The term ‘hedge fund’ is most likely heard during financial news reports in relation to a highly active market, a noted financial personality with a significant investment, or when billions of dollars move into or out of a financial product. That can make hedge funds seem like money-making enterprises for the elite of Wall Street.
In practice then, what is a hedge fund? It is an investment fund that is made up of money from investors and where professional money managers are provided with a great deal of flexibility as to where investors invest their money. A fund can purchase stocks, sell short, trade bonds, play around corporate events, or speculate on economic conditions in other parts of the world, depending on its approach.
The secret is flexibility. In principle, traditional investment funds are generally run based on rules and strategies that are more standard. Hedge funds can have greater flexibility in their practice of investments by using more varied methods to try to achieve these returns, to limit certain types of risk, or to capitalize on certain opportunities that traditional methods of investing don’t necessarily pursue. While this flexibility may provide opportunities, it may also present significant risks.
How Does a Hedge Fund Actually Work?
Essentially, a hedge fund is a grouping of investors who choose to pool their money with an investment manager. Mutual funds are similar to hedge funds in that they pool investors’ capital, with hedge funds having far more freedom in regard to the strategies that they can pursue. According to the SEC’s Investor.gov, such strategies may involve short sales and other speculative investment vehicles, such as leverage.
Suppose that a hedge fund raises $500 million from both rich individuals and institutional investors. Not all $500 million raised by its manager is invested in stocks that he or she believes will increase in value.
Rather, the portfolio may feature:
- Stocks that the manager thinks are trading at a discount.
- Stocks expected to go down in value are the subject of which type of investment?
- Bonds of various governments or corporations.
- Options, futures, and other derivatives.
- Projects involving currency or goods.
- Investing activities of mergers or restructurings.
- Norman: Money you save for future opportunities.
- This interweaving depends on the strategy that the fund follows.
If a manager thinks Company A is better than Company B, for instance. The fund could purchase Company A, and at the same time sell Company B short. It may be that you are in both of these companies, with Company A improving by 15% and Company B declining by 10%; that could both work to your benefit.
That is also an illustration of why the “hedge” term can be confusing. The traditional definition of a hedge is a position meant to counteract another risk. Though many hedge funds have a high hedging quotient, there are some in this modern age that aren’t necessarily conservative portfolios that are put together mainly to minimize risk. The methods that they use differ from fund to fund.
The goals a hedge fund pursues are often different as well. Some are designed to produce positive returns in varying market conditions, while others have their attention on beating a benchmark or taking advantage of a specific market opportunity. Not all hedge funds adhere to the same strategy.
What Strategies Do Hedge Funds Use?
Hedge funds are given a lot of attention in part because their managers have the ability to utilize techniques that are not typically offered to an ordinary retail fund. Common categories of competitor coverage include long-short investing, global macro, event-driven investing, and arbitrage; it’s important to know what sort of activities managers are trying to accomplish, which makes it easier to get the gist.
- Long-short equity: when a manager buys stocks he believes in and shorts those that he expects to lose. It isn’t necessarily to predict the rise and fall of the whole stock market. Instead, the manager might attempt to gain from inter-firm discrepancies.
- Global macro: The funds invest based on broad economic trends. Managers can compare interest rates, inflation, area currencies, government policy, commodity prices, and economic growth of various countries.
- Event Driven Investing: Corporate events can generate out-of-the-ordinary pricing opportunities. A fund could allocate, for instance, to mergers, bankruptcies, restructurings, and spin-offs.
- Relative value: Managers look for differences in the price of securities that exhibit some correlation. When they think that the price correlation between the securities has deviated from what they think it should be in the short term, they may trade one security while taking a position opposite in the other.
Some funds use quantitative strategies, which are based on mathematical models, algorithms, and massive databases. Models can be coded so that computers recognize patterns and can place trades based on specific rules, but sometimes when the markets do not proceed by the rules’ assumptions, models fail.
Two techniques are mentioned in a number of these strategies.
The first is a technique called short selling. The fund does not buy an asset and hope for its price appreciation, but is long the asset in a way that it will benefit if the price goes down.
The second is leverage. A fund can buy or sell derivatives, which allow it to gain exposure to an investment that is larger than the capital invested. While the use of leverage can amplify winning trades, it can also amplify losing ones. SEC, in particular, defines leverage as one practice that concentrates both investment exposure and risk.
Hedge Funds vs Mutual Funds and Other Investments
Before you know what a hedge fund is, you need to see how a hedge fund is similar to a mutual fund.
Both collect capital from several different investors and have professionals acting as investment managers. Beyond that similarity, the sort of experience that an investor has can vary greatly.
- Availability to investors: The mutual funds and ETFs are readily accessible to retail investors. Generally speaking, hedge funds are dollars that are only open to investors who meet certain financial or sophistication criteria and that they are private.
- Investment freedom: A traditional mutual fund generally has a set investment approach and rules. Hedge funds are more flexible in general, regarding the type of trading that they can engage in (which includes leverage, complex strategies, and the ability to short securities).
Liquidity is the one area where most investors can redeem their open-end mutual fund shares on a day-to-day basis according to the Net Asset Value. Hedge funds are another investment vehicle that might have certain time restrictions attached to an investor’s ability to withdraw their investment.
Some employ lockup periods, and other properties have redemption time periods. According to Investor.gov, hedge funds aren’t subject to the same daily-redemption policy that is in place for mutual funds.
- Disclosure: Registered funds have to provide extensive disclosures. As private hedge funds are not subject to the same federally required disclosures as other investments, this can make consideration more complicated.
- Fees: Hedge fund fee structures can be more complicated and expensive. The manager might receive a management fee, based on the assets being managed, and/or an incentive/performance fee based on investment performance.
The terminology “2 and 20” is often used to describe a 2% management fee as well as a 20% performance fee. It is a known model of the past, but investors should not assume that all newer hedge funds will charge the same fees. This is the actual term and varies with each manager and fund.
Even hedge funds and private equity are different. Hedge funds typically engage in security and other financial asset trades, and private equity funds typically invest in buying a substantial interest in privately held businesses or acquiring public businesses and, in both cases, taking them private.
This means that despite the fact that there are many more assumptions that apply to a hedge fund investment than the usual private-equity vehicle, the investment may be more liquid than one’s typical private-equity investment, depending heavily on the investment strategy and terms of the fund involved.
Who Can Invest in Hedge Funds in the United States?
Hedge funds aren’t necessarily available to most Americans simply via a normal brokerage account.
The investor may be required to meet criteria for accredited investors and/or qualified purchasers [depending on the type of offering by the fund and its terms and conditions]. The granular details because the investor safeguards in a registered public offering are not necessarily built into private investments.
The SEC has issued guidance that there are several ways a person can be classified as an “accredited investor.” Typical financial criteria are:
- Net worth of more than $1 million (of himself/herself and his or her spouse or spousal equivalent, not counting the equity of the main home).
- Earns more than $200,000 during each of the last two years, and reasonably expects to do so during the year.
- Income of $300,000 or more from any other source with a spouse or spousal equivalent with the same general timing requirement.
- Possession of certain professional licensing, such as Series 7, series 65, or Series 82, in good standing.
- Some entity/for-profit and certain trusts fit into other categories.
Referring to any one of these criteria does not make a hedge fund necessarily a good fit for an investor. Eligibility and suitability are two distinct issues.
When considering an investment in a wealth creation scheme, prospective investors need to study the scheme’s offering document, investment policy, management structure, withdrawal limitations, valuation methods, and fee policies. They should also be aware of the details of their money, including where and when it can be cashed in.
Another obstacle is the minimum amount that can be invested. They can vary significantly from fund to fund and can be large, especially at high-quality managers.
Why Investors Use Hedge Funds and What Risks Matter
Why would investors settle for extra fees, convoluted strategies, and maybe restricted access to their funds?
The first one is Diversification. Hedge funds that use different strategies than stocks and bonds may have a different pattern of returns. That may expand a portfolio’s sources of profit – but diversification doesn’t guarantee profit.
One of the interesting points is adaptability. Managers are not just waiting for asset prices to go up: they can look for opportunities even when markets are falling.
Something that could have benefited a significant number of people, however, comes at a cost.
- Leverage can cause losses if used in a multiplier effect: When one makes a great deal with borrowed money and derivatives, the returns can be great, or the losses can be as well.
- There are special risks associated with short selling: A conventional stock investment can lose all of its value. A short sale can also continue to lose if its price continues to increase.
- Your funds may be harder to obtain: Withdrawals may not be as expected with a hedge fund, so investors should be mindful of any restrictions that may be in place.
- Exposure will not always be apparent in a complex state: During severe market moves, a portfolio of derivatives with leverage and multiple intertwined positions can act in an unanticipated way.
- Fees take away from the investor’s return: The value of management and performance fees can be a material part of gains, and the net performance can actually be more significant than the gross performance of the fund.
Not all disclosure and regulation are the same. Rules that apply to mutual funds and ETFs to safeguard investors don’t necessarily apply to hedge funds. They remain subject to the anti-fraud regulations and the fund managers have a fiduciary duty to the funds they administer, but an investor should not presume that the protections are the same.
It is important, therefore, for due diligence to be of paramount importance. Before investing, an eligible investor should know what the fund invests in, how it generates returns, special conditions under which they may be investing in a money-losing plan, the fee, and how to get money back.
Frequently Asked Questions
What is a hedge fund in simple terms?
A hedge fund is a private pooled investment company that employs flexible investment strategies. Depending on the nature of its mandate, it can purchase securities, short securities, leverage, trade derivatives, or seek out special market opportunities.
Do hedge funds always make money when the stock market falls?
No. Hedge fund strategies exist that aim to decrease the amount of exposure that the fund would have in a market or make some sort of profit when prices decline, but these can turn heads down even when prices go up. Performance is dependent on the approach and the manager’s decision.
Why are hedge funds considered risky?
They may be exposed to leverage, short selling, derivatives, concentrated positions, limited liquidity, and complex strategies. There can be very significant variations in the risk of various hedge funds.
Can an ordinary investor invest in a hedge fund?
Hedge funds are typically offered to retail investors. An accredited investor or qualified investor status may be required.
Are hedge funds regulated in the United States?
Yes, but not necessarily the same way as mutual/ETFs. Depending on the circumstances, hedge funds and their managers may be subject to securities laws, anti-fraud requirements, and fiduciary duties, as well as registration and/or reporting requirements. Investors don’t receive all of the regulatory protections associated with registered investment companies.
Conclusion
Learning about what a hedge fund is is very easy when it doesn’t explain it using Wall Street jargon. It’s little more than a privately structured pool of investor money that provides some flexibility that a retail fund doesn’t offer. That versatility makes it possible to trade short, arbitrage, global macro, and even event-driven, yet it comes with an increased level of complexity, increased fees, restrictions on liquidity, and substantial risk.
If one is being considered by a qualifying U.S. investor, the fund’s strategy, its manager, the fees, the redemption provisions, and the potential downside risks are no less important than whether or not it has achieved its historical results.
For more information, also read our related article here.