What are Hedge Funds? An In-Depth Guide
Hedge funds are alternative investments that use complex and aggressive strategies in an attempt to generate outsized returns. They are more loosely regulated than traditional investments like mutual funds, allowing them greater flexibility and risk-taking.
However, they also have high minimum investments and are exclusive to accredited investors. This guide will explore what hedge funds are, their history, major players, investment strategies, risks, and regulations.
Key Takeaways
- Hedge funds are actively managed alternative investments that undertake risky strategies in an attempt to generate big returns
- They are less regulated than other funds and accommodate only accredited investors due to complexity and risk
- Hedge funds utilize leverage, derivatives, and strategies like short selling to profit in rising and falling markets
- Major hedge fund figures include Ray Dalio, Bill Ackman, Jim Simons, and Carl Icahn
- Common strategies involve equity long/short, event-driven, macro trading, and relative value arbitrage
Understanding Hedge Funds
A hedge fund is an investment vehicle that employs a variety of risky techniques and leverage in an attempt to generate outsized returns. They are set up as private partnerships and operated by professional investment managers. Some key characteristics include:
- Use of leverage – Hedge funds borrow capital to increase buying power and potential returns
- Complex trading strategies – Short-selling, arbitrage, and derivatives strategies exceed mutual funds
- Light regulation – Much less regulated than mutual funds
- High investor minimums – Typically limited to accredited investors with $1 million+ in net worth
This combination allows hedge fund managers significant flexibility in their investment approach. However, risky strategies can also magnify losses in falling markets.
| Global Hedge Fund Market Overview | |
|---|---|
| Total Assets Under Management | $3.6 trillion |
| Number of Hedge Fund Firms Globally | Over 10,000 |
| Percentage of Assets Held by Top Managers | >70% concentrated among the largest hedge funds managing over $5B |
| Percentage of Funds Located in North America | Approximately 60% are located in the United States |
| Percentage of Funds Located in Europe | Roughly 35% concentrated in global financial hubs like London and Switzerland |
Accredited investors that meet high wealth and income thresholds supply capital to hedge funds, enticed by the potential for market-beating returns. However, the complexity and lack of regulation also expose investors to significant risk.
A Brief History of Hedge Funds
The first hedge fund is credited to Alfred Winslow Jones in 1949, through his firm A.W. Jones & Co. He combined short-selling stocks with buying others long as a market-neutral strategy. His use of leverage to enhance returns was an innovation that spawned the hedge fund industry.
Over the decades hedge funds evolved from being small, niche funds to a major force in alternative asset management handling billions in assets globally. Major developments include:
- Shift to a limited partnership structure in the late 1960s
- Growth to over 68 funds managing $3.9B combined in assets by 1968
- The rapid rise in popularity in the 1990s under market instability
- Trillions now managed globally across over ten thousand funds
This exponential growth can be attributed to investors’ desires for non-correlated returns and absolute performance objectives rather than just beating benchmarks.
Types of Hedge Funds
There are many categories and specialty areas that hedge funds focus on. At a high level, major types include:
Global Macro
- The top-down trading approach across global markets – currencies, equities, commodities, etc
- Managers like Ray Dalio at Bridgewater Associates
Equity Hedge
- Combination of long and short equity positions
- Managers like James Simons at Renaissance Technologies
Relative Value Arbitrage
- Attempt to profit from price discrepancies between securities
- Fixed income and convertible bond arbitrage
Event-Driven
- Merger arbitrage, distressed debt, special situations
- Managers like Daniel Loeb at Third Point Capital
Within these broad categories, there are countless strategies hedge funds develop and concentrate on from risk arbitrage to managed futures trading.
Common Hedge Fund Strategies
While hedge fund strategies are diverse, there are a few widely used approaches:
Long/Short Equity
This involves buying undervalued stocks expected to rise and selling short overvalued stocks expected to fall to generate a net positive return. It helps hedge against market declines.
Event-Driven/Merger Arbitrage
Seeks to profit from major corporate events like bankruptcies, mergers, and takeovers. For example, when a merger is announced, the target’s stock price rises while the acquirer’s falls, allowing hedge funds to buy the target and short the acquirer.
| Major Hedge Fund Strategies | Key Points |
|---|---|
| Long/Short Equity | – Involves owning undervalued stocks and shorting overvalued stocks – Market neutral – profits in rising and falling markets – Risk management through variable net exposure |
| Event-Driven/Merger Arbitrage | – Top-down trading approach across global markets – Identify macroeconomic trends to take directional bets – Influenced by shifts in fiscal/monetary policy, geopolitics, etc. |
| Global Macro Trading | – Capitalize on pricing inefficiencies between related securities – Fixed income, convertible bond arbitrage – Quantitative and technology-driven strategies |
| Relative Value Arbitrage | – Capitalize on pricing inefficiencies between related securities – Fixed income, convertible bond arbitrage – Quantitative and technology-driven strategies |
Hedge funds combine these strategies to create an uncorrelated return stream based on fundamental, technical, or quantitative analysis.
Notable Hedge Funds and Investors
The hedge fund industry has numerous influential figures and firms managing billions in assets:
- Ray Dalio – Founder of the world’s largest hedge fund Bridgewater Associates, managing over $150 billion in assets
- James Simons – Mathematician who built quant fund Renaissance Technologies into one of best long-term track records
- Bill Ackman – Activist investor and founder of Pershing Square Capital Management with $22B in assets
- Carl Icahn – Veteran corporate raider and founder of Icahn Enterprises (IEP) with $34B in assets
These investors have generated tremendous returns through various hedge fund strategies and grown enormous firms. However, with big returns comes significant risk.
The Risks and Downsides
While hedge funds promise tempting returns, there are considerable risks involved as well that investors must be aware of:
- Aggressive strategies magnify losses – over 60% decline in the 2008 crisis
- Lack of transparency and liquidity restrictions
- Possibility of mismanagement due to limited regulation
- Significant investments required – $1 million minimum
- High fees – typical “2 and 20” structure charges 2% management fee and a 20% performance fee
Thorough due diligence into a hedge fund’s strategy, risk management, liquidity terms, and past performance is critical before investing. While outcomes can be outstanding, there is an increased risk of loss as well.
Hedge Fund Regulation Differences
Unlike mutual funds, hedge funds face less regulatory oversight from bodies like the SEC regarding disclosure requirements, leverage limits, and more:
| Key Regulations | Overview |
|---|---|
| Assets Under Management Threshold | – File public document disclosing firm details – Business, fees, services, strategies, ownership structure, etc. |
| Form ADV | – File public document disclosing firm details – Business, fees, services, strategies, ownership structure etc. |
| Form PF | – Confidential report submitted to SEC on risk exposure – Liquidity, leverage, investor details, investment positions |
The rationale is that accredited investors supply capital knowing the risk, complexity, and lack of transparency involved. This lighter regulatory touch allows managers more flexibility to undertake risky investment strategies aimed at absolute, market-beating returns.
The rationale is that accredited investors supply capital knowing the risk, complexity, and lack of transparency involved. This regulatory leeway allows managers more flexibility to undertake risky investment strategies. However, it also provides an opportunity for potentially dangerous risk-taking behavior.
Conclusion and Key Takeaways
Hedge funds represent a segment of alternative investments that undertake risky and complex strategies aiming for outsized returns. Key takeaways for investors include:
- Limited regulation – flexibility but increased risk
- Reliance on manager skill – thorough vetting of critical
- Accredited investors only – high wealth and sophistication
- Aggressive leverage – magnify returns and losses
While hedge funds offer tempting return potential, their complexity, illiquidity, and risk mean thorough due diligence is vital before investing.
Frequently Asked Questions
What is the typical fee structure for hedge funds?
A: Most hedge funds follow a “2 and 20” fee model, charging 2% of assets as a management fee and 20% of investment profits as a performance fee.
What is a lock-up period and do all hedge funds have one?
A: A lock-up period restricts investors from withdrawing capital for a set timeframe, typically 1-2 years. Lock-ups allow fund managers flexibility without dealing with frequent redemptions. About 60% of hedge funds have lockups.
Can hedge funds only be accessed by accredited investors?
A: In the U.S., hedge funds can only accept capital from accredited investors or qualified purchasers to stay exempt from registration. These rules don’t apply in overseas markets.
What requirements are needed to qualify as an accredited investor?
A: The SEC requirements include having $1 million+ in net worth excluding primary residence or earning $200k+/year ($300k jointly). Banks/RIAs can also qualify.
What is a high watermark provision?
A: This provision means managers only earn performance fees on profits exceeding the highest historical level. This aligns managers with investors by preventing charging fees for recovering past losses.
