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What’s is: Hedge funds are pooled investment funds by private investors, established in limited partnerships, and managed by professional fund managers using various complex strategies to generate above-average returns on investment. They use high-risk methods such as investing with significant leverage and trading non-traditional assets to achieve positive returns even when market performance deteriorates. In addition, they may take long and short positions simultaneously, supported by advanced portfolio construction and management techniques to improve performance.
Apart from being a risky alternative investment option, investing in hedge funds requires a significant minimum investment, unlike investing in stocks or bonds. For this reason, only a few qualified investors participate. Instead, they usually have accredited investors such as wealthy individuals, insurance companies, or pension funds.
Hedge funds generally make money from two sources. First, they charge a base fee or management fee, which is determined based on the assets under management. Second, they also usually receive performance-based incentive fees. Thus, they earn more money when the funds under management are more significant and generate high positive returns.
Are hedge funds an alternative investment?
Yes, hedge funds are alternative investments. They don’t just invest in traditional asset classes like stocks and debentures. However, they also trade in other asset classes such as commodities, real estate, and even cryptocurrencies. They become a vehicle for us by which we can generate capital gains, although only a few accredited private investors may participate.
Apart from hedge funds, other alternative investments are:
- Private equity funds – pooled investment vehicles focused on companies such as startups or youth companies. Or, the target is a troubled, established company with cash-generating solid potential. They may also target publicly traded companies to go private. Two types of private equity funds are venture capital and leveraged buyout funds.
- Real estate – this includes investments in land or buildings directly or indirectly, such as through Commercial Mortgage-Backed Securities (CMBS) and Real Estate Investment Trusts (REITs). Commercial real estate may include industrial estate, office space, retail space, apartments, and warehouses.
- Commodities – investment exposure to commodities can be by purchasing them physically or investing in commodity-based companies. Another channel is commodity futures contracts or commodity indexes. Investing in the SPDR Gold Trust, iShares Gold Trust, and iShares Silver Trust are examples. They are the three largest commodity ETFs by assets under management.
In addition to these three, alternative investments include cryptocurrencies, art, antiques, stamps, and patents. Crowdfunding and peer-to-peer lending are other examples.
Why are they called hedge funds?
We call hedge funds hedge funds because they strive to generate positive performance even when the market is underperforming. They use complex investment strategies to hedge their investments to reduce portfolio volatility. For example, they invest in non-traditional asset class instruments to get returns when traditional asset classes are underperforming.
Combining leverage is another strategy. In addition, hedge funds may also take long and short positions and amplify them with considerable leverage to make profits. Thus, when an asset class’s performance is falling, they can still optimize short positions with certain leverage to protect long positions while making profits.
What exactly do hedge funds do?
Hedge funds raise money from accredited private investors. Their money is then managed by professional fund managers under a limited liability investment management firm. Fund managers use various investment strategies to generate positive returns.
Purpose
Hedge funds seek to generate high returns. It may be measured in absolute terms. Or it is performance relative to benchmarks.
Investment managers have different ways to generate high returns. For example, they might place funds in various non-traditional asset classes when traditional asset classes are falling. Others may use highly leveraged short positions to exploit advantages in conventional asset classes. Their goal is to generate positive returns on capital, even when the market they invest in is down.
Investment strategy
Hedge funds build complex portfolio construction and risk management to achieve above-average returns. To do so, they invest in various asset classes and derivative products. In addition, they can also take long or short positions simultaneously to minimize risk when the market performs in a reverse direction.
In addition, they may use leverage to maximize profits. Thus, the funds invested do not only come from investor contributions. But, it can also come from loan funds.
Fund managers are usually unrestricted by significant investment restrictions in carrying out investment strategies. Thus, they are more flexible in managing portfolios and making decisions. And they can also develop more aggressive investment strategies than conventional investments.
In general, investment strategies by hedge funds fall into four categories, according to Hedge Fund Research, Inc. (HFRI). They are:
- Equity hedges. This strategy focuses on the public equity market. Investment managers use a bottom-up approach. They take long and short positions in equities and equity derivatives to optimize profits.
- Event-driven. This strategy focuses on short-term events related to significant corporate actions such as restructuring and acquisitions. Fund managers then take long and short positions in securities issued by the company, such as common stock, preferred stock, debt securities, and debt options.
- Macro strategies. This strategy uses a top-down approach. Managers focus on the broad macro environment and take investment positions (long and short) in broad markets such as commodity indices, fixed income, currencies, and equity indices.
- Relative value. Under this strategy, hedge funds exploit pricing discrepancies between related securities. Or, they profit from short-term mispricings.
Partnership
Hedge funds are generally structured as limited partnerships. And they include two partners:
- General partners
- Limited partners
The general partner is a management company and has limited liability. They manage the fund and earn income from base fees and incentive fees. The base fee or management fee is determined based on the assets under management. Meanwhile, incentive costs are determined based on performance.
Limited partners are accredited private investors. They may be institutions – such as pension funds and insurance – or wealthy individuals. They have a fractional interest based on the amount they invest. Their money is pooled into a fund and managed by a general partner.
Unlike conventional investments, limited partners cannot withdraw their investment at anytime. This is because hedge funds usually impose limits on redemptions. Thus, limited partners cannot withdraw their investment during the lock-up period. And they have to provide notice before they can disburse the funds, usually between 30 and 90 days.
Regulation
Hedge fund regulation varies around the world. In some countries, such as the US, they are more strictly regulated. In other countries, on the other hand, they may be less regulated.
In the US, for example, hedge funds must register with the SEC if they have more than $100 million in assets under management. Additionally, if the fund manages a minimum of $1.5 billion in assets, they must report quarterly within 60 days of the end of their quarter and provide information related to the investment value for the type of asset, duration of fixed income holdings, and so on. Then, if they have exposure to commodities, their operations are regulated by the Commodity Futures Trading Commission (CFTC) and, therefore, subject to the Commodity Exchange Act.
What are examples of hedge funds?
Bridgewater Associates is considered the world’s largest hedge fund. They manage assets of $ 105.7 billion as of June 30, 2021, citing the Pensions & Investments survey. The funds they manage are quite far compared to the second largest, Man Group. Which hedge funds are the largest in the world? Here are the Top-20:
- Bridgewater Associates: $105.70 billion
- Man Group: $76.80 billion
- Renaissance Technologies: $58.00 billion
- Millennium Management: $52.31 billion
- TCI Fund Management: $40.00 billion
- D.E. Shaw Group: $39.74 billion
- Two Sigma Investments/Advisers: $39.55 billion
- Farallon Capital Management: $38.10 billion
- Citadel: $37.63 billion
- Davidson Kempner Capital Management: $37.35 billion
- Marshall Wace: $33.11 billion
- Anchorage Capital Group: $31.08 billion
- Baupost Group: $31.00 billion
- AQR Capital Management: $26.10 billion
- Capula Investment Management: $23.90 billion
- BlackRock: $23.09 billion
- Wellington Management: $22.60 billion
- D1 Capital Partners: $22.00 billion
- Point72 Asset Management: $21.80 billion
- GoldenTree Asset Management: $19.73 billion
Why do people invest in hedge funds?
Diversification is the main reason to invest in hedge funds. They seek to generate capital gains in alternative investments. While they may not always generate high returns, investing in hedge funds offers diversification because their performance is usually lowly correlated with traditional asset classes such as stocks and debentures. That way, they can make money even when the stock and bond markets are bearish.
However, do hedge funds always have a low correlation to traditional asset classes? The answer is no. It depends on each individual’s strategy, including their exposure to traditional asset classes. For example, hedge funds highly correlated with traditional asset classes in 2008. However, the correlation decreased in 2009.
What to read next
- Alternative Investment: Characteristics, Types, Investors, Pros, and Cons
- The Pros and Cons of Alternative Investment You Need To Know
- Hedge Funds: Examples And What Do They Do?
- Hedge Funds Strategy: Macro, event-driven, relative value, and equity hedge strategies
- Private Equity: Examples, Strategies, Targets, Its Ways To Make Money
- Private Equity Structure and Fee
- Venture Capital: How It Works, How It Makes Money, Investment Horizon
- What Are the 3 Stages of Venture Capital Financing?
- Leveraged Buyout (LBO): How it Works, Funding Sources, Criteria for Target
