A hedge fund is a limited partnership involving private investors whose pooled money is managed by professional fund managers. These managers utilize a broad range of strategies, including leverage (borrowed money) and trading non-traditional assets, to achieve above-average investment returns.
An investment in a hedge fund is often considered a risky, alternative choice and typically necessitates a high minimum investment or net worth. These funds generally target wealthy investors.
Key Takeaways
- Hedge funds are actively managed alternatives to traditional investing, often utilizing higher-risk strategies.
- They usually require accredited investors and high minimum investments or significant net worth.
- Hedge funds have higher fees compared to conventional investment funds.
- Strategies vary, targeting equity, fixed-income, and event-driven goals depending on the fund manager.
- Investments are often locked for a year, after which investors can withdraw funds or sell shares.
Understanding Hedge Funds
Hedging Their Bets
“Hedge fund” refers to an investment vehicle with pooled funds diligently managed to beat average market returns. Fund managers often hedge the fund’s positions to safeguard against market risks. This can involve allocating a portion of assets in securities that typically move opposite to core holdings. Theoretically, if core holdings decrease, the hedge securities maximize and offset the losses.
As an example, a hedge fund focused on a cyclical sector like travel might divert part of its assets to a non-cyclical sector such as energy. Gains in non-cyclical stocks can then offset potential losses in cyclical stocks.
Risk Uncovered
Hedge funds often engage in high-risk strategies, leverage, and derivatives. As such, these usually suit accredited investors, individuals who meet specific income or asset thresholds. Common stakeholders include institutional investors such as pension funds and insurance companies, as well as affluent individuals.
Investments in hedge funds are considered illiquid since they often require maintaining investments for at least a year, commonly referred to as the lock-up period. Withdrawals usually occur at pre-set intervals like quarterly or bi-annually.
Types of Hedge Funds
Common categories include:
- Global Macro Hedge Funds: Actively managed funds that profit from market swings due to political or economic events.
- Equity Hedge Funds: They can be global or country-specific, focusing on lucrative stocks while hedging against market downturns by shorting overvalued stocks or indices.
- Relative Value Hedge Funds: These exploit temporary pricing differences between related securities.
- Activist Hedge Funds: Activists who invest in firms and push for changes to boost stock prices, such as cost-cutting, restructuring, or altering management teams.
Common Hedge Fund Strategies
Hedge funds employ a vast range of strategies across investment types, including debt and equity securities, commodities, currencies, derivatives, and real estate. Key strategies include:
- Long/Short Strategy: Extensions of pairs trading, where investors go long and short on two competing companies in the same field based on relative valuations.
- Fixed-Income Strategy: Aiming for capital preservation and minimal volatility by taking long and short positions in fixed-income securities.
- Event-Driven Strategy: Capitalizing on temporary mispricing caused by corporate events like mergers, acquisitions, or restructuring.
Notable Examples of Hedge Funds
Prominent hedge funds by assets under management (AUM) include:
- Bridgewater Associates: Founded in New York (1975), with over $124 billion in AUM and headquartered in Westport, Conn.
- Renaissance Technologies: Established in 1982 and headquartered in East Setauket, N.Y, known for mathematical and statistical investment strategies with over $106 billion in AUM.
- AQR Capital Management: Founded in 1998, headquartered in Greenwich, Conn., specializing in applied quantitative research investment strategies with over $94.5 billion in AUM.
Hedge Fund Compensation
The first hedge fund was launched in 1949 by Australian investor Alfred Winslow Jones. Through A.W. Jones & Co., he devised a method of minimizing risks using short-selling, heralding what’s now known as the long/short equities model.
Today, standard hedge fund fees are referred to as the ‘2 and 20’ system, meaning a 2% management fee and a 20% performance fee. The management fee, calculated based on the net asset value of each investor’s shares, covers a hedge fund’s operational expenses. The performance fee, typically 20% of profits, incentivizes the hedge fund manager.
Hedge Fund vs. Mutual Fund
Hedge funds are less regulated by the Securities and Exchange Commission (SEC) compared to mutual funds, which are practical, cost-efficient means of developing a diversified portfolio of stocks, bonds, or short-term investments available to the average investor.
Hedge funds cater exclusively to accredited investors with high annual incomes or substantial net worth without considering their primary residence. They permit investments across various assets while mutual funds focus on stocks or bonds.
Unlike mutual funds with flexible share selling protocols, hedge funds impose locked periods typically spanning one year before investors can redeem shares. Additionally, mutual funds incur lower expense ratios, compared to the 2% management and 20% performance fee structure prevalent in hedge funds.
Key Considerations Before Investing
Prior to investing in hedge funds, thorough research is crucial to match their services with your investment goals. Factors to consider include the fund’s size, history, required minimum investment, and withdrawal terms. Hedge funds are active globally, spanning the U.S., U.K., Hong Kong, Canada, and France.
The SEC suggests further evaluating:
- Fund documents that cover investing procedures, strategies, locations, and risks.
- How the risk level aligns with your goals, timelines, and tolerance.
- Use of leverage or speculative techniques indicating dual capital investments.
- Hedge fund managers’ disclosed potential conflicts of interest and reputations.
- The fund’s asset valuation approach affecting management fees.
- Performance determination reflecting actual cash or performing managers estimates.
- Any restrictions imposed for redeeming shares.
Comparing Hedge Funds to Other Investments
Hedge funds can be compared to mutual funds and exchange-traded funds (ETFs) which likewise pool investors’ money in pursuit of profits. Hedge funds utilize professional managers to actively buy and sell with a goal of broad market returns while embracing greater risks, and unlike mutual funds, they are subject to looser regulatory oversight.
Why Invest in Hedge Funds?
Wealthy individuals keen on diversification vie for hedge funds, drawn by premier manager reputations, unique strategies, or specific asset involvement.
The Bottom Line
While hedge funds present a risky investment alternative demanding high initial investments or net worth, they offer diversified strategies encompassing various asset types, including debt, equity securities, commodities, currencies, derivatives, and real estate. Loosely regulated and adhering to the 2% management and 20% performance fee mechanism, hedge funds remain a special alcove in the investment landscape.
Related Terms: mutual funds, accredited investors, investment strategies, alternative assets, performance fees.
References
- U.S. Securities and Exchange Commission. “Hedge Funds”.
- Nasdaq. “Top 10 U.S. Hedge Funds of April 2024”.
- CFO. “A Short History of Hedge Funds”.
- U.S. Securities and Exchange Commission. “Investor Bulletin - Hedge Funds”.
- U.S. Securities and Exchange Commission. “Updated Investor Bulletin: Accredited Investors”.
- Morningstar. “Investors Piled Into the Cheapest Funds in 2022”.
