What Are Hedge Funds and How Do They Work

What Are Hedge Funds and How Do They Work

Hedge Fund Definition and What Is A Hedge Fund Manager

A lot of investors have taken an interest in including hedge funds as part of their investment strategy. A hedge fund can also be referred to as a partnership where multiple investors pull their money together and then a professional fund manager manages this money based on a financial strategy that has been decided. Generally, the investors make financial contributions and then it is the job of the fund manager to ensure that the money is well managed and it earns a profit. This strategy might sound a lot like mutual funds, but there are no other similarities between these two funds. Generally, when you compare hedge funds vs mutual funds, hedge funds are a much riskier investment, are exclusive and offer better returns when compared to mutual funds.

What are hedge funds

The name “hedge funds” came about because of the techniques that fund managers use to manage this money. The manager will use various strategies to minimize risk, even though the strategies employed might even increase the risks involved. The fund manager should make sure that whatever they have invested in will get the investors good return, even when the stock market is on a decline. Some of the things that the fund manager can do are go long if they anticipate the market going up or they can go short if the market is likely to go down.

What’s the Aim of Hedge Funds?

The main objective of these funds is to make money whether the market is doing well or not. Therefore, fund managers are not classic investors, but they are more of traders. However, not every hedge fund is hedged as fund managers use different strategies to manage the funds.

Hedge Fund Characteristics

  • Only accredited and expert investors can be allowed to invest in hedge funds – You have to meet certain criteria for you to be allowed to invest in hedge funds, for instance, your net worth should be more than 1 million, or you should have been earning an income of $200,000 or more in two years or more.
  • Freedom to invest in various assets – A hedge fund can invest in a lot of things. This varies from real estate to currencies, alternative assets and derivatives. In contrast, mutual funds are only allowed to invest in bonds or stock.
  • Use leverage – In most cases more money can be borrowed to boost the financial investments of hedge funds. This is a great way of getting better returns. However, the risk of this is that if everything does not go according to plan, such as in the 2007-2009 economic recession, hedge funds will be hard hit. They will be exposed to collateralized debt obligations.
  • Fees – You will be charged a performance ratio and an expense ratio. The most common fees structure is where you will be charged 2% management fee for your assets and 20% of the profit made. This is referred to as the two and 20 models.

Hedge funds have other multiple features. They are investment vehicles that are meant for the wealthy people; consequently, they have a wide latitude of what they can do. The key thing is the fund manager must let the investors know upfront what investment strategy they are using. As much as this is a good thing, it is also very risky.  Hedge funds have had some of the worst financial blow-ups. However, due to the flexibility that the funds provide, a skilled fund manager can do a lot in ensuring that investors get a good return.

how hedge funds work

How Hedge Funds Work

To understand how hedge funds work, we can examine how a fund will work for one year.  Hedge fund example that we can use is called Value Opportunities Fund, LLC, as an example. According to the Operating Agreement- the legal document that shows how hedge funds should be managed – I am free to invest in anything and everything anywhere in the world. I also get 25% of any profit made over 5% per year.

10 investors decide to join Value Opportunities Fund, LLC and they each contribute $10 million. This then means that I have 100M to invest. Each of these investors must sign an investment agreement. This is like the form you fill when applying for a new bank account. Each of these investors will then hand over the money to a fund investor or a broker or an accounting firm. After noting down the investment in his records, the administrator will then send the money to the broker. At this point, I can start managing the money and looking for lucrative opportunities to invest in. Once I find a good investment opportunity. I call my broker and tell him what to do with the 100 million.

After a year of investing, my funds reach $140 million. According to the operating agreement, 5% of this $40 million profit will first be allocated to the investors. 5% of $40 million is $ 2 million. This will be divided among the investors. This 5% is also popularly known as a hurdle since you must achieve it first before you can even get paid from the profit earned. The remaining 38 million will be divided between the fund manager and the investors. I will get 25% of the profit, and the investors will get the remaining 75%.

This means that within the first year I will be paid $9.5 million. The investors will get $30.5 million. This shows you how profitable this kind of investment can be. If let’s say I was managing $1 billion instead, then it means that I would have earned $95 million profit and the investors would have gotten $ 305 million.

Due to the huge earnings, a lot of people complain because they think that the fund manager is being paid too much. However, in most cases, it is the bystanders who are complaining and not the investors, since the investors have already gotten their cool $ 305 million. A lot of people point at the commission that the fund manager is making, but they fail to see how much money the fund managers are making for the investors.

Two and Twenty

Two and twenty is a compensation method that is used by fund managers. This remuneration method has been heavily criticized by many people.

In this remuneration model, the fund manager gets 2% of assets and 20% of gains made each year. It is this 2% that many people do not agree with. There is a reason for this. Even if the fund manager doesn’t make any profit for the investors, he still gets his 2%.  That means that if the manager is managing $20 billion, he will get $ 20 Million every year even if he does nothing. A worse scenario is him still making the $20 million even if he loses his investors’ money. This puts him in an awkward situation where he must explain why he deserves the $20 million yet the investors get nothing. In the example that we are using here, I decided to forfeit the 2% fee, and I instead went for a 25% – not 20% – fee performance fee. This means that if the investors are making money, I am also making money. However, this is a rare investment in many hedge funds. The 2 and 20 models persist, while some managers are starting to use a 1 and 20 model.

Hedge Fund Types

There are so many strategies for investing hedge funds. This includes equity, macro, relative value, activism and distressed securities. A macro hedge invests in bonds, stocks, and currencies with the aim of making a gain because of the changes in the economy. Equity hedge funds are either global or specific to countries. It invests in stocks and hedges against the economy going down by shorting stock indices or overvalued stocks. A relative hedge fund focuses on price inefficiencies. Other strategies used by hedge funds include new markets, short selling, fast growth, and income.

There are some cases where the fund manager will want to control the amount of risk that funds are exposed to. This can be done through a ‘fund of funds’ hedge. This is a mix of hedge funds put together with other investments. Since these mixes different kinds of assets and strategies, it is less risky and more stable than hedge funds that have only invested in one asset.

There are some hedge funds that are well known and have performed incredibly well in the market. This includes Paulson Funds. This fund made a notable profit in 2008 because of betting against mortgages. He made billions. This fund was started by John Paulson, he has other hedge funds as well, including funds that have invested in gold as assets.

Hedge Fund Types

Another notable fund is the one started by Bill Ackman known as Pershing Square. Ackman’s strategy is to invest in an undervalued stock. Then he works on increasing the value of the stock by changing various things about the company to help improve its performance. For instance, he can advocate that the company is sold, or he can push for a change of management or change of directors. Another successful hedge fund is the one that is headed by Carl Icahn. Most people who don’t want to be actively involved in hedge funds invest with Icahn because of his reputation of producing good returns. In fact, he has a well-known company, Icahn Enterprises (IEP) that is traded publicly.

Hedge Funds Are Not for Everyone

Hedge funds offer some benefits as compared to traditional investment funds.

Some of the major advantages are:

  • They can make a profit whether the bond or equity markets are doing well or not
  • There is a higher chance of getting positive returns and minimizing your risk if you include hedge funds in your portfolio.
  • You can come up with a personalized strategy based on the different investment styles that hedge funds offer.
  • You can get to work with skilled investors that are known worldwide

There are disadvantages of working with these funds:

  • A concentrated investment plan has huge risks
  • Your money will be locked up for a couple of years. Therefore, this is a less liquid investment as compared to mutual funds.
  • In case the fund manager uses leverage, this can multiply small loses into big losses

Conclusion

What are hedge funds in simple terms?

In a hedge fund, a group of investors agrees to pool their money together with the aim of investing it. Then a professional fund manager is appointed to manage these funds. This is the same case scenario as mutual funds. However, there is a difference between hedge funds and mutual funds. When it comes to investing, there is less rigidity when it comes to hedge funds. Also, there are stricter requirements if you want to join a hedge fund. These funds have riskier investment strategies that they can pursue as they wish without giving too much disclosure.

Each investment company has a strategy which they use to manage the funds. The main aim of any of these strategies is to make money for the investors. Each hedge fund has an “offering memorandum” or prospectus, which outlines the strategy that they will use to invest the funds they are managing. They will also disclose what their leverage limit is.

Fund managers of hedge funds earn a higher fee than mutual fund managers. There are also fees involved with hedge funds that mutual funds do not have. A hedge fund manager can earn 10-30% fees, and it is possible to earn more than this still. Most people who invest in hedge funds usually expect large profits, and in most cases, they expect any losses to be recouped before any future profit is paid as incentive fees to the fund manager.

In the US, most people who invest in hedge funds are high-income earners and have a net worth of more than $1 million. Since the funds are not overseen by SEC, they have greater operational flexibility, consequently earning them the reputation of being an investment for the rich that is based on speculation.

 

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