Hedge funds - The Fiscal Forge

Overview

A hedge fund is a collaboration between private investors whose money is collected and managed by fund managers in hopes of beating typical market returns on investment. These hedge funds are usually paid on how effectively they perform and tend to use aggressive strategies to produce positive results.

As hedge fund managers use aggressive strategies, investment into hedge funds is seen to be risky and often requires a high minimum investment or net worth.

Understanding Hedge Funds

One of the main roles of a hedge fund manager is to protect their clients from market risk. They achieve this by investing a proportion of the fund’s main assets into securities whose value moves in the opposite direction of the hedge fund’s main security investments (often called hedged securities).

This theoretically enables hedge funds to offset any losses in the main asset investments as the value of the hedged securities should move up while the value of the main asset investments may be moving down. Hedge fund investors typically need a minimum level of income or assets (called an accredited investor) due to the risk involved when investing into securities such as options and futures. Investors tend to be institutional such as insurance companies and pension funds, as well as high-net-worth individuals.

Additionally, a main attraction of hedge funds is the reputation of the hedge fund managers themselves – as the world of hedge fund investing is very private and limited, a manager who has a strong reputation of producing positive results can stand out.

Types of Hedge Funds

There are four main genres of hedge funds:

Equity hedge funds can be specific to a certain country or global and attain their returns on investment by investing into potentially profitable stocks, or shorting stocks or indices that are over-valued by the market.
Activist hedge funds attain their profits by utilising business stocks. As they invest into these stocks, they will promote business activities that may increase business value overtime (such as cost cutting or asset restructuring).
Global macro hedge funds are hedge funds that profiteer from major market swings produced by significant economic or political events.
Relative value hedge funds achieve their profits by utilising short-term price differences of related securities, enabling them to gain from inefficiencies of prices or spreads.

Hedge fund investment strategies

Hedge fund investments target debt, equity securities, currencies, derivatives, real estate and many more. Typically, a wide myriad of investment methods and risk strategies are utilised.

A hedge fund long/short strategy is where investors will identify two competing companies in the same industry and choose to go long and short on either one, depending on their valuations of each respective company's worth.
An event-driven hedge fund strategy identifies mispriced stocks potentially caused by mergers or acquisitions, bankruptcy, takeovers or restructuring and takes advantage of these stocks.
A fixed-income hedge fund strategy provides investors with great capital preservation, minimal monthly volatility, and sturdy returns on investment. On fixed-income securities, they utilise both long and short positions.

How they make money

Hedge funds make their money by charging two types of fees which are management and performance fees. The usual management fee is 2% and is based on the value that each individual investor provides to the hedge fund. If one was to invest $2 million, they would pay $40,000 as a yearly management fee. The performance fee tends to be 20% of profit made that year. If a hedge fund manager performs effectively and increases an investment from $1 million to $1.3 million, they will take a further $60,000 (20% of $300,000). The difference between hedge funds and mutual funds Mutual funds are regulated much more strictly by the Securities and Exchange Commission than Hedge funds.

Hedge funds usually solely accept investments from accredited investors who are seen as suitable to handle the risks that hedge fund managers will take. These individuals’ incomes normally exceed $200,000 or a net worth exceeding $1 million.
Whereas mutual funds are available to the public and common investor and consist of very varied portfolios of short-term investments, bonds, and stocks.
Hedge funds are also able to invest into a larger variety of commodities such as stocks, real estate, derivatives, and currencies whereas mutual funds tend to only use long-term investment instruments such as stocks or bonds.
In mutual funds, investors can choose to withdraw their shares and profits at any time, hedge funds tend to induce a period where shares cannot be redeemed (typically a year).
Furthermore, mutual funds tend to charge an “expense ratio” that varies between 0.5 and 1.5% although index fund fees can be much lower (closer to 0%). Whereas hedge funds have a management fee of 2% and an additional performance fee of 20% (to profits).

Examples of hedge funds and statistics

AQR Capital Management, which was founded in 1998 and headquartered in Greenwich, utilised quantitative research investment strategies, and more than $94.5 billion in assets under management.
Renaissance Technologies, which was founded in 1982 and headquartered in East Setauket, had over $106 billion in assets under management and utilised mathematical- and statistical-based investment strategies.
Bridgewater Associates was Founded in New York in 1975 and was a global leader, with more than $124 billion in assets under management. B
Blackrock is the largest asset management company in the world and holds over $9 trillion in assets under management. The majority of these assets are contained in exchange-traded funds (ETFs) and mutual funds, but BlackRock also enables both retail and accredited investors alternative investments through its hedge fund.