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What Is a Hedge Fund?

Before describing what a hedge fund is, it’s important to understand fund management. Fund management is a financial service where funds from a pool of investors are collected and invested on their behalf by a professional fund manager to meet the investors’ goals.

Hedge funds are a form of alternative investment vehicle that invests and manages portfolios of different securities and derivatives using complex strategies. It is a private investment vehicle that accepts funds from individuals and companies willing to invest large initial investments. Hedge funds only accept large funds from HNI (High Net-worth Individuals) and companies and aren’t accessible to the general public.

How Does a Hedge Fund Work?

Hedge funds are normally structured as a limited partnership or a limited liability company. Hedge funds have limited and general partners. The limited partners are the investors who provide capital to invest. The general partners are the professionals who make decisions, manage the capital, and conduct overall day-to-day operations.

Hedge funds impose restrictions on the redemption of funds. Investors generally cannot withdraw their funds or redeem their shares for a minimum period referred to as the lockup period. Redemption of shares is possible only after the notice period, usually 30 to 90 days after an investor gives the notice to redeem their shares. Redemptions may require the fund manager to liquidate some positions and incur transaction costs, which is why funds sometimes charge redemption fees to discourage redemption.

What Exactly Does a Hedge Fund Do?

Hedge funds invest in varieties of asset classes, both traditional and alternative assets and derivatives. They are not subject to extensive regulations, which enables them to deploy various strategies and take both long and short positions and use leverage. Leverage has the effect of magnifying gains and losses by enabling funds to take a large position relative to their capital.

Stocks and bonds are considered traditional investments. Whereas commodities, derivatives, real estates, artworks, and infrastructure fall under alternative investments. Since different sectors and asset classes aren’t highly correlated, hedge funds provide diversification benefits. 

How Do Hedge Funds Make Money?

Hedge funds use different strategies to make money. Traditionally, the description of hedge funds comes from a long-short position strategy, but today they deploy many complex and niche strategies. A long-short position strategy is to take a long position in stocks expected to generate higher returns and short positions in stocks expected to generate lower returns. 

A long position refers to an asset exposure where the investor gains if the price of the asset increases. Similarly, a short position refers to an exposure to an asset in which the investor gains if the asset’s price decreases. People learning about the financial market often get confused about how short positions generate returns. 

Let’s take an example if one stock of ABC corp. is currently trading at $200 and if a trader thinks the stock is overvalued, he/she can take a short position whereby one unit of ABC corp. is borrowed from the broker and is sold instantly at the market price of $200. If the trader is correct and the price of the stock falls to $150 in a few weeks, the trader buys the stock at $150 and gives it back to the broker making a profit of $50 (excluding commissions).

Other strategies used by hedge funds are merger arbitrage, distressed debt, convertible arbitrage, managed futures, Global Macro, etc.

Are Hedge Funds High Risk?

There is a general belief that hedge funds are risky. This consensus might be why the funds have exposure to different asset classes, positions, and usage of leverage. However, historically the returns of hedge funds have less than the perfect correlation with the stock market returns. 

Hedge funds shine in volatile markets because a diversified portfolio lowers risks to sudden drops in the market. However, during times of severe distress, the correlation between most assets approaches 1. Hence, hedge funds are not risk-free. 

How Much Money Do I Need to Invest in a Hedge Fund?

The US Securities and Exchange Commission allows only accredited investors to invest in a hedge fund. To be an accredited investor, an individual must have an annual income of $200,000 ($300,000 if married) or have a personal net worth of over 1 million dollars. 

What Is a Hedge Fund Manager?

A Hedge Fund Manager is an individual or an investment firm that oversees the hedge fund’s strategies, investment decisions and operations.

A typical hedge fund management fee structure is 2 plus 20%. It means the investors are charged 2% of the AUM (Assets Under Management) every year along with 20% of profits. This standard fee structure encourages hedge funds to take more risk. Hence hedge funds have different features like hurdle rate, highwater mark clause and clawback clause.

A hurdle rate is a minimum return the fund must generate before the incentive fees are payable. The Highwater mark clause ensures that the incentive fee is only applicable when cumulative profits of investors are positive. For example, if a hedge fund with AUM worth $50 million loses $5 million in the first year, the fund must make $5 million next year before an incentive fee returns. And clawback clause allows investors to offset future losses with incentive fees paid in the past.

Example of a Hedge Fund

Some well-known hedge funds are Bridgewater Associates, Renaissance Technologies, Soros Fund Management and Pershing Square Capital.

Best Features of Hedge Funds

Some of the key features that distinguish hedge funds from traditional fund management services are:

  • Usage of Leverage: Leverage is a strategy of using borrowed sums to increase return on investment. A leverage ratio of 2.5 ( or 40% margin) means that if the stock price increases by 10%, the investor will experience a 25% return on equity and vice-versa. Leverage allows funds to take larger positions relative to their capital.
  • Long and Short Positions: Hedge funds take both long and short positions. A long position generates profit if the price of an asset increases. Similarly, a short position generates profit if the price of an asset decreases. 
  • Variety of Exposure: Hedge funds invest in a wide variety of assets – stock, commodities, derivatives, currencies, real estate, etc. It provides diversification benefits.

Advantages of Hedge Funds

Some advantages of hedge funds are diversification benefits, professional advice and new opportunities.

  • Diversification Benefits: Hedge funds invest in different asset classes, which give investors diversification benefits. Historically, hedge fund returns have a less than perfect correlation with the stock market. 
  • Professional Advice: Investment strategies and decisions are formulated and implemented by professionals. Hedge funds hire quants, economists, computer scientists, business graduates, etc., from top universities with years of experience.
  • New Opportunities: Hedge funds give exposure to investors to assets that are usually not easily accessible, for example, derivatives, artworks and other exotic assets.

Disadvantages of Hedge Funds

Some disadvantages of hedge funds are high management fees, illiquid position and lack of transparency in investment strategies.

  • High Management Fees: High management fees erode the net returns to the investors. It is reported that Renaissance Technologies charged as much as 5 plus 44%  
  • Illiquid Position: Liquidity is the ability to convert assets into cash immediately at fair market value. Since hedge funds have a lockup period of usually 1 year, investors cannot redeem their shares before the lockup period.
  • Lack of Transparency: Hedge funds give prospective clients some information to explain their value propositions but do not disclose everything.

Hedge Fund vs Mutual Fund

Hedge funds are pooled investment vehicles, as are mutual funds. However, they are very different in terms of redemption, strategies they use, positions they take, regulations, and investors.

  • Redemption: Mutual funds allow investors to redeem shares on any day. Hedge funds usually have a lockup period of 1 year.
  • Strategies and Positions: Mutual funds can generally take only long positions on stocks and bonds. Hedge funds usually don’t have any restrictions as such.
  • Leverage: Mutual funds aren’t allowed to take on leverage. Hedge funds, however, use leverage to maximize returns.
  • Regulations and Type of Investors: Mutual funds are investment vehicles for small investors and hence are subject to strict regulations. On the other hand, only accredited investors are allowed to invest in hedge funds.

Navigating the World of Hedge Funds

Hedge funds are more than just investment vehicles. They are a breeding ground for new trading strategies and innovation in the world of trading and investments. They also play a vital role in identifying mispriced securities and eliminating arbitrage opportunities that enforce market efficiency.

Hedge Fund’s strategies, exposures, positions and even fees can be difficult to comprehend. Unlike mutual funds, they are not obligated to disclose their strategy to the investors nor the public. It is often very difficult to understand how and where your funds are being used in such circumstances. 

Thus. it’s always advisable to seek help from a financial advisor before investing in Hedge Funds. A financial advisor will give proper insight into the world of hedge funds and guide you towards fulfilling your investment objective.