What is a Hedge Fund?

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Hedge funds are alternative investments that pool money collected from a multitude of investors. Because of the complex investment strategies they deploy, hedge funds are typically available to accredited investors only, such as high-net-worth individuals, banks, financial institutions, and other large corporations.

Hedge Fund Structure and Fees

Hedge funds are set up and run as Limited Partnerships (LP). This type of legal structure includes:

  • General Partners (GPs)- they are responsible for managing a given investment pool; they have unlimited liability.
  • Limited Partners (LPs)- the investors in the fund; they have minimum liability and a profit share that’s proportionate to their investment.

Limited partnerships are mostly established in tax-efficient locations, such as Belize, Costa Rica, or the Bahamas; they aren’t subject to strict regulations as they are not typically offered to the general public. Qualified investors such as institutions and high net-worth individuals are the ones who handle them. These investors are normally expected to have more than adequate knowledge of the market and are thereupon able to take on higher risks.

The common fee structure of pooled investment funds includes a management (or base) fee, and an incentive (or performance) fee. The management fee is calculated annually on assets under management (AUM). The incentive fee, also known as a hurdle rate, is calculated on profits above certain targets.

Another widely used feature is the “high watermark”. This is the highest net asset value (NAV) that a fund has reached and for which a performance fee is paid. Setting a high watermark protects investors from paying fees on underperformance. It also ensures that they won’t pay twice for the same increase in NAV. In other words, when high watermarks are in place, managers must recover any losses before charging a performance fee on the newly generated profits. In simple words, it plays the role of a reference point for the involved parties.

In practice, hedge fund performance is measured either in terms of an absolute return, for example 15%, or on a relative basis versus a benchmark index, e.g. 10% above the S&P 500.  Redemption terms include a lock-up period during which investors cannot withdraw the money they have put in a given hedge fund. The notice period is also part of the redemption terms. It usually lasts between one and three months. This restriction is posed for a reason. It often happens that hedge fund managers need to exit illiquid positions and convert holdings into cash. The notice period gives them time to do that in an orderly manner. Note that hedge funds may have redemption fees intended to offset any transaction costs incurred in this process.

Hedge Fund Strategies

The most common hedge fund strategies are:

  • Event-driven strategies
  • Relative value strategies
  • Global macro hedge fund strategies
  • Equity hedge fund strategies

Event-driven strategies are based on various corporate actions such as mergers, acquisitions, or restructuring. They entail taking long or short positions in equity or debt securities of the companies involved.  

Relative Value Strategies, on the other hand, focus on taking long and short positions in related securities and profit from a temporary discrepancy in their perceived price relationship.

The third category of strategies used has to do with Macro hedge funds. Rather than analyzing specific companies, they look for opportunities arising from global economic and political events. Macro hedge funds bet on global market trends by taking long or short positions across equities, derivatives, fixed income, currencies, and commodities.

And finally, we have Equity hedge fund strategies that involve taking long and short positions in public equities and related derivatives. Unlike event-driven or macro strategies, they use a bottom-up rather than a top-down approach.

In practice, many hedge funds begin by employing only one of them. Over time, they develop additional expertise and expand to become multi-strategy funds.

Risk and Benefits of Hedge Funds

The benefits are most visible in down equity markets, where hedge funds perform better than global equity markets. Low long-term correlation with equities can also provide diversification benefits. Of course, these benefits vary across strategies. Due to the great variety of approaches and the tendency of increased correlations during market turmoil, we should be careful when generalizing the diversification benefits of hedge funds.

On the other hand, due diligence can be quite challenging. Looking at the big picture, these investment vehicles have light regulatory disclosure requirements which potentially make them less transparent.

Hedge Funds in Practice

When assessing hedge funds, we need to focus on the following questions:

  • What are the strategy and investment processes they use?
  • What are their historical returns, longevity, amount of assets under management, valuation and returns calculation methods?
  • What are their management styles, key person risks, and risk management systems?
  • And what are their sources of competitive advantage, reputation, and growth plans?

Some of these factors are difficult to quantify. Even the ones that seem more straightforward, like returns for example, can present challenges to investors. For instance, strategies that have been successful in the past may decrease in effectiveness as more funds begin to use them.

Hedge Funds vs. Mutual Funds

Similar to mutual funds, hedge funds represent a pool of money collected from a number of investors for the purpose of making a profit. However, similarities between the two end here. Hedge funds are far less regulated than mutual funds. In addition, they have higher minimum investment requirements which make them be perceived as a luxury that only the rich can afford. It comes as no surprise, considering the fact that mostly accredited investors have access to hedge funds.

Actually, there may be a way for small investors to gain access to a diversified portfolio of hedge funds through the so-called funds of hedge funds.

At a Glance

  • Hedge funds represent a pool of money provided by a multitude of accredited investors, such as banks, financial institutions, and other big corporations.
  • Their fee structure includes a base fee and a management fee.
  • The most common hedge fund strategies can be divided into four main categories: event-driven, relative value, Global macro hedge fund, and equity hedge funds.
  • Hedge funds have light regulatory disclosures and are located in tax-efficient jurisdictions.
  • Hedge funds have higher minimum investment requirements than mutual funds.