Hedge funds got a lot of press lately. And they have image problems. Hedge funds are often seen as shady, greedy, arrogant entities, sometimes even evil. They are shrouded in an air of mistery.
Let us demystify hedge funds for you! What is a hedge fund? A hedge fund is an investment company, which pools investors’ money and invests those funds in a wide range of publicly available securities and derivatives in the financial markets to generate a higher-than-average return.
Why are they so opaque and secretive? Hedge funds are not mainstream investments. First of all, they are not allowed to openly market themselves so you won’t come across many ads promoting hedge funds. They are mostly privately owned and managed. And they often fear visibility because they want to keep their exotic investment strategies to themselves. Fiinally, some of them consciously strive to create and maintain that image of exclusivity.
What is a hedge fund?
Overview of the hedge fund industry
Hedge funds trace back to 1949, when Australian journalist Alfred Winslow Jones set up a partnership to invest in stocks using a combination of long and short positions. This was the world’s first hedge fund and Jones became the "godfather" of the hedge fund industry. However, hedge funds weren’t widely known until Hungarian-born financier and hedge fund manager George Soros made an estimated $1 billion profit in a single day by short-selling the British pound in 1992. Soros became known as "the man who broke the Bank of England” and the whole world learnt what a hedge fund was.
Today there are over 9,100 hedge funds managing nearly $3.6 trillion using diverse strategies, which include significant capital exposure to out of favor, deep value equites, according to Hedge Fund Research Inc (HFR). HFR produces over 200 hedge fund performance indexes ranging from industry-aggregate levels to specific, niche areas of sub-strategy and regional investment focus.
HFR sees further growth in the industry in 2021 after assets managed by hedge funds surged to record levels last year.
With an emphasis also on opportunistic positioning and sustained capital appreciation achieved through specialized long-short portfolio management, leading institutions are likely to continue expanding allocations to hedge funds as a tool for achieving their long-term portfolio objectives.
Hedge Fund Research Inc.
As hedge funds are not allowed to openly advertise themselves, they are not exactly household names. Not too many retail investors would be able to name even the top hedge fund managers.
The annual global hedge fund ranking can help you with that. Tiger Global topped the list in 2020, while Renaissance Technologies, which ranked third in the previous year, didn't make the list due to heavy losses at some of its funds.
|Manager||2020 Gains (in billions of dollars)||Launch Year|
Source: Bloomberg, LCH Investments
What is a hedge fund?
Who can invest in hedge funds?
In the US, hedge funds are generally not required to register with the Securities and Exchange Commission (SEC). That's the main reason why the SEC stipulates that hedge fund investors need to be "accredited investors". They are typically institutional investors and ultra rich, sophisticated individuals, who understand the risks related to the complex investment strategies that these funds follow.
The SEC broadened the definition of accredited investors in August 2020 after individual investors who didn't meet specific income or net worth requirements regardless of their financial sophistication, had been denied the opportunity to invest in private markets. Under the amendments, natural persons qualify as accredited investors based on certain measures of professional knowledge, experience or certifications in addition to the previous income or net worth requirements.
"For the first time, individuals will be permitted to participate in our private capital markets not only based on their income or net worth, but also based on established, clear measures of financial sophistication."
SEC Chairman Jay Clayton
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What is a hedge fund?
The structure of hedge funds
Hedge funds are set up as limited partnerships by a management company. The "general partner" manages the fund or funds. The investors, or limited partners, contribute funding and in exchange get a share in the fund that is called "unit".
Compared to mutual funds, hedge fund investors face higher fees, a higher minimum investment amount and usually have a longer investment horizon. Hedge fund managers typically charge an annual asset management fee of 1% to 2% of total assets. On top of that there is a performance fee of 10-20% of profits, typically over a hurdle rate. It is sometimes called carried interest. Hedge fund managers’ compensation structure is often referred to as “2 & 20”.
Unlike mutual funds, investments in hedge funds are illiquid with restrictions on resale. It means that you cannot sell your units whenever you want to. You can add or redeem assets only on specific dates, for example at the end of the quarter or the year. Note that hedge funds often charge a redemption fee.
What is a hedge fund?
Hedge fund investment strategies
Hedge funds are riskier than mutual funds mainly because of their complex and exotic investment strategies. Make sure you understand the fund's strategy before committing any funds.
Hedge funds typically use speculative and high-risk practices such as short selling and leverage. Some funds use diversified strategies and investments. Others prefer a single strategy or a concentrated position.
Some of the most common investment strategies and techniques used by hedge funds include:
- short selling: sale of a security you do not own
- arbitrage: buying and selling a security in different markets to profit from the price difference
- hedging: buying/selling a security to offset a potential loss on a related investment
- leverage: borrowing money for investment purposes
- concentrating positions in securities of a single issuer or market
- investing in distressed or bankrupt companies
- investing in derivatives, such as options and futures
- investing in volatile international markets
- investing in privately issued securities
Source: Financial Industry Regulatory Authority (FINRA)