If you are an investor, you must have heard about mutual funds. But are you familiar with Hedge Funds? These pooled investment vehicles use specialised investment strategies across various asset classes to generate hefty returns.
In simple terms, hedge funds are similar to mutual funds but are only available to ultra-wealthy institutional and accredited investors. However, unlike mutual funds, Hedge funds utilise advanced trading strategies like hedging, shorting, and using leverage to minimise risk and at the same time generate high returns for their wealthy clients.
Hedge funds are actively managed by professional traders and designed to produce high returns using advanced trading strategies. This is why they charge a much higher fee than traditional mutual funds and ETFs available to retail investors. Moreover, hedge funds also feature very high investment minimums, making them inaccessible to the average investor.
In the investment market, hedge funds are considered alternative investments, which means they don’t quite fit into the equity or fixed-income security categories. Since these funds are subjected to less regulation than traditional mutual funds, the assets they buy and the strategies they use can differ significantly.
In this blog, we will dive into the world of Hedge funds and sum up everything there is to know about them.
What are Hedge Funds?
A hedge fund is a private investment vehicle that uses the funds collected from accredited investors like banks, high-net-worth individuals, insurance firms, etc. and implements advanced and diverse strategies to earn large returns for its investors. This is why these funds often function as private investment partnerships or overseas investment corporations. Unlike other mutual funds, they are not required to be registered with SEBI, nor are they required to disclose their NAV periodically.
Hedge funds are quite similar to mutual funds. However, they are comparatively less regulated, use broad and aggressive strategies, and have very high investment minimums, making them unavailable for the average investor.
These funds cater to a small number of huge investors who are usually ultra-wealthy and are able to absorb the loss of the entire capital. Most hedge funds only allow investors who are ready to invest a minimum of $10 million. Hedge funds are generally managed by a Hedge Fund Manager who is responsible for the operations of the fund and investment decisions.
The criteria for becoming a Hedge Fund Manage is quite unique- you must be one of the largest investors in the fund which will make you extra cautious when making crucial investment decisions.
How Do Hedge Funds Work?
In simple terms, the primary objective of a hedge fund is to use advanced trading strategies that will allow it to generate returns regardless of the market condition. Hedge funds aim to profit whether equities or other assets are going up or down so their wealthy clients can make a profit even in bear markets.
Most hedge funds buy publicly traded stocks but can also utilise alternative assets like real estate, currencies, fine art, cryptocurrencies, and more in their money-making strategies. Each hedge fund is different and utilises different techniques to achieve its goals. However, all aim to produce large returns for their investors while minimizing risk.
Originally, the hedge fund industry formed from the objective of hedging the portfolio risk stemming from long positions. The name hedge funds comes from the way they minimize risk- most funds ‘hedge’ their bets by taking an offsetting position in assets they have been holding for a long time. This can mean buying put options or even investing in assets that tend to outperform at different times in the market. In doing so, they can minimize their losses if the assets they have been holding for long decrease in value.
Who Can Invest in a Hedge Fund?
Unlike open-ended funds like mutual funds and ETFs, hedge funds are inaccessible to most retail investors. Generally, only high net-worth individuals, accredited investors, or institutional investors can buy into hedge funds.
The criteria for qualifying as an accredited investor are monumental. In order to qualify, you must have a net worth of $1 million+, have an annual income of $200,000, or be a licensed investment professional. Most hedge funds have investment minimums of $25,000 to $1 million.
Types of Hedge Funds
While there are various types of hedge funds, each with its own focuses and objectives, 4 of them are the most common. Here are the types of hedge funds common in the market.
Long-Short Equity Hedge Funds
Long-short equity funds are the most common type of hedge fund in the market. These funds buy(go long) stocks they think will appreciate and sell(short) stocks they think will decrease. This strategy helps minimize risk and exposure to market volatility by maintaining a position that can churn out returns in both bull and bear market conditions.
Global Macro Hedge Funds
Global Macro hedge funds aim to capitalise on the changes in macroeconomic factors like market shifts that occur due to economic and political events happening worldwide. Macro funds rely on research and make careful trading decisions based on fluctuations in things like interest rates, national and international policies, indexes, and currency values.
These funds are generally highly diversified and use a lot of leverage to maximize returns. Due to this reason, Macro hedge funds are considered quite risky and many notable funds like the Long-Term Capital Management have failed.
Relative Value Arbitrage Hedge Funds
Relative value hedge fund investing aims to make money from the price differences of closely related securities. In order to do this, they attempt to determine which securities are undervalued compared to their counterparts and which ones are overvalued. After that, they buy long and sell short accordingly. These types of hedge funds buy on margin and often use leverage.
Distressed Hedge Funds
As the name suggests, distressed hedge fund investing often involves distressed securities like junk bonds of companies that are in financial distress but can recover from it. Due to the high level of risk involved, these bonds are quite cheap for their yields. Moreover, distressed funds also invest in instruments like loan payouts and restructuring.
How Do Hedge Funds Make Money?
Now that you have understood what is a hedge fund along with the various types of hedge funds, you must be wondering- How do hedge funds make money?
Traditionally, many hedge funds charged clients the “2 and ‘20 arrangement, which is a 2% management fee and a 20% performance fee.
2% Management Fee:
A 2% management fee is charged based on the net asset value(NAV) of each limited partner’s(LP) investment contribution. It is also used to cover the cost of operating the hedge fund and employee compensation.
20% Performance Fee:
A 20% performance fee incentivises hedge fund managers to achieve stronger returns. It is also known as carried interest.
Once the General Partner(GP) is on board and earned the 20% carried interest, all profits from the fund are split into 20% to the GP and 80% to the LP. This had been the traditional fee structure in the industry before the 2008 recession.
Following the 2008 recession, the fees charged in the hedge fund industry have significantly declined. Over the past decade, the management fee and performance fee have notably declined across the industry, especially for larger more institutionalised hedge funds.
- Management Fee: 2% to 1.5%
- Performance Fee: 20% to 15%
Moreover, the LPs of a hedge fund can negotiate certain provisions to ensure no preemptive performance fee has been obtained-
Claw-Back Provision: The Limited Partners can retrieve fees previously paid for the original percentage of the agreement, which implies that the fund incurred losses in subsequent periods.
Hurdle Rate: A minimum rate of return is established which must be surpassed before any performance fee is collected. Sometimes, once the threshold is completed, there is a catch-up clause for the General Partners to receive 100% of distributions.
High-Water Mark: In this provision, only capital gains above the high water mark ( the highest peak value of the fund reached) are subject to a performance-based fee.
Read Also:- A Comprehensive Guide on Options Contracts
Hedge Fund vs Mutual Funds: What’s the Difference?
While hedge funds and mutual funds may seem similar, they are actually distinct investment vehicles with significant differences.
|Hedge funds are not available to the general public and only cater to a select group of investors that fit the criteria. More often than not, the Limited Partners are institutional investors like accredited individual investors. Moreover, the minimum investment is also way higher than normal, sometimes more than a million dollars.
|Unlike hedge funds, mutual funds are available to the public and can be bought by retail investors.
|Hedge funds often employ relatively riskier investment strategies to get more yield, which has become more and more difficult over the years. The most common strategies include short-selling, reliance on leverage(i.e. borrowed funds), financial derivative instruments, and arbitrage strategies.
|Mutual funds are generally more conservative and suitable for the long term. The focus tends to be on capital preservation and managing risk through a diversified portfolio of stocks, bonds, and other securities. However, some mutual funds also engage in riskier strategies but they are considered exceptions.
|Hedge funds have a wide range of investment strategies and often adjust their management style based on changes in the financial markets and sometimes the global economy.
|Mutual funds are traditional investment vehicles with predefined investment strategies which are described to the investor. This means that the investing style of the mutual funds cannot switch abruptly and deviate from the strategy listed in the mutual fund’s prospectus, or the manager of the funds will be at risk of litigation.
|Hedge funds are more flexible than mutual funds as they are relatively less regulated. However, they are also prone to risks like insider trading investigations and scrutiny from the general public.
|In comparison, the SEC highly regulates mutual funds to ensure transparency and ensure that mutual fund managers are adhering to specific standards designed to protect the best interest of investors.
|The fee structure in the hedge fund market is “2 and ‘20, which means the firm charges a 2% management fee and a 20% performance fee.
|Similar to hedge funds, mutual funds also charge a management fee which is known as an expense ratio. It is based on the percentage of assets under management but the fee is much lower compared to hedge funds and there is no performance fee.
How to Invest in a Hedge Fund?
If you are interested in investing in hedge funds, you must fulfil one of the listed criteria to qualify as a limited partner-
- Personal Income of $200,000+ annually
- Combined Income with Spouse of $300,000+ annually
- Personal Net Worth of $1 million+
You must also supply documented proof that you are more than capable of maintaining your current income level for at least two or more years.
The investors or limited partners of a hedge fund are generally individual and accredited investors who are looking to diversify their portfolios while still earning hefty returns simultaneously.
Institutional Investors: The institutional investor refers to companies with significant amounts of capital to allocate across various asset classes. Common examples of institutional investors include university endowments, pension funds, sovereign wealth funds, and certain firms in the banking industry.
High Net-Worth Individuals: High Net-Worth Individuals(HNIs) are non-institutional investors with a large amount of personal wealth. You must have a net worth exceeding $1 million (excluding the value of the primary resident) or have a personal annual income of $200,000(or $300,000 combined income with a spouse) to qualify as an accredited investor in the United States of America.
Family Offices: Family offices are private wealth management firms that cater to individuals with high net worth. Unlike traditional wealth management firms, where the offers are available to every investor, family offices only serve affluent individuals or families.
Funds of Funds(FOF): The investment structure of funds of funds invests in various types of funds, including hedge funds. The FOF strategy is tailored around allocating capital across different funds, rather than selecting the equity or debt investments themselves.
Note: Hedge funds carry substantial risks and the illiquid nature of investments along with the high fee structure are significant disadvantages compared to ETFs and mutual funds. The high minimum investment is to limit access to more sophisticated and experienced investors.
Features and Benefits of Hedge Funds
Here are the most common benefits of investing in hedge funds.
High Net-Worth Investors
Because of the high investment minimums, only individuals with high net worth, or accredited investors can buy into hedge funds. They are mainly ultra-wealthy individuals, insurance companies, banks, endowments, or pension funds. The minimum ticket size for investing in hedge funds ranges from $25,000 to $1 million
Hedge funds have a comprehensive portfolio of investments including currencies, stocks, real estate, fine art, cryptocurrencies, equities, bonds, derivatives, etc. They nearly cover all asset classes and are only limited by the mandate.
High Risk, High Reward
The investment strategy for hedge funds can expose them to significant losses. Moreover, the lockdown period for investments is also quite long. In other words, hedge funds can be incredibly risky and investors must be prepared for losses. However, high risk often comes with high rewards. If your strategy works, you can stand to earn millions.
Hedge funds are capable of making profits even in volatile market conditions. This ability equips them to generate returns with little correlation to traditional investments. It is not mandatory that if the market is going down, the portfolio would be making a loss and vice versa.
Hedge funds are generally considered a risky alternative investment choice with high investment minimums. Moreover, they are only accessible to accredited investors or high-net-worth individuals There are various strategies that can be used to maximize returns including investment in debt and equity securities, commodities, currencies, derivatives, real estate, etc.
Unlike mutual funds, hedge funds are loosely regulated by the SEC and earn money from the 2% management fee and 20% performance fee structure.
Frequently Asked Questions(FAQs)
Ans. Hedge funds are private investment vehicles that offer great returns to the investor. Moreover, they are only accessible to accredited investors and individuals with high net worth. A wealthy individual who can afford to cover their losses might be interested in diversifying their portfolio with hedge funds. They may also be attracted to the reputation of their manager, the specific assets, or the unique strategy that it employs.
Ans. The primary hedge fund investment strategies are as follows-
Global macro strategies
Directional hedge fund strategies
Event-driven hedge fund strategies
Relative value arbitrage strategies
Ans. Hedge funds and mutual funds are pools of money contributed by many investors who aim to earn a profit for themselves and their clients. However, hedge funds are actively managed by managers who buy and sell particular investments with the sole aim of exceeding the returns of the markets. While hedge funds aim for the greatest possible returns, they also take the greatest risks to accomplish that objective.