It’s very likely that you’ve heard about hedge funds before. These investment vehicles have attracted their fair share of attention, especially compared to their much duller and static cousin, the mutual fund.
However, lots of misconceptions surround hedge funds, especially their purported reputation for risk-taking. In reality, every hedge fund is different and takes on its own unique strategy; the “hedge” in hedge fund is even historically tied to the practice of hedging against risk.
So what is a hedge fund? Let’s explore in greater depth to learn exactly how these funds operate and are structured.
1. Hedge funds are pooled investments
Here’s a simple definition from the Securities and Exchange Commission (SEC): “Hedge funds pool money from investors and invest in securities or other types of investments with the goal of getting positive returns.”
This is similar to how mutual funds work, but hedge funds are offered privately. While employees are able to invest in mutual funds through a 401(k), they aren’t likely to find a hedge fund offered in their retirement plan. As such, hedge funds are sometimes referred to as “alternative investments.”
Hedge funds have much greater latitude in investing than mutual funds, which are often limited to stocks and bonds. While hedge funds can hold equities and bonds, their investments can range from real estate and foreign currencies to startup companies and derivatives (e.g., options, futures and credit swaps).
Hedge funds are generally structured as limited partnerships. The limited partners of the fund are its investors. Together, their investments are pooled into the fund and managed by the general partner(s). These are the fund managers who decide on and implement an investment strategy, as well as generally oversee the business of the fund.
Hedge funds typically require:
- A large minimum initial investment.
- That money invested with the fund is locked up for an initial time period. The fund may also limit the number of times an investor can redeem shares or cash in during a certain time period.
2. Availability is limited to institutional and accredited investors
There is one big caveat to hedge funds: Only institutional and accredited investors can invest through such vehicles.
This condition is largely to do with how hedge funds are regulated. For example, they aren’t subject to some of the regulations that govern public disclosure and investor protections for mutual funds. However, hedge fund managers are still bound by their fiduciary duty.
An accredited investor is generally a high-net-worth individual who meets a minimum threshold for income or assets under ownership. You are an accredited investor if you have:
- At least $1 million in total net worth, excluding the value of your primary residence.
- An income of at least $200,000 for each of the last two years. If you’re married, that minimum level is raised to $300,000.
Institutional investors are also part of the eligible hedge fund investing audience. An institutional investor is often a large organization or its investment wing. Such entities include:
- Pension funds.
- University endowments.
- Insurance companies.
- Investment banks and other financial institutions.
- Sovereign wealth funds.
- Mutual funds.
That last type of institutional investor presents an interesting wrinkle. Mutual funds can invest in hedge funds to become a fund of funds (FOF), thereby granting retail or retirement investors potential exposure to hedge fund performance.
3. They’re different from mutual funds in lots of ways
One reason why hedge funds have become popular is because they can offer eligible investors different advantages than mutual funds. But what is a hedge fund offering in comparison to a mutual fund? There are quite a few important points of differentiation between the two:
- Potential investments: Hedge fund managers have few restraints on investment strategy. Because they are private entities, hedge funds can pursue opportunities that mutual funds are typically not allowed to, such as short selling, derivatives, illiquid assets and even cryptocurrencies.
- Regulation: Depending on the level of assets under management (AUM), a hedge fund may not have to register with the SEC. Comparably, mutual funds are required to register and their operations are regulated by the Securities Act of 1933 and the Investment Company Act of 1940. Section D of the 1933 Act allows hedge funds to bypass registration by only selling to accredited investors.
- Transparency: Mutual funds are legally required to publish a prospectus for the purposes of investor education and transparency. Hedge funds do the same thing, but a little differently, documenting the specifics of the fund in a private placement memorandum (PPM).
- Performance reporting: It can be hard to quantify performance for hedge funds based on the types of investments they make. Some assets can be hard to price, and no two hedge funds follow the same methodology in valuation. By comparison, mutual funds are mandated by federal securities law to calculate performance using standard models that compute current yield, tax-equivalent yield, average annual total return and after-tax return.
- Absolute returns: Mutual funds are designed to provide returns relative to benchmarks and what the market allows. Performance is defined as variance from a benchmark, so in a down economy mutual funds can still have a “winning” year if they lose less than their benchmark. Hedge funds, on the other hand, pursue absolute returns regardless of the market. This is also known as alpha investing, or the practice of generating excess returns that beat the market. Hedge funds can achieve this by implementing a diverse range of complex and nuanced investment strategies.
4. The first hedge fund started in 1949
While the exact history of hedge funds is a bit murky, there’s large consensus that Alfred Winslow Jones was a pioneer in the field.
A.W. Jones is credited as founding the “original” hedge fund in 1949. As the story goes, Jones was writing an article for Fortune magazine about markets and interviewed several leading financial forecasters. Struck with an idea, he decided to test his own hand at money management and launched his namesake fund, A.W. Jones & Co., initially raising $100,000.
His investment strategy was to long undervalued stocks and short-sell overvalued stocks, thereby creating a hedge against risk. The long/short equities strategy is Investing 101 now, but it was groundbreaking at the time. According to CFO magazine, A.W. Jones — which still exists today — earned 17.3% in its first year and outperformed mutual funds by 87% in its first decade.
Jones is also known for one other innovation that bred modern hedge funds: leverage. Leverage is borrowed money taken on to increase buying or trading power. The bigger the bet, the bigger the potential return for investors and the fund — however, the risk is also increased. Combined with the concept of hedging, Jones was instrumental in laying the groundwork for hedge funds.
Investors can also thank Jones for the “2 and 20” fee structure for hedge funds — but more on that in a bit.
5. Hedge funds manage trillions today
Hedge funds now look a lot different 70 years after Jones opened the door and have grown to become a force to be reckoned with in finance. According to the 2020 Preqin Global Hedge Fund Report, hedge funds had $3.61 trillion in assets under management (AUM) in November 2019.
According to the Preqin report, U.S. hedge funds accounted for $2.7 trillion in AUM in November 2019. Fund managers in:
- The U.K. had $463 billion in AUM.
- Hong Kong had $61 billion in AUM.
- Sweden had $45 billion in AUM.
- Canada had $40 billion in AUM.
6. Hedge funds have a unique fee structure
Hedge funds have greater flexibility to structure their fees than mutual funds do. One widely used framework is the “2 and 20” rule, which refers to:
- An annual 2% fee charged on AUM for a particular investor. For example, if you invest $150,000 in a hedge fund, you can expect to pay $3,000 in asset management fees.
- A 20% performance fee. One-fifth of profits go back to the hedge fund, while 80% is returned to the investor pool. Whereas the asset management fee is levied regardless of fund performance, this 20% is only taken if profits are realized.
However, a fund’s fee structure is not set in stone. Some may tweak these percentages — like a 0% management fee and 30% performance fee.
7. All sorts of hedge fund strategies exist
There are 31 flavors of hedge funds — and then some. Investment strategies vary greatly between hedge funds, thanks to the wide latitude they are afforded in pursuing different types of alternative investments and assets.
This diversity is a benefit for accredited and institutional investors, who can find a hedge fund that aligns with their market perspective, risk tolerance, personal preferences and other factors. According to the Hedge Fund Association, a sampling of hedge fund strategies includes:
- Distressed securities: Funds buy shares, debt or claims of companies facing financial headwinds such as bankruptcy or reorganizations. Assets can be had at a deep discount because of the market undervaluing their true worth and are then sold for a profit when the position is exited.
- Emerging markets: Funds invest in equities or debt from companies or bond issuers in emerging markets, which can offer both high-growth upsides along with volatile risks, including political strife or rampant inflation.
- Income: Funds invest in a way that is meant to generate consistent income and yields. Generally a low-volatility option, income funds may buy bonds or fixed income derivatives to benefit from interest.
- Opportunistic: Funds choose investments based on the potential to profit from events like mergers and acquisitions, initial public offerings (IPOs), economic cycles and asset price swings.
Learn more about the Magma Total Return Fund
Have more questions related to “what is a hedge fund?” Check out this handy guide from the SEC.
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