Articles


What do hedge funds do?

H
edge funds are privately managed pool of capital that are loosely regulated or unregulated and not widely available to the public. Generally Hedge funds focus on absolute return, their aims are to make money whatever the market does, hedging its risk or not. A common misconception is that hedge funds hedge their risk. This is not true as hedge funds can place a bet on a specific market taking some risk in order to generate profits.

Experienced fund managers who have left their company in order to run a business themselves usually run hedge funds. In April 2011, the total asset under management for hedge funds was nearly $2 trillion.

If you are a regular individual investor, it will be difficult to invest directly in a hedge fund. Most hedge fund investors are high network individuals and institutional investors (pension funds, endowments, foundation, insurance companies). If you want to invest in a hedge fund, you have to be a qualified investor or accredited investors (see the SEC website)

»Accredited investors

Your net worth is more than $1 million, you earn $200‚000 alone and 300‚000 combined with a spouse.

»Qualified purchaser

You are an individual with at least 5 millions in investable assets or an institutional with at least $25 millions in assets.

In addition, the minimum investment with a hedge fund can reach $1 million plus further commitments. Don’t be disappointed, we will see that it is still possible to invest indirectly in hedge fund strategies.

Hedge fund industry uses a particular vocabulary, before continuing we need to explain some of them.

Hedge fund glossary

»Leverage

Leverage can be achieved by borrowing from financial institutions or by using derivatives. Hedge funds utilize leverage with the purpose of magnify the profits. Unfortunately it is a double-hedged sword as it can multiply your losses.

»Short Selling

When you want to bet that a security price will fall, you use the short selling technique. Usually you borrow a security from your broker and if the security price falls, it will cost you less to reimburse this "borrowing".

»Alpha

According to the investment theory alpha doesn’t exit because markets are perfectly efficient. Alpha can be generated by hedge fund manager and represents riskless profits. For example, if a fund manager has generated 5% profits when his benchmark (like an index) has returned 3%, the alpha is 2% with the condition that the fund manager and benchmark positions are exposed to the same amount of risk.

Hedge fund structures

Hedge funds are generally structured in partnerships: one general partner (with unlimited liabilities) and limited partners (the investors with limited liabilities).

Because hedge funds exploit unique opportunities, their structures are different from regular mutual funds.Hedge funds have for example fewer disclosure requirements than mutual funds.

Mutual fund cannot charge any performance fees. Instead, most hedge funds charge a management fee plus a performance fee. So, in general, hedge funds are more expensive than mutual funds.

The regular fees structure for a hedge fund is the following: 2% management fee (a fee to pay each year based on the average asset under management) and 20 % performance fee (a fee to pay each year based on a specific performance).

A hedge fund is way less liquid than a mutual fund. In order to deal with non-liquid investment (investment that you cannot sell unless suffering a big discount), hedge funds have created the side pocket system.

»Side pocket

Side pockets are special shares distributed to investors that contain rights on illiquid investments. With this system, the hedge fund manager avoids selling assets at a discount.

»Notice period for redemptions

If you are invested in a hedge fund and you need your money back, you will have to suffer a redemption period. A redemption notice can be few months or a year.

»Redemption fees

In addition to the redemption period, a hedge fund can also charge you a redemption fee. It is generally a percentage on the amount withdraw.

»Lock-up period

A lock up period is a period in which an investor can withdraw his funds. This system has been implemented to help hedge fund manager to manage money without being bothered by early redemptions.

Notice period, redemption fee and lockup period are all ways to reduce the portfolio turnover and make the hedge fund manager’s work easier. For example, the hedge fund manager won’t be forced to sell assets at distressed prices because of redemptions.

Because of the performance fee system and in order to treat all investors equally, hedge funds have created special formulas. High water mark and hurdle are two of them.

»High water mark

High water mark is a formula that prevents an investor from paying twice the performance fees. For example, if you have subscribed one share at $100 and the hedge fund price goes to $120, you will pay the corresponding performance fees. After this the price goes to $90 and jump back to $120, you will not pay again the performance fee.

»Hurdle

A performance fee is due only if the performance is superior to the corresponding benchmark

Hedge funds strategies

As hedge funds are lightly regulated, they are able to engage any kind of strategies (only legal ones!). Here are the principal strategies, please note that the following list is not exhaustive.

Tactical
»Managed futures

The fund manager takes positions in the future commodity market. We can distinguish two sub categories: CTA discretionary traders and systematic traders.

CTA (commodity trading advisor) discretionary in which fund manager decides which future to sell or buy.

In a CTA systematic, it is generally a computer-based model generating trades.

»Global macro

A global macro fund manager uses macroeconomics data in order to invest. A global macro fund has generally huge assets. It also uses leverage to take sizeable positions in various markets.

Equity Long/short

An equity long/short strategy involves to taking both long and short positions inequities.

»Short sellers

Even if the majority of hedge funds are using short selling strategies, pure short sellers are very rare. A pure short seller strategy is very risky because you go against the crowd.

»Emerging market

Emerging market funds specialize in investing in developing countries where a low level of information permits potential profits for hedge fund managers.

»Market timer

This strategy is based on high level of trading.

Event driven

Event driven strategies are related to all corporate structure events. We can distinguish three categories:

»Distressed

Distressed strategies take advantage of bankruptcies, liquidations, recapitalizations or divestitures. In general, the fund manager takes positions in the debt of a distressed company. This strategy works better in bear markets when a lot of companies meet some difficulties.

»Merger arbitrage

When a merger is announced, the stock of the acquirer decreases and the stock of the target increases. To exploit this opportunity, the fund manager takes a short position in the stock of the acquirer and a long position in the stock of the target. The major risk with this strategy is if the merger may not go through.

»Event driven multi strategies

An event driven multi strategy can use both distressed and merger arbitrage strategies, switching from one to another depending on opportunities.

Relative value
»Arbitrage

You can profit from this opportunity by taking positions in securities and waiting for their prices to converge to their appropriate values.

»Convertible arbitrage

The fund manager takes a long position in a convertible bond and sells short the associated stocks.

»Fixed income arbitrage

Fixed income arbitrage strategies encompass various strategies, all related to fixed income securities. Some common strategies are exploiting the difference in yield curves, in tax treatments.

»Equity market neutral

This strategy is similar to the equity long/short strategy with the difference that equity market neutral has a stated goal of eliminating market risk using long and short positions.

»Index arbitrage

The fund manager exploits the difference between an index and the derivatives associated to it.

Relative value

With fund of funds the capital is allocated across various hedge funds. This vehicle permits to diversify both across manager and styles.Fund of fund is an expansive way to invest in hedge funds.

Why? Because you already pay management fees and performance fees at the individual hedge fund level. With the fund of fund, you pay additional performance and management fees at the fund of fund level. For example, if an individual hedge fund is delivering a performance of 10 % (with a performance benchmark at 5%), you will be left with less than 5.4%.

How to invest in a hedge fund if you are not a qualified investor?

Find mutual funds that use similar strategies. A lot of mutual funds propose long short strategies for example. Exchange traded funds are also a good instrument for individual to invest in hedge fund strategies.

Hedge fund performances

Don’t be misled by the stellar performance of hedge funds. First of all, hedge funds performances have diminished along the years because today too much money is chasing too few opportunities. Additionally the historical hedge fund performances are biased upward because of what we call the survivor bias.

»Survivor bias

This problem appears when calculating an index performance. Because under performing funds are closed and withdraw from the index, the index performance is biased upward.

How to pick up hedge funds?

Here are the principal questions to ask before investing in a hedge fund.

-Strategy, does this strategy can make money today?

-Fund manager, does the manager has a hedge on this strategy?

-Risk (volatility, maximum drawdown), operational risk (team, procedures)

-Performance: past performance and future performance.

Hedge fund resources

Websites

Hedge index has a large hedge fund database.

Hedge fund intelligence proposes news and hedge fund datas.

Eurekahedge is an independant data provider specialized in hedge fund and private equity.

Hedge fund research HFR specializes in the areas of indexation and analysis of hedge funds.

Hedgeco: Free education, articles on hedge funds.

Hedgefund.net proposes some free reports

Opalesque: Some resources are free. Free Youtube channel with Opalesque TV.

Hedge week: Fund performance and comparison tables.

Books

Hedge fund for dummies is good introduction on hedge funds.

When Genius Failed, The rise and the fall of Long-term Capital Management.The biggest hedge fund blow up in history.

Back to top

Dec 23, 2011