The short version
- Hedge funds are investment vehicles that pool money from investors and invest in various highly liquid assets, including stocks, bonds, and derivatives.
- These funds are typically managed by professional money managers who use aggressive strategies to achieve high returns and who also take “performance fees” from the fund's profits.
- There is no single hedge fund strategy; however, many fall under the same broad category of techniques, such as long/short equity and merger arbitrage.
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A short history of hedge funds
Investor, writer and sociologist Alfred Jones coined the term “hedged fund” in 1949. His idea was that the fund would ” go long” and buy company shares and then avoid market risk by shorting other stocks. This would neutralize any significant swings in the market and allow a manager’s stock-picking ability to shine through.
Hedge funds didn't achieve instant popularity. However, in the 60s, they outperformed mutual funds and were the subject of articles in high-profile publications such as Wall Street Journal and Fortune. Early hedge fund managers included Bernard Baruch, Jesse Livermore, and George Soros.
The 1990s bull market saw a massive increase in the number of hedge funds. Pension, insurance, and endowment funds began to allocate significant capital to hedge funds, whereas before, most investors were wealthy individuals or families. Today, hedge funds are a significant force in the financial world, with trillions of dollars in assets under management.
How do hedge funds work?
Hedge funds are designed to protect investments against market risk. To do this, hedge fund managers will often short stocks. This means they will sell a security they do not own and hope to repurchase the same security at a lower price so they can pocket the difference. By hedging this way, the manager can offset any losses they might incur on the long positions in the portfolio.
While this strategy can effectively protect against market risk, it's also risky. If the market moves against the hedge fund manager, they could lose money on both the long and short positions in their portfolio.
Read more: What Is short selling stocks? Should I do it?
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How do hedge funds make money?
Hedge funds make money by charging management fees and performance fees.
Management fees are typically charged as a percentage of assets under management and they cover the fund's costs. Performance fees are usually a percentage of profits, providing an incentive for the fund managers to generate returns.
Traditionally, hedge funds use the “2 and 20” rule for fees. This means the fund manager will charge a 2% management fee and a 20% performance fee. However, there is a lot of variation between different hedge funds, and fees have gotten smaller in recent years.
Who can invest in hedge funds?
Hedge funds are typically only available to accredited investors. In some cases, hedge funds may also be available to institutional investors, such as pension funds.
While non-accredited investors can't invest in hedge funds, they can invest with Titan which is a robo-advisor that aims to mimic many of the same strategies.
Types of hedge funds
Hedge funds can hold various assets: Hedge funds have bought everything from uranium to New York City taxi medallions. Below are some of the major hedge fund categories.
Stock picking: Many hedge funds maintain that they can charge their high performance fees because of their ability to pick undervalued stocks that will outperform the market. Some investors focus on value investing or growth investing, while others cover specific market areas. A great example of this kind of hedge fund is Bill Ackman’s Pershing Square Capital.
Long/short equity: This is the original hedge fund strategy. With a long/short strategy, a hedge fund manager will invest the same amount in shorting stocks as their long positions. The idea is that this neutralizes the broad moves of the market and allows the performance of individual stock picks to shine through. How managers construct their long/short portfolios varies from hedge fund to hedge fund.
Merger arbitrage: These funds bet on the successful completion of corporate mergers and acquisitions. The strategy involves buying shares of the target company and short-selling shares of the acquiring company.
Volatility arbitrage: The goal of volatility arbitrage is to profit from the gap between an asset's expected future price volatility, such as a stock, and the implied volatility of options based on that asset. It may also look for spread fluctuations to widen or narrow to predicted levels. This technique involves using options and other derivative instruments.
Global macro: These hedge funds bet on global economic trends, such as interest rate changes, currency fluctuations, and commodity price movements. The goal is to generate returns by taking long or short positions in a variety of asset classes around the world.
Event-driven: Event-driven hedge funds seek to profit from corporate events, such as mergers, bankruptcies, and restructurings. The strategy involves taking long or short positions in a company’s stock, bonds, or other securities.
Pros and cons of investing in a hedge fund
Pros
- Hedge funds are not constrained by the same regulations as traditional investments, so they can pursue a broader range of strategies.
- They typically have lower fees than traditional investments.
- The fee structure aligns the fund manager's interests with those of the investors.
- Hedge funds can help to diversify a portfolio and reduce risk.
Cons
- They are often highly leveraged, which can amplify losses.
- Investors in hedge funds are typically required to make hefty minimum investments in addition to meeting the accredited investor requirements.
- Hedge funds can sometimes be illiquid, so investors may not be able to access their money for long periods.
Hedge fund vs. venture capital vs. private equity funds
Hedge funds have a few main differences from venture capital funds (VC) and private equity funds (PE). VC and PE funds tie up investors’ money for a set period – often up to ten years. With hedge funds, however, generally, an investor must give their hedge fund manager one quarter’s notice to liquidate their position.
This is because VC and PE funds invest in assets that aren’t traded on an exchange, such as real estate, private businesses, infrastructure (PE) or technology startups (VC). It can take years before the investment can be converted into cash.
On the other hand, hedge funds generally invest in publicly traded stocks, bonds, commodities and currencies. These more liquid investments mean it's easier for investors to cash out.
The bottom line
Despite their long history, hedge funds remain a controversial investment vehicle. Some critics argue that they're not worth the risk. Nevertheless, hedge funds continue to attract a significant amount of capital and will likely remain a major force in the financial world for years to come.
If you're considering investing in a hedge fund, it's essential to research and ensure you understand the risks involved. For example, you could start with information from the SEC. But for many investors, the potential rewards of hedge fund investing make it worth taking on that risk.
Further reading:
- How do employee stock options work?
- How to invest in the S&P 500 Index
- What Is fractional share investing?
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