to exploiting pricing disparities between similar securities. In case of an opportunity, the manager buys a lower priced security and sells the higher one at the same time, thus, profiting from the price difference. Since the window of opportunity is small, the managers use leverage to amplify returns. As a result, there is a danger associated with such strategies because of the additional risks introduced by using leverage. Even the most mundane strategies may have nasty surprises.
Quantitative funds, or quant funds, are funds that use quantitative models and algorithms to identify trades. They analyze large amounts of data searching for patterns too complex for humans to discern and can execute thousands of trades per day. Some of the biggest hedge fund companies in the world are quant shops, employing mathematicians, physicists, and engineers. However, the models can sometimes fail, if the market acts unpredictably.
Activist funds have a different approach, as they buy a significant amount of the company’s shares and make demands, such as changing the management, selling a particular division, and even altering the spending policy. Proponents argue that activist funds affect the stocks’ price unfairly and want to take control of the company to maximize the value for all the shareholders, while opponents claim that it leads to the growth of wealth for some shareholders in the short term and makes the company undervalued for the long run. However, in any case, such funds may have a considerable impact on well-known corporations.
A considerable number of funds employ leverage, which is borrowing money to buy a bigger position than the amount of money deposited by investors. Leverage works both ways: whereas leveraged positions can amplify gains, they also magnify losses. That is, a highly leveraged long position of a fund can be liquidated with a relatively small drop in the share price. Funds also use derivatives, which is financial instruments that derive their value from another asset, for instance, a stock, an interest rate, or another derivative. Derivatives can be used to hedge or to speculate.
Fees and lock-ups
Then there is the issue of fees. The standard traditional hedge fund arrangement is two and twenty. This means that the fund charges two percent in annual fees to investors and another twenty percent in profits. So if we have a one-hundred-million dollar fund, which makes ten percent, the manager will collect two million dollars in fees and take away some of the profit. The intense competition in the industry has led to reduced fees for many funds. However, top managers are still able to charge a premium.
Performance fees are frequently protected by one or more barriers, such as a high-water mark. This implies that the fund is permitted to make profits from one or more of the assets following a period of losses; otherwise, the performance fee would need to be returned. Most hedge-fund compensation schemes contain hurdle rates, which the fund needs to surpass for its performance charge. A detailed discussion of such fees is beyond the scope of this book, but it is essential to understand how much of an impact they may have on an investor’s return.
Hedge funds also have the tendency to impose restrictions on the time of withdrawal of funds. Such funds usually have a lock up period, during which the client is unable to make a withdrawal. This period is typically around one year, after which withdrawals are allowed on some specific terms, for example, once a quarter ahead of time with a notice of several weeks. Furthermore, in case of market stress, some funds impose additional restrictions on redemptions as portfolio managers hold securities that cannot be easily liquidated without incurring substantial losses and thus must protect all stakeholders by preventing any early distributions.
How well they perform
How well do hedge funds perform? The truth is, they can perform exceptionally well for some managers, but often underperform the market for others. Studies on the industry as a whole have shown that the average hedge fund fails to significantly beat the overall market, after accounting for expenses. It's important to remember that these funds generate eye-catching stories, as successful funds draw attention while those that underperform simply disappear.
The survival effect is worth noting. Frequently, poorly performing funds are terminated, and their returns simply drop off the face of the earth. (More precisely, they are delisted.). This is an important issue because the industry's numbers are made up of survivors, which is why, as a whole, it looks so good. The survivors are the only funds still around telling their success stories. This phenomenon is known as survival bias, and it's not a good thing.
Hedge funds are often portrayed as two-faced markets. On the one hand, they are seen as malicious oligarchs who short the stocks of main stream companies. On the other hand, they are considered to be the key pillars of the financial market, providing liquidity and enabling realistic prices of bonds and commodities. In both cases, there is some logic in the thinking of the people. On the one hand, short sellers do help in revealing frauds, while active trading helps in finding buyers and sellers more quickly, which is beneficial for both sides. Nevertheless, there are examples of speculative adventures of hedge funds and private bankers, as well as scandals around them.
A cautionary tale is Long-Term Capital Management, which was a fund created in the 1990s and staffed with Nobel Prize economists. This fund implemented leveraged trades of apparently secure securities, but, when Russia defaulted on its debt in 1998, the market value of these bonds collapsed unpredictably, emptying the fund of billions of dollars and nearly destabilizing the global economy. This theory was rescued by the Federal Reserve, which orchestrated a merger of the major banks that had bailed out the LTCM, as the collapse of this fund would have had catastrophic consequences for the world economy.
Who invests, and how to look before you leap
It is helpful to distinguish hedge funds from several related concepts. Private equity funds purchase entire companies, hold them for a period of time, and sell them to recoup the investment and make a profit. Venture capital funds make investments in young companies. Mutual funds are similar but are publicly traded and tightly regulated. Hedge funds primarily trade in the markets for securities that are easily converted to cash and are much more liquid than most other hedge funds.
Big institutions are major investors in hedge funds. Pension funds, university endowments, and charitable foundations can put a small amount of their money into them in the hopes of diversifying their risk. This diversification is a huge benefit because while the stock market plummets, a well-run hedge fund will hold its ground. In reality, not all hedge funds are able to do this.
Individuals who are not highly wealthy and cannot afford to invest in hedge funds directly can sometimes gain indirect exposure to hedge-fund strategies. Mutual funds and exchange-traded funds that employ long-short strategies and other hedge-fund methods offer alternatives with far lower minimums, daily liquidity, and greater regulation and transparency, if less flexibility. These funds typically charge lower fees than do hedge funds, and the returns often reflect those of the hedge funds that inspire them.
If one was ever considering investing in a hedge fund, due diligence would be paramount. One would want to know all about the strategy in detail, and would ask about the manager's compensation. We would review the fund's track record, the size of the fund, how long the team has been together, who audits the funds, where the assets are held, and the fee structure and liquidity terms. If one couldn't understand something about the fund, that should serve as a red flag.
Be wary of any investment that promises consistently high returns with no risk: real investing is a gamble, and the biggest frauds, such as the Madoff case, were based on apparently secure, steady earnings. In fact, Madoff's fund was not a hedge fund at all, but a scam masquerading as one: persistent, apparently perfect returns are a danger signal. A competent manager will tell you when your investments are at risk of losing value.
Transparency can be limited which is a trade-off. Managers want to protect their own secret strategies and therefore share only summary information. Investors are at the mercy of other people's judgment and independent checks on the fund's work. Many funds are now disclosing more information than before, especially for institutional investors. However, you still need to take a leap of faith if you can't understand what securities a fund holds.
The business has come a long way since its infancy on a small corner of Wall Street. From an obscure backwater it has grown to span the globe and control trillions of dollars of assets. A financial crisis in 2008 meant that regulators were more careful and investors more wary about how their money was being used, which affected the kinds of funds that were popular. There are now funds of all sizes, from small operations run by a couple of people to massive concerns employing hundreds of staff and using cutting-edge technology.
Alpha, risk and the people behind the scenes
When you listen to the hedge funds, you will hear them talking about alpha and beta. The beta is their market risk, and it is their share of the return, which comes from the movement of the overall market. If the market goes up 10 percent, and your fund makes a similar return on its investments, this is mostly beta, and something you could get cheaply with an index fund. The alpha is the return earned by the manager's skill. Their cut of the return is supposed to pay for the alpha.
To evaluate an active manager, we need to look at risk-adjusted returns. A manager who has delivered an 8% return with relatively little risk is much better than a manager who delivered 10% with loads of risk and, most importantly, drawdowns. The simplest way to calculate this is the Sharpe ratio, which measures the extra return per unit of risk. Of course, none of these ratios are perfect, but they give a rough idea of where two mutual funds may stand in relation to one another.
Behind the scenes, there is a cast of supporting players, including prime brokers who provide financing, securities lending, execution services, and custody, administrators who value the funds’ holdings, auditors who review financial statements, and lawyers who deal with legal details. To an investor, these roles are less interesting, but they are critically important: the more independent these roles are held by different firms, the more difficult it is for anyone to cook the books.
Some investors opt for a fund-of-funds strategy, where a fund allocates money to numerous hedge funds. While the attraction is diversification and the assured expertise of the fund managers who pick the funds, there's the issue of double fees; these funds charge an additional fee on top of the charges of the individual funds they're invested in. After the scandals and disillusionment of the past decade or so, many big investors have turned to direct investment or less costly alternatives.
Good managers treat risk management seriously. They set a limit on the amount of money that can be invested in one security, diversify investments by placing them in different markets, and define stop-loss levels. Good managers often have risk management teams that are always on the lookout for impending danger. The key to effective risk management is the fact that managers understand that they cannot control everything and that one wrong move can empty a fund. Ask any good manager about risk management and listen closely to their answer.
Hedge funds also have a significant impact on market forces. By actively trading, they facilitate the process of finding a counterparty, that is, they provide liquidity to the market. At the same time, by conducting research and being willing to sell overvalued assets, they can correct the prices of these assets. On the other hand, the activities of many funds in the same direction can lead to imbalances in the market and its collapse. Thus, the impact of funds can be both positive and negative.
Taxes and paperwork can be more complex for hedge fund investors than they are for many investors in standard funds. Income from these funds may take unfamiliar forms, and tax filings may be due at later dates because fund accounts close more slowly. Before making such investments, it’s a good idea to make sure that you have support from a qualified tax expert to help you with any questions that may arise. The tax consequences of investing in these types of instruments are significantly dependent on the jurisdiction in which they are located or established. Thus, general recommendations can be given only in broad terms.
What is the lesson for average savers? That hedge funds are one option among many, and a potentially profitable one. But many financial advisors believe that most individual investors would be better off with a diversified portfolio of low-cost index funds, rather than with hedge funds. Hedge funds are best for big institutions and wealthy individuals who are comfortable with the risks and the long time horizons of such investments.
In a nutshell, a hedge fund is a privately held investment vehicle that makes use of alternative investment strategies, such as short-selling, leverage, and derivatives, in an attempt to generate positive returns in both bullish and bearish markets. These funds are usually available only to qualified investors and are lightly regulated – and difficult to understand. Some have delivered astonishing results; others have gone bankrupt. Knowing how they work – their costs, their risks – is a good way to start understanding the daily financial news.
