CFA Investing

What are Hedge Funds?

Everyone starting off in the finance world wants to work for one, but how many of them actually understand what they are?

Chances are you’ve heard of hedge funds, but do you know what they are?  These investment vehicles for the uber wealthy are often in the news and fund managers are interviewed across all media chains daily, but the specifics are never explained.  Why is this type of investment so mysterious to the everyday investor?  This article will demystify hedge funds and hopefully answer all of your questions.

Hedge funds got their start in the early 1950’s when Alfred Winslow Jones created a portfolio and called it a “hedged” fund: his portfolio was hedged against major market moves through the use of leverage and short positions.   In this context, to hedge means to limit so a hedge fund is a fund that is limiting, or trying to limit, loss. Although the name has been shortened all of the other characteristics remain the same, specifically their legal structure.  Hedge funds are structured as limited partnerships where the fund manager is the General Partner (GP) and the investors are Limited Partners.  In many instances, the GP does not want to bear the unlimited liability in case things go awry, so the general partner can be a limited liability corporation.

The investors (the LPs) have fractional interest in the fund and the gains and losses are passed to them.   The limited partners will be charged a management fee based on the total amount of asses held, as well as an incentive fee which is a percentage of the realized profits.  A typical fee structure seen across the hedge fund market is “2 and 20,” or “1 and 10,” which reflects a 2% or 1% management fee and a 20% or 10% incentive fee, respectively.  The fees can change depending on the amount of capital the LPs give to the fund as well as the redemption and lock-up period agreements.

Redemptions are any withdrawals made by the investors, and a lock-up period is a time where investors cannot make any redemptions.  These can affect the fee structure of a hedge fund because if a limited partner agrees to not make any redemptions agrees to a long lock-up period, they may be given a discount.

The management fee is based on the year/period end market value of the total assets that are under the fund’s management.  For instance, if you invest $100 million in a hedge fund and throughout the year the fund appreciates by 15%, you will be paying a management fee based on $115 million.  In the case of a “2 and 20” fee structure, this will be $2.3 million.

The incentive fee is where fund managers make their money and is based on the appreciation of the fund during the year/period.  Assuming the $100 million initial investment, a fund return of 15%, and the “2 and 20” fee structure, the manager will receive $3 million if the incentive fee was calculated independently of the management fee.  Depending on the fund agreement the management fee may be deducted from the total return before the incentive fee is calculated. In this particular example, if the incentive fee was calculated net of the management fee then the fund manager will only be getting $2.54 million (still  not too shabby).

Some fund agreements have provisions built-in to them that protect the investors such as hurdle rates and high water marks.  A hurdle rate is a rate of return that must be met before the manager will earn their incentive fee.  In some cases this could be the rate of inflation or the risk free rate.  If a fund earns a return of 10% and the hurdle rate is 7%, then the incentive fee will be calculated from the 3% return.  For instance, with a $100 million initial investment that has a “2 and 20” fee structure, the incentive fee will be $.6 million instead of $2 million if there was no hurdle rate (assuming the incentive fee was calculated independently of the management fee).

A high water mark is the highest value, net of fees, which a fund has reached.  Suppose a fund with an initial investment of $100 million has the following year-end market value over three years: $110 million, $102 million, $110 million.  During the third year the manager will not earn an incentive fee because the fund has not appreciated over the high water mark of $110 million (not taking into consideration the net of fees aspect).  High water marks protect investors for paying for the same performance twice.

Now that you understand the legal structure of hedge funds, as well as the management and incentive fees, it is probably a good time to dive into the strategies that hedge funds use.  To begin, hedge funds use long and short positions and are usually heavily leveraged, meaning that they invest borrowed funds.  The main goal is to earn a return that is independent of market performance through several different strategies including event-driven, relative value, and equity hedge strategies.  By no means is this list exhaustive – there are an unlimited amount of strategies that hedge funds can use, and most of the time they are kept confidential.

Event driven strategies seek to profit from short-term events that affect individual companies such as a mergers/acquisitions or the restructuring of a company’s debt.  Examples include purchasing the stock of a company that is being acquired and selling short the stock of the acquiring company when the M&A is announced.  Another example of an event-driven strategy is when funds focus on purchasing enough equity in a company so they can influence its direction (such as replacing management).

Relative value strategies seek to profit from pricing discrepancies between securities that are related.  An example is convertible arbitrage which occurs when a fund simultaneously purchases a company’s convertible bond and sells short the same company’s common stock.

Lastly, equity hedge strategies focus on public equity markets and take long and short positions in equity and equity derivative securities.  A simple example of this is a hedge fund taking a short position in an equity that they perceive is overvalued in the market.

At the end of the day, hedge funds use derivatives and leverage to maximize their return.  It is important for potential investors to do their due diligence on funds because the managers may take on large amounts of risk to chase their 20% incentive fee.  Although the use of leverage can magnify returns, it can also be very costly if a fund bets the wrong way and has a margin call.  The reason hedge funds can take on additional risk and use derivatives and leverage is because unlike mutual funds and other investment vehicles, hedge funds are not subject to some regulations by the SEC.  However, the Obama administration did crack down on hedge funds and their managers in 2010 through the singing of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

So, hedge funds are investment vehicles that are less regulated then others which employ any type of strategy to make their investors money no matter what state the economy is in.  You might want to know where you can sign up for one.  Well… not so fast.   There are many stipulations that must be met in order for you to ‘qualify’ to be an LP such as the total amount of your assets, the total amount of your investable assets, your ability to absorb losses, and your tax status.  This article explains who can invest in hedge funds in more detail.

The hedge fund business is probably the most competitive field in the finance industry, and many hedge funds want employees that have backgrounds besides finance/economics such as math, physics, and engineering.  Hopefully this article gave you some insight on what a hedge fund is legally, the cost of investing in one, as well as the strategies that they use.

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