What are Hedge Funds?
Hedge funds are a type of security fund consisting of people and institutions who expect to profit from taking on risk, a financial investment that involves making a large number of speculative investments for the purpose of profiting from favorable market fluctuations. Hedge funds are often used by investors who seek greater risk and higher potential return in contrast to standard asset allocation. Fintalent’s hedge funds consultants observe that they derive their name from hedging, which refers to the use of specific financial instruments or other investments intended to offset one or more directional financial risks.
The term “hedgehog” is often used in relation to hedge funds as they will tend to have longer holding periods with diversified portfolios, typically not investing in just one market segment. They often hold mutual funds and other investment vehicles, which are pooled together to form one portfolio. These will typically be available for purchase in the same way that listed securities are.
There is no limit on the amount of money that can be invested and there are no restrictions other than those set out by the fund operator itself. The fund’s managers make their own investment decisions, including entering into financial contracts with their investors (e.g., warrants, options etc.). Investors in hedge funds normally pay a management fee and/or a performance fee, both charged monthly or quarterly. Hedge funds generally do not normally have set redemption fees and they can rarely be closed. The managers of the funds may also take a short position on securities or other investments with their investors’ money to thwart short-sellers. There are specialised internal investment strategies which allow for high levels of risk, where the fund may invest in a single security or index across many different markets.
Hedge fund managers typically employ quantitative analysis to make investment decisions as opposed to analysis based on fundamental research, although some large hedge funds still use both quantitative and fundamental analysis. In the past, hedge funds were known as “alternative investment funds” or “managed futures.” The term “hedge fund” is sometimes used as a synonym for private equity fund, though there are differences: Hedge funds invest long-term, while private equity funds invest short-term only.
Hedge fund managers have become a focal point of concern in recent years as their strategies and operations drew increasing criticism for their complexity and opacity. Some hedge funds have also been criticized for their limited performance, extreme leverage and high fees.
Hedge funds are different from other investment vehicles in that they use a form of ownership known as “carve-out,” which has been described as a form of share ownership in an investment vehicle with its own limited liability. A carve-out is the designation given by a management company to its portfolio managers to do business under a unified entity’s name (or “carve out”), allowing the managers to avoid registering with any regulatory agency or filing financial disclosures or reporting obligations that would be imposed on them if they were to register separately as unlisted investment companies, mutual funds or private equity funds. One of the biggest problems with the hedge fund industry, particularly in the United States, is that funds are not required to register as investment advisors or disclose their investments in a public or uniform format. Hedge funds may operate under an exemption from registration as mutual funds or private equity funds as long as they meet certain requirements and/or limitations to their activities
Hedge funds are often managed by smaller, private investment companies called limited partnerships. The partnership’s assets are pooled together with other investors’ money and used for specific purposes including investing in stocks and bonds, purchasing real estate and options on financial indices.
Because hedge fund managers concern themselves only with managing investments, they tend to be more anonymous than some other investment professionals. Unlike investment bank professionals, hedge fund managers usually do not have an office or principal place of work. Also, hedge funds often choose to operate in a jurisdiction that offers generous tax and regulatory incentives to their industry, allowing them to charge high management fees.
When Hedge Funds entered the market in 1982 there were only around 200 Hedge Funds in existence globally. Today there are estimated to be over 3900 Hedge Funds globally with assets valued at $2 trillion USD. The “Hedge Fund Journal” and the “Hedge Fund Research Alliance” provide an annual report and survey of estimates for the number of hedge funds globally.
Hedge funds often employ active strategies such as very large negative alpha, multistage mean-variance hedging or asymmetrical risk arbitrage in addition to derivatives, futures or other securities trading. These active strategies can be used to
- Mitigate risks,
- Create leverage, or
- Enable a fund’s manager to capture unexpected opportunities.
The high risk, high return investments that hedge funds manage result in an average performance that is positive but lower than the average performance of stocks. However, certain hedge fund strategies have historically demonstrated low correlation to equity markets, providing protection for investors in down markets. Such strategies may be employed by the investment company or fund to manage the risk of its overall portfolio and hedge against adverse movements in their respective market positions. These strategies include:
Despite their complexity and use of sophisticated techniques, most hedge funds are similar in some respects to a closed-end mutual fund. Both are pooled investment vehicles holding a collection of assets, trading on the secondary markets and seeking to achieve positive returns on investment for their investors. Both often have relatively high minimum investment thresholds, as well as lock-up or redemption fees when assets are withdrawn before a specified time period.
Both hedge funds and mutual funds are also required to disclose certain items of information to the public including net asset value per share (NAV), quarterly performance and the identity of managers, directors and major shareholders. Like mutual funds, hedge funds often charge investors an annual management fee (2% is common) plus a performance fee (20%).
Hedge funds are generally more opaque than mutual funds, with less disclosure. Mutual fund positions and holdings must be reported daily to the U.S. Securities and Exchange Commission (SEC). In contrast, hedge funds typically disclose their holdings quarterly in summary fashion after the close of each quarter with no disclosures on a daily or intra-day basis; they do not have to report to the SEC unless they have assets of $100 million or more under management.
Additionally, hedge funds must generally register with the SEC if they meet one of two thresholds: either they manage $100 million or more in assets or have more than 499 investors. The U.S. Securities and Exchange Commission also regulates hedge fund managers, who must register under the Investment Adviser Act of 1940 and agree to additional regulation.
In order to protect their investments, investors have begun requiring hedge funds to agree to less investor-friendly provisions; these are called “anti-fraud provisions” or “fiduciary duties”. Some investors have even gone as far as requiring that hedge fund managers obtain insurance on their investments.
The main difference between hedge funds and mutual funds is the ability of a hedge fund to trade with the capital on behalf of the investors while a mutual fund cannot. Hedge funds are believed to be able to operate more efficiently than mutual funds due to their greater flexibility.
The most common investment strategies used by hedge funds include market neutral, risk arbitrage and macro strategies. Other common strategies used are event-driven and value investing, including hedging and overlay strategies. The asymmetric bet is another strategy that is common among many hedge fund managers, who may use this technique to exploit this asymmetry in market conditions. Hedge funds that trade on the stock market are called “hedged equity”, while those that trade on commodity markets are termed “commodity trading advisors” or “CTAs”.
