Hedge Fund: What It Is & How It Works
Hedge funds are alternative investments that use complex investing techniques, which differentiates them from mutual funds and ETFs.
What Is a Hedge Fund?
A hedge fund is a professionally managed fund that uses pooled money to buy investment securities and other investments. Hedge funds are private funds that are exempted from the regulatory and operational constraints of public mutual funds, allowing them to take higher risks and engage in more sophisticated strategies. This exemption, however, requires them to limit their participants to high net worth investors and institutions.
To maximize returns and minimize risk, a hedge fund manager may hold traditional investment securities, such as stocks and bonds, but they may also use non-traditional strategies, including short positions and derivatives, such as options. Because of their aggressive and speculative nature, hedge funds may be riskier than public funds, such as mutual funds and exchange-traded funds (ETFs).
How a Hedge Fund Works
Similar to a mutual fund or ETF, a hedge fund uses money from investors to employ its investment strategies. Hedge fund investors are commonly institutional investors, pension funds, and high net worth individuals that can afford the high minimum investment requirements often associated with hedge funds, which can range from $100,000 to $2 million.
Hedge funds typically have short-term investment objectives, which means that the fund holdings are somewhat liquid assets, though some strategies involving derivatives or private equity may be much less liquid. Investors are able to invest and withdraw their capital at net asset value, much like a mutual fund. However, many hedge funds only allow withdrawals at the end of a month or quarter and some give themselves the right to freeze withdrawals altogether if conditions warrant.
Part of what allows hedge funds to employ non-traditional investment strategies is that they are exempted from certain regulations by the Securities and Exchange Commission (SEC). However, hedge funds are required to adhere to certain requirements set forth in the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. Some hedge funds are regulated by the Commodities Futures Trading Commission (CFTC).
Hedge Fund History
The first hedge fund is believed to have started in 1949 by Alfred W. Jones, who used a strategy of buying stocks hedged with short sales. Jones later created a hedge fund with an incentive fee and converted the fund into a limited partnership, which is a common entity structure of modern hedge funds.
Perhaps the largest boom of hedge funds occurred in the 1990s, when greater known hedging firms, such as Bridgewater Associates and Paulson & Co., became prominent. According to an article by Rene Stulz, since 1994, hedge funds have produced returns overall that were similar to the S&P 500 index but with less volatility. However, since the financial crisis of 2007-2008, many hedge funds have underperformed the broader market indices.
Warning: Many hedge funds can produce stable returns in normal economic and market environments but can turn volatile in others, which can lead to declines in value that are potentially much steeper compared to traditional investments, such as stocks, bonds and mutual funds.
Hedge Fund Requirements
For individuals, investing in hedge funds is generally limited to accredited investors who must have a minimum liquid net worth of $1,000,000 or a minimum income of $200,000 for the past two years, with a reasonable expectation that this income will continue in the current year.
Hedge Fund Fees
Hedge fund fees typically range from 1-2% of the fund's assets, plus 20% of the fund returns above a predetermined benchmark. A common fee structure is called a "2 and 20," which reflects the 2% charge on assets plus the 20% performance incentive that goes to the hedge fund manager or management team.
Hedge Fund Strategies
Hedge fund strategies can include a wide array of assets and strategies beyond traditional stocks and bonds, including alternative assets such as precious metals, commodities, fixed income swaps, real estate, and art.
Strategies may include:
- Short selling
- Volatility trading
- Arbitrage
- Leveraged equity
Common categories of hedge funds include:
- Managed futures: Trading a portfolio of equity, currency, or commodity futures.
- Long/short equity: Maintaining long positions in some equities along with short positions in others at the same time -- a strategy designed to enhance returns while reducing overall market risk.
- Event driven strategies: Often involves buying securities of distressed companies, those declaring bankruptcy, those expected to merge, or those predicted to be impacted by a specific event, expecting to profit when the event occurs.
- Quantitative strategies: May employ the use of automated trading based upon systematic or algorithmic data analysis.
- Global macro strategies: Analyzes global macroeconomic trends to exploit investment opportunities associated with geo-political events, currency exchange rates, interest rates, or commodity prices.
Evaluating Hedge Funds
The process of evaluating hedge funds is fundamentally similar to researching mutual funds and ETFs, though hedge fund details are not disclosed to the general public and they will only share their information with accredited investors. Investors should consider the fund's fees, performance, risk factors, investment strategy, and requirements to invest. It's also important to read the fund prospectus and research the background of the hedge fund management.
- Fees: Hedge fund fees are commonly 1-2% of assets, plus 20% of performance above a predetermined performance benchmark.
- Performance: Past performance is no guarantee of future results but it's still important to research the history before investing. Investors may review a combination of short-term and long-term performance history, as well as performance during volatile market conditions or economic downturns.
- Risk factors: Investors may review volatility ratings, such as standard deviation, and look at maximum drawdown and months to recover from extreme market conditions.
- Strategy: There are sophisticated hedge fund strategies, such as arbitrage, long/short equity, and event driven, that investors should understand before investing.
- Requirements to invest: Hedge funds require investors to be accredited before investing, which means they must have a minimum net worth of $1,000,000 or a minimum income of $200,000 for the past two years.
- Prospectus: This document includes details about a fund's investment objective or strategy, fees, performance, management, and redemption policy.
- Form ADV: This is a required regulatory filing that includes background information on fund management.
Tip: Investors, including retail investors not qualifying to invest in a hedge fund, may consider investing in a "fund of hedge funds" as an alternative. For example, a single mutual fund may invest in multiple hedge funds. This, however, also adds an additional layer of fees for the management of the fund of funds, over and above what the individual hedge funds charge.
Notable Hedge Funds
Notable and famous hedge funds in history include:
- Bridgewater Associates: The largest hedge fund in the world and founded in 1975 by Ray Dalio, who was recently named one of the 100 Most Influential People, by Time magazine.
- The Quantum Fund: Advised by George Soros and one of the best known hedge funds dating back to the 1970s. In 1992, the Quantum Fund reportedly "broke the Bank of England" by betting against the British pound.
- Long Term Capital Management: Not all hedge funds are successful and the dramatic fall of LTCM is perhaps the most notable example. Founded in 1994 by several Nobel prize winning economists, and although successful for a time, LTCM famously lost $4.6 billion in less than four months in 1998. The fund was recapitalized under the supervision of the Federal Reserve and was dissolved in 2000.
Bottom Line
Hedge funds are private, alternative investments that use money from investors to build a portfolio of investment securities and other assets. They employ a variety of methods to achieve a primary objective, which is generally to produce above-average returns. Because of the use of sophisticated strategies, such as short selling, derivatives, and leverage, hedge funds tend to be riskier than traditional investments, such as mutual funds and ETFs.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.