Hedge Fund

A hedge fund is a type of investment fund administered by professionals whose strategy of investing is riskier, but potentially more profitable than others. The fund managers can earn profits above the average by operating with borrowed money, derivatives and other risky financial instruments or types of assets. These investment strategies differ from the strategies used in typical mutual funds, which usually put the risks aside in order to avoid unexpected losses.

Hedge funds have a high entry level and take a sizable amount of commissions, thereby leaving this investment option mostly for wealthy and prosperous investors, who have an ability to cover these expenses, on the one side, and have a safety net in order to take the associated risks, on the other.

These funds are widespread in the UK and US. In some other countries hedge funds have a more complicated process of registration, therefore they are not so common. 

History of the Hedge Fund

The first hedge fund was established in the middle of the 20th century by Alfred W. Jones. He created a classic long/short equities model, which is aimed to reduce the risks of long-term investment by short selling, also known as shorting. The main idea is to gain hedge profits from selling borrowed securities.

A decade later, in the 1960s, hedge funds substantially exceeded other funds in profits and gradually gained more popularity among investors. The difference between the most profitable mutual funds’ and hedge funds’ return was around 100% in favor of the latter. But during the next decade a lot of hedge funds suffered great losses because of their riskiness. The funds were left out in the cold until 1986, when they got their second wind with Julian Robertson’s Tiger Fund. 

The 1990s were a golden era for hedge funds. However, in the 2000s hedge funds’ investors again suffered the consequences of their venturousness. The global financial crisis of 2008 exacerbated the situation, and hedge funds completely dropped out of view. Nowadays, the number of these funds has been increasing again. According to the Preqin data, in 2019 the amount of active hedge funds in the world was above 16,000 with the total asset value of $3,6 trillion.

Most hedge funds have transformed since the date of their foundation. The current funds differ from the initial ones. However, there still are some of them, which are similar to the original long/short equities model.

Characteristics of the Hedge Fund

As was mentioned before, hedge funds have a risky strategy of investment management aimed to gain more income than typical funds, which are guided by a safer strategy for getting better control over the capital.

A few essential characteristics of hedge funds can be distinguished:

• high risks and potentially high profits;
• limited number of affluent investors;
• less control from government agencies and an extensive variety of possible investment strategies;
• operating with borrowed money, or using leverage.

Let’s consider these points in detail.

High-risk strategies. Sometimes, the unorthodox strategies of investing can give profitable results in a short period of time, but they’re less stable than some of the traditional ways of investing such as investing in stocks or bonds.

Hedge funds’ reputation is highly correlated with the reputation of their managers, because they are responsible for the funds’ investment style, activity and success. There are a lot of strategies that managers can choose from: stocks, bonds, futures, options, real estate, forex, etc. But the two main ones are event-driven investing and fixed-income arbitrage. 

Limited number of investors. The possibility of earning significant returns and high risks associated with these nontraditional strategies of investment require hedge funds to charge high commissions for their work. It takes around 20% of the returns and 1-2% of the price of each managed asset as well. This type of fee structure is also known as “2 and 20”.

Besides the commissions, hedge funds have a high level of minimum investment, which leaves some of the interested investors behind. Also, hedge funds investments are generally considered to be illiquid because these funds have a specified lock-up period, which lasts for at least a year. Potential investors should take it into consideration and estimate their possibilities to leave this sum of money out of their reach for a certain period of time. Additionally, these funds are often established as limited partnerships with a limited number of accredited investors.

Generally, hedge funds are open to the members with a net worth over $1 million or annual income over $200,000 for the last two years. As you can see, the bar for entry is pretty high, and some of the fund managers set it even higher. These requirements vary from one country to another, as well as from one fund to another.

Less control from the SEC. These restrictions for the entry have been imposed by the Securities and Exchange Commission (SEC) in order to limit the number of investors willing to take the risks in exchange for a greater profit. In other words, these restrictions cut off the small investors from this activity and leave it to the more experienced ones who are expected to manage the risks better. For the rest, the SEC doesn’t regulate hedge funds as strictly as other funds.

Using leverage. Investing with borrowed money has always been risky, but hedge funds often use leverage to close short positions. However, sometimes the price of this risk is too high. A lot of hedge funds collapse because of leveraging. 

Types of Hedge Funds

There are different types of hedge funds, which gain profits through different strategies:

1. Global macro hedge funds are aimed to make returns from investments during market movements. The market is highly sensitive to some political, economic, and other significant changes. The managers of this type of hedge funds try to use these changes in their advance.
2. Equity hedge funds are based on the classic long/short equities model. The strategy is to make long-term investments and lower the risks of losses by making short positions at the same time.
3. Relative value hedge funds try to profit on the transitory price changes of related securities. One of the specific strategies used by these funds is pairs trading, when long and short positions are set in the correlated stocks.
4. Activist hedge funds are aimed to invest in businesses and actively influence some of their major changes, which consequently lead to the stock price fluctuations.

Common strategies of Hedge Funds

Despite the fact that different hedge funds gain income from using distinctive strategies, there are some commonly used:

1. The long/short equities strategy, which was mentioned before. It’s considered to be a classic hedge strategy.
2. A fixed-income strategy, which is based on investing in fixed-income securities. Some positions are long-term, some are short.
3. An event-driven strategy, as its name implies, is based on the exploitation of price fluctuations during some significant changes in the world, country, or particular company. 

Comparison of Hedge Funds and mutual funds

We’ve already defined shortly some differences between these funds, while describing the characteristics of hedge funds. But let's summarize them in the table below.

Guide for investing in the Hedge Fund

Hedge funds are different from mutual funds, but they’re also different from each other. Some of them are riskier than others. If you decide to invest in hedge funds, take attention to a few important guidelines that we’re going to describe in this article. If the chosen fund doesn’t comply with these recommendations, then you should probably make another choice.

You can search for hedge funds by using different guidelines. These guidelines can be set for funds’ absolute or relative performance.

Absolute performance guidelines. Define a sustainable criterion for comparing the funds with. For example, you can find information on the return of the Citigroup World Government Bond Index (WGBI) and set the guideline above it by 1%. It helps you to cut off funds with the return below this guideline. Also, it shows you funds that outperform these numbers. 

Another guideline can separate out funds, that are worth consideration, by their standard deviation for the recent years. This metric demonstrates volatility of hedge funds, or how stable their results are.

By that time you’ll probably sort out some funds for your consideration. The next step will be to study what strategies these funds use. Choose one of them and conduct a peer analysis within similar funds that use the same investment strategy. Then apply the median in order to filter the results.

All these steps will help you to narrow down the number of trustworthy hedge funds, but probably there still will be a lot of them to choose from. Therefore, you can add other guidelines. The only problem that might complicate the search is that different guidelines apply to different strategies.

It’s important to note that the results of the funds’ previous performance analysis don't always reflect their performance in the future. The market environment is quite unstable, therefore some of the previously successful strategies might stop working and there will be a need in choosing others.

Relative performance guidelines. These guidelines are more concentrated on the specific strategies that hedge funds use, rather than on their overall performance. The analysis can be made with the help of the Morningstar software program. You need to choose a hedge fund strategy, then conduct the peer analysis. It’s better to use the 50th percentile, or median, because the 60th percentile will probably include only a small part of considerable funds, and the 40th percentile will narrow the selected group insignificantly.

Besides that, the following metrics might be of use for choosing the hedge fund to invest in:

• a downside deviation, which demonstrates the volatility of the fund’s losses over the recent years;
• a maximum downfall, which demonstrates how big the fund’s losses were over time;
• the time spent on a recovery from the downfall, which demonstrates how well the fund manages failures.

Other possible guidelines that can narrow down the number of hedge funds to choose for investing:

• Fund size. Some investors are more attracted to small funds, some on the contrary – to the big ones.
• Track record. If it’s essential for the investor to study the fund’s performance for at least a year or more, then this guideline can separate out new funds that have existed for less than a year.
• Entry investment size. The investor can choose the fund with an affordable size of minimum investment. Usually, hedge funds with a high entry investment have a sizable portion of institutional investors.
• Redemption terms and lock-up periods. Basically, the longer these periods are, the more challenges investors can face.

Examples of the world’s major Hedge Funds

Despite the associated risks, hedge funds continue to gain enormous capital over the years. Let’s review some of the most successful funds of 2022, according to the U.S.News. 

Renaissance Technologies LLC (otherwise called Medallion fund) is an extraordinary hedge fund established by Jim Simons, which has been generating significant profits since 1988. The exception was only 1989, when the fund suffered losses. Due to these incredible results the fund has changed the standard fee structure of “2 and 20” to “5 and 44”. The fund’s strategy is based on the mathematical models and algorithms which successfully distribute the fund’s investments. However, a very limited number of investors are able to join Renaissance Technologies.

Brightwater is another prosperous hedge fund based on the same strategy as the previous one. It was founded in 1975 by Ray Dalio. This fund has a spectacular capital of around $150 billion and an incomparable amount of return since its foundation – over $52 billion. This fund along with the Medallion fund demonstrates the full power of the “quant” strategy.

Citadel LLC is a large and successful multinational hedge fund established in 1990 by Kenneth C. Griffin. The history of the fund's 30-year existence shows the annual return around 19% per year, which is higher than a typical mutual fund can offer. The fund is based on a combination of multiple strategies such as stocks, bonds, commodities, etc.