Wednesday, 31 July 2013

What are hedge funds?

If you are at all interested in finance, and especially if you are interested in working in finance or are currently in a finance role and looking at what else you can do then you would have heard of hedge funds.  They have been in the news a lot recently however they are not really a new concept.  We hear of billions of dollars being made for the owners of these funds and the spectacular returns they offer their clients.  Less often we hear about their spectacular falls from grace as well.

However when you really think about it - it is actually hard to nail down what a hedge fund is in a simple sentence.  This is because it is not a homogeneous beast.  They use many different strategies to invest money all with the intention of providing a return to their investors.

This post will cover the basics of what makes a fund a hedge fund.   I will do a post soon on the different strategies that hedge funds use to make money.

What is a hedge fund

Traditionally hedge funds referred to funds that attempted to generate returns that were uncorrelated with market returns - that is they were 'absolute return' funds.  However more recently the name has become associated more with the structure of the fund and the class of investors that it caters to rather than the investment strategy.

Hedge funds, like all other investment vehicles are regulated by the market in which they operate.  In the United States, and in most jurisdictions they cater almost exclusively to rich investors and so are less regulated than those funds which cater to retail investors and so have much more stringent prospectus and risk requirements.

How are hedge funds structured

This discussion will focus on the average hedge fund.  Because it is such a broad term it is possible to find exceptions to almost all the rules of thumb outlined below.  However when one uses the term hedge fund this is typically what they are talking about:

  • Most often set up as private investment partnerships that are open to a limited number of investors and require a large initial investment
    • This reduces the amount of disclosure that the fund is required to make, both to regulators and also reduces the limits on what they can do with their investment portfolio
    • In the US, the majority of investors must be 'accredited', that is they must earn a certain minimum amount of money and have a net worth over $1 million.  Investopedia describes it as a 'mutual fund for the mega rich'
  • Hedge funds are open ended however require a minimum investment period
    • Open ended funds means that investors can add and withdraw capital however as hedge fund strategies often require time to play out they often require investors to keep their money within the fund for a certain period of time
  • Have much higher fees than ordinary mutual funds
    • This is a characteristic of most hedge funds however does not make a great deal of sense.  Theoretically you are paying for the extra potential return and the skill of those people that run these funds - i.e. people at hedge funds are meant to be 'smarter'
    • However what it does is create perverse incentives - the people running the fund make a lot of money when the fund makes money however lose very little if the fund performs poorly
    • A typical fee structure is called 2/20
      • The fund gets a 2% management fee (which is already significant)
      • The fund also receives 20% of any out performance above a certain benchmark return rate
  • A hedge fund is fundamentally an investment vehicle
    • To the point I mentioned above, theoretically there is nothing that a hedge fund does that you couldn't do yourself as an investor
    • It is a vehicle for fund managers who have more aggressive strategies to gather funds to use these strategies on a larger scale

Hedge funds often come with a 'mystique' which makes them attractive to both investors and financial industry employees

Hedge funds most often make the news for the crazy returns they make for investors in seemingly all market conditions.  You just need to look at the coverage that Paulson's hedge fund and others got from the money they made from shorting the housing market before the GFC.  I did a review of The Big Short by Michael Lewis which covered this very scenario.  Investor's love hearing about these types of stories and hedge funds encourage it because it causes inflows into their funds.  Indeed for a period it was almost 'fashionable' to have your money invested in hedge was a status symbol.

These same stories also created a surge of finance graduates to look to hedge funds as the next 'holy grail'.  Private equity was out and hedge funds were in.  The stories of Paulson's $5 billion pay check in 2010 was enough to make anyone's mouth water.

However people often ignore the losers in this industry.  There are a few big explosions which make the news - for example the fall of Long Term Capital Management - see my book review.  However what the news ignores are those funds which fail to live up to expectations, which experience redemption's and which are forced to close their doors quietly.

Some hedge funds make money, some lose money and you need to keep this in mind when thinking about working in one or if you are thinking about investing in one.  There is no big secret that they hold to incredible wealth although no doubt some contain investors that are better than others.

Over the next few weeks I'll do a few short posts about some of the different investment strategies that hedge funds use.

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1 comment:

  1. Thanks for the share! All this information has really given me a strong grasp on the basics of hedge funds. I am curious though, which hedge fund strategies do you find to be the most successful in terms of ROI?