What’s a Hedge Fund?

Who doesn’t like the idea of sky-high annual returns?

The idea of attaining such is one of the reasons why people look to the services of hedge funds.

Apart from perhaps cryptocurrencies, hedge funds are among the only investments that can generate such returns—and the hedge funds suffering from such success achieve it far more reliably than most cryptocurrencies. 🪙

Furthermore, while cryptos are often considered the gold of future crashes, hedge funds are tried-and-tested investments for weathering crises and still inspire a lot of confidence. This became apparent with a surge in their popularity amidst the Covid-19 crash of 2020.

Still, they aren’t perfect, and many of you might consider them dated and inaccessible in a world where stock trading platforms have made many prime assets readily available to everyday investors.

Despite their flaws, with two-decade track records of average returns of over 60%, and yearly gains of 258%, hedge funds remain a vital part of the market’s eco-system and a very popular choice for those who can afford them.

So let’s take a deep dive into the fascinating world of hedge funds. 👇

The Definition of a Hedge Fund 📚

Hedge funds are pools of investments from multiple investors, managed with the intent of bringing significant positive returns. Unlike the now-popular index funds, which simply follow the market, hedge funds are actively managed—the fund manager makes active decisions on the investment strategy to vastly outperform the overall market.

Many of the big names of the investment world either are or have been hedge fund managers. Some of the most famous names among these managers include George Soros and Michael Burry—whose big short of 2008 came at the tail end of the latest real hedge fund golden era.

These investment vehicles can trace their lineage to 1949 and the Australian investor Alfred Winslow Jones. His company pulled $100,000 and combined holding long positions with hedging them against losses by short-selling other stocks.

This approach is the basis of one of the major hedge fund strategies—the so-called classic long/short equities model. Modern hedge funds employ numerous methods to varying degrees of success and can focus on and include any type of asset—from stocks and bonds all the way to cryptocurrencies in the last few years.

Throughout their long existence, hedge funds have achieved varying degrees of success. They were revolutionary when they came out, hailed as some of the best money-makers in the 60s—and got a lot of attention after a 1966 Fortune article—and are generally seen as sub-par since the crash of 2008/2009.

Hedge Fund Requirements 📜

Hedge fund requirements tend to be the biggest roadblock to investing in them. They boil down to “you have to be really rich to get in”. Essentially, an investor must fulfill certain criteria to invest either individually or as an institution.

Individuals have to be accredited investors by the merit of either:

• ☑ Having an annual income of $200,000 for more than two consecutive years;
• ☑ If married, having a total annual household income of $300,000 or more for two consecutive years;
• ☑ Having a total net worth of more than $1 million. For this purpose, your primary residence does not count as a part of your net worth.

Institutions are eligible if they either:

• ☑ Are a trust of more than $5 million with a “sophisticated investor” in charge. Sophisticated simply means a person with enough knowledge and experience to make informed financial decisions.
• ☑ Have a membership composed exclusively of individual accredited investors.

Apart from these requirements, most hedge funds have a very high minimum investment—you often have to make an initial investment of at least $1 million or more. Investors are also required to have at least $1 million invested in the fund at all times.

That said, some hedge funds will allow investors in on the action for as little as $100,000. On the other side of the spectrum, some funds have incredibly high minimums of over $5,000,000.

Are Hedge Funds Regulated? 🛡

While hedge funds must adhere to anti-fraud laws and requirements and have the fiduciary duty to act in their clients’ best financial interest, they aren’t regulated as intensely as other investment vehicles such as mutual funds.

The crux of this laxness is that hedge funds usually don’t have to register with the SEC. As a result, some funds adhere to various disclosure agreements and rules designed to protect investors. Furthermore, this makes researching and vetting a hedge fund beforehand somewhat tricky.

A particular double-edged sword regarding hedge funds regulation is their liquidity—hedge funds aren’t obliged to keep a portion of their assets in cash which can make exiting a fund hard for an investor.

On the flipside, the lack of such a regulation gives a hedge fund more ability to efficiently invest and make more money—which is in stark contrast to mutual funds, which are obliged to keep a percentage in cash and are often severely limited by it.

How Do Hedge Funds Work? ⚙

In a nutshell, when you invest in a hedge fund, you add your money to the money of numerous other investors and hand it all over to the fund’s managers to invest as they please—obviously, as long as everything is legal.

Subsequently, the fund may choose to invest in any type and combination of assets to maximize gains. These investment vehicles were initially designed to hedge against potential losses—hence the name—through a diversified strategy that often combined holding certain long positions while shorting other stocks.

Over the years, the name stuck, but many modern hedge funds include very little or no hedging in their strategies—which have, in turn, often become far more aggressive. These aggressive strategies often include leveraging—borrowing even more money to invest in a potential big earner—and contrarian investing.

Contrarian investing looks at the current market trend through a method like the Dow theory and does the exact opposite. While this might look incredibly imprudent, strategies like this can work exceptionally well. Just think of how Burry bet against the housing market in 2008—when that was considered a dumb move—and made billions when it crashed.

Hedge funds often use esoteric and other hard-to-acquire assets in their strategies. An esoteric asset is an asset that is very hard to evaluate and understand and is thus unavailable to the average investor.

Since hedge funds often employ convoluted, risky, or simply hard-to-grasp techniques, they have a minimum investment period. For example, many funds require at least a year-long commitment from their investors. Unfortunately, this can make hedge funds illiquid and make their risk-levels skyrocket to an unacceptable degree for all investors without a very high-risk tolerance.

The entire structure of modern hedge funds makes them a major double-edged sword. Their freedom to pick any strategy makes their earning potential limitless and makes reading the fine print beforehand mandatory. 

But on the other hand, the barriers to entry and exit help their managers make decisions they know will work but are hard to explain to non-professionals. Unfortunately, this can also lead to strange, unconventional strategies that can lose money.

Hedge Fund Fees 💵

Fees incurred with hedge funds are often considered their main drawback. A particularly common and unpopular fee structure is the infamous 2 and 20. This model entails that if you have $1,000,000 invested in a hedge fund, you have to pay $20,000 yearly, no matter the returns. On the other hand, if the fund makes a profit, the manager takes 20%.

The 2 and 20 Structure 💳

So, say that an investor, Sean, has around $1 million in the fund and that the fund lost about 2% in a year. He’d still have to pay them around $20,000. The following year, the fund does better and earns $50,000 for him. 

Then Sean would pay the usual $20,000 and $10,000 on top of that as a performance fee leaving him with an actual profit of $20,000. After that, he still has to pay taxes, and if he withdraws any money, it can get chipped at by inflation and so on.

This payment structure incentivizes managers to try and maximize profits no matter the associated risks—the $20,000 makes striving to win as big as possible very profitable, and the 2% ensures they are somewhat insulated from losses since they get paid either way.

Such an incentive can be both a great and a terrible thing. On the one hand, if the manager has a real sixth sense regarding finances, their victories are the investor’s victories, and one might even be able to start considering early retirement. 

On the other hand, if the strategy fails, the investor is not only at risk of losing a lot of money but have to pay the fund for the privilege of having them squander their savings.

Fortunately, though still common, the 2 and 20 model appears to be going away slowly. For example, the hedge fund Melvin Capital attempted to reinstate performance fees to mitigate its stunning 53% loss amidst the GameStop craze.

However, a year later, they announced they were scraping this initiative due to—among other factors—severe backlash. Such a development isn’t surprising considering how various index funds and ETFs—praised for their low fees—have seriously started encroaching on hedge fund turf.

Other Fee Structures 📃

That said, the 2 and 20 model hasn’t been the only fee structure for decades. Many funds will simply require a yearly percentage of invested assets. For example, the aforementioned Renaissance Technologies LLC (Medallion Fund) never charged a performance fee but just took a 5% asset fee.

While this might appear better—and often is—a 5% fee is still pretty steep and, combined with how often hedge funds underperform compared to broad market indices, is still far from perfect. Moreover, even 1-2% fees can seriously eat into profits, and the higher they go, the less money will be earned.

For example, let’s say there are two very similar funds—both have an annual return of 40%, but one charges 2%, and the other 5%. Let’s also say you want to invest for ten years, starting with $1 million and adding $100,000 every subsequent year.

Different Hedge Fund Strategies 👨‍🏫

While hedge funds can use any number and combination of strategies and assets, some general patterns remain prevalent, and most funds can fall under a limited number of categories. These categories are strategy-determined, and some of the major ones include long-short equity, event-driven, merger arbitrage, etc.

Hedge fund strategies will also often partly depend on the type of the fund. They can be open-ended, where shares are continuously issued; closed-ended, where the shares offered are a limited number initially; and listed hedge funds, where investors can trade shares on the market. 

Global Macro 🌐

Global macro hedge funds often employ some of the riskiest tactics to generate returns. These funds analyze global macroeconomic trends, including interest rate changes, currencies, large demographic shifts, crises, and many other events. 

They then target assets that have the potential to be affected by the changes located in the affected areas. While global macro funds can trade anything, there is generally a preference for currency forwards and futures trading among the managers.

These hedge funds tend to make big one-directional bets once they identify a trend from where the added risk comes. While betting big and being correct in one-directional trades can generate fantastic returns, things don’t always pan out as expected. Since few global macro managers hedge their investments, these hedge funds tend to have very volatile performance.

For example, the Russian invasion of Ukraine drove the oil prices sky-high and promised upheaval in the sector, which might have prompted global macro fund managers to make all sorts of bets. However, Russia is far from being the only oil supplier globally. In fact, Germany recently greenlit an embargo on Russian oil— making the actual outcome of the crisis much harder to predict—and thus much harder to earn from.

Long-Short Equity 🔗

The long-short equity funds keep the hedge in the hedge fund. Their basic strategy revolves around pairs—two companies in the same sector—and betting one will outperform the other. Think of the rivalries like Coke and Pepsi, McDonald’s and Burger King, Boeing and Airbus, Microsoft and Apple, and Disney and Netflix.

Essentially, a fund manager would analyze the market and determine if Boeing will outperform Airbus soon. Then, they would assume a long position on Boeing and short the shares of Airbus.

This approach is relatively safe since it has a pretty good number of successful outcomes—and thus a pretty good chance of success. The only thing needed is for Boeing to perform better than Airbus. After that, it doesn’t matter what happens on the broader market, and it doesn’t even matter if both companies lose money. 

As long as Boeing does better, investors can use that long position to cover the cost of shorting Airbus, and some money will be left over as profit.

Event Driven 📈

Event-driven funds base their strategy on significant market events and focus on distressed companies under the looming threat of bankruptcy or on companies whose distress has already turned into bankruptcy. The main tools of these funds are buying debt—primarily senior debt, which has the highest likelihood of repaying—and shorting the stocks of firms that are in trouble.

Managers and investors of these hedge funds need patience and nerves of steel—trying to make money off of struggling companies carries a significant amount of risk, and corporate restructuring and recovery can take months, or even years—if it happens at all.

The mass attempts to short the perceived-as-dying GME in late 2020 can be seen as a move of event-driven hedge funds. However, this particular event also highlights the risks associated with this type of fund as the subsequent short-squeeze sent several hedge funds into bankruptcy—and arguably pulled GameStop out of the gutter.

Market Natural 📊

Market neutral funds employ similar strategies to long-short equity funds but with vastly different goals. While most other funds attempt to generate returns as high as possible, a market-neutral fund tries to remain neutral—to protect its assets from market fluctuations.

This neutrality is achieved by placing the equal value of capital in long and short positions, thus rendering the overall market exposure to zero. Generally speaking, this makes market-neutral funds less risky than other types and comes with significantly reduced returns. 

Furthermore, finding a fund with very low fees is paramount since you might lose money even if the fund remains neutral. If you have to pay $20,000 yearly to the fund that is making you only about $10,000 in the same period, you might as well let inflation chip away at your savings.

Merger Arbitrage ⛓

Merger arbitrage funds seek to make money off of corporate mergers. Since the shares of the company being acquired are discounted, and the overall values of stocks are temporarily harder to accurately determine, this period is full of opportunities.

Furthermore, since the discount is guaranteed, there is little need for hedging the bet, allowing the manager to go all-in and make a hefty profit. However, as is usually the case, there is a catch.

Numerous inside and outside factors might prevent or complicate the merger—the main ones being shareholders voting against it and the overseeing institutions not approving it for some reason.

Since the opportunities that merger arbitrage funds seek happen before a merger has been completed, there is still a possibility of the bet going wrong—and if the merger fails, the hedge funds are bound to lose a ton of money.

Quantitative 👨‍💻

Quantitative funds employ quantitative analysis—as their name implies—on a vast number of stocks to find the best possible trading opportunities. Managers of these funds tend to have more of an overseeing role than an executive one. These hedge funds usually rely on algorithms that execute the trades as soon as they find an opportunity.

Subsequently, the management of the fund looks at the performance of their software and the quality of the parameters they’ve employed and makes tweaks to improve efficiency. Quantitative funds tend to be high-frequency traders—meaning they tend to make numerous large trades over relatively short periods.

While errors aren’t as common as you think with such a rapid trading strategy, problems can arise and cause issues like flash crashes—though these tend not to be very impactful long-term.

Examples of Hedge Funds 📝

While some of the drawbacks inherent to hedge funds might make them appear like a dying industry, they carry just enough appeal to remain relevant and continue growing in the modern markets. Between 2012 and 2019, the total assets under the management of hedge funds have grown from $2,2 trillion to over $3,5 trillion.

Furthermore, their numbers are growing as in 2022, there are more than 16,000 hedge funds, while they were fewer than 5,000 at the beginning of the century. But, as tends to be the case in the 21st century, a disproportionate amount of these assets are under a handful of giant hedge funds—so let’s take a brief look at some of them.

The Big Hedge Funds of Today 📗

Bridgewater Associates is one of the largest hedge funds globally and the most prominent global macro fund, with over $140 billion in assets under management. This fund boasts an impressive reputation with clientele, including various institutions like private foundations and even certain countries and central banks.

They have also proven reasonably worthy of the reputation. As of Q1 of 2022, the hedge fund has achieved returns of 16% since the year started.

Bridgewater’s strategy isn’t the ultimate winner, though. For example, Li Bei’s Shanghai-based Banxia Macro Fund closely followed Bridgewater’s doings until 2020, when they ditched their attempts to emulate the successes of the behemoth—and found a lot of success in doing so.

Banxia made an impressive gain of 258% in 2020 after altering their approach, and they have been going strong as recently as 2021 when they achieved 60%. However, 2022 has been rougher on the Chinese markets, and Banxia has again switched to a more defensive strategy akin to some market-neutral funds.

AQR Capital Investments is another behemoth among hedge funds. They are based in Connecticut and have around $164 billion in assets under management. This fund is known for employing both traditional and alternative investment strategies.

Renaissance Technologies (Medallion Fund) is one of the long-running outliers among various hedge funds. As we’ve touched upon, they haven’t had a bad year since 1989, and their consistently good returns are even more impressive considering they have nearly $131 billion under management.

This fund has also successfully transitioned to more computer-run and algorithm-driven investing, continuing to perform into 2022. Renaissance Technologies has also been a bit of a mystery even by hedge funds’ standards, which is pretty intuitive—why would they blunt their edge by sharing valuable strategies with competitors.

This fund also encountered legal trouble with the IRS, which ended in a court settlement worth $7 billion.

Hedge Funds vs. Mutual Funds ⚔

On the surface level, hedge funds are very similar to mutual funds—both investment vehicles pool money from numerous investors and try to generate the best returns possible. However, on closer inspection, it becomes obvious that there are many key differences.

Accessibility 🧐

The first factor most will be concerned with is the accessibility of a fund. Mutual funds are a clear winner in this category. While hedge funds have a minimum initial investment of up to $1 million, investors can get in on the action with a mutual fund for as little as $500.

Furthermore, while a hedge fund’s operations aren’t too regulated, investing in one certainly is. Retail investors, and institutions, must be accredited to even get a chance to invest—hedge funds are known to reject clients regardless of how wealthy or established they are. 

There are no such prerequisites for investing in a mutual fund.

Approach to Money Making 💰

Hedge funds tend to be more free-form than mutual funds, which, while different from ETFs, also tend to have a benchmark index. Essentially, this means that mutual funds tend to have a similar composition to their index of choice—S&P 500, for example—and try to emulate the results of that index.

On the other hand, hedge funds can have any composition their manager chooses and don’t have a set benchmark to compare themselves to. This freedom of investment is further compounded by the laxer regulation affecting hedge funds. For these reasons, hedge funds have a far greater earning potential than mutual funds—but can and often do lose more money than mutual funds.

Hedge vs. Mutual Funds Fees 🤺

A factor closely related to the profitability of funds is the associated fees. Mutual funds are, once again, akin to exchange-traded funds and have an expense ratio that tends to stay in the 0.5 to 1.5% zone. On the other hand, hedge funds tend to be far more expensive and often charge 2% of one’s total investment annually and seize a performance fee—the industry standard being 20% of returns.

While not all hedge funds have the dreaded 2 and 20 structure, even the funds that don’t charge a performance premium tend to have a much higher baseline cost—often in the zone between 2 and 5%.

Asset Liquidity 🌊

The liquidity of your assets in a fund is another major difference. Since mutual funds are obliged to keep a portion of their assets in cash, they are near-completely liquid. On the other hand, mutual funds can be fairly illiquid. For example, they often have a minimum investment duration of a year. Even after that period has passed, they allow new entries or exits only once a month or quarterly.

Things to Consider Before Investing in a Hedge Fund 🤔

Considering the numerous strategies a hedge fund may employ, their usually high fees, and wildly varying success, there are many important factors to consider when investing in a hedge fund.

The required minimum investment should be the first thing you look up. There is little point in even considering hedge funds you can’t afford to invest in.

The Initial Steps 🚶‍♂️

As with most forms of investing, another important initial step an investor must take is to define their goals and risk tolerance. This will help identify agreeable funds and determine an acceptable performance benchmark. Generally speaking, there are several steps investors take when seeking a benchmark. 

The first one—like with most risky assets—can be finding out the return rates of risk-free assets. Since there is little reward with no risk, these tend to be small, so one might as well immediately disregard any fund that doesn’t outperform this benchmark.

Then, we can check out how the market overall has been doing. This is particularly important since hedge funds—on average—underperform compared to the S&P 500.

Considering the number of ETFs and mutual funds that either consistently outperform the market or at least match it—and the ease of access to these funds through low-cost online brokers—it would be pointless to invest in a losing and pricey hedge fund.

Additional Considerations 🗃

After these initial steps to weed out the bitter herbs, investors can focus on other, more specific criteria. The size of a hedge fund is one of these. One might find extremely large funds appealing if they are a big investor. But, on the other hand, if an investor doesn’t have tens of millions to spare, they might not want to risk the red tape and other complications a fund with $100 billion under management might face.

That said, this isn’t really a deciding factor. A fund that has spent the last decade with an average return rate of 80% is better than a fund that tends to make 10%—no matter their size. The fund’s track record is perhaps the most critical factor to consider.

The other incredibly important factor is the associated fees. Often we’ll find that a fund with a return rate of 40% is better than one making 80% if its fees are significantly lower.

Finally, investors should consider the fund’s liquidity. Money’s no good if one can’t actually get to it, right? This factor, along with the risk levels of a fund, becomes increasingly more important the closer someone is to retirement and the lower their overall savings are. 

A person that will have to start withdrawing money next year can afford far less illiquidity than an aspiring investor in their twenties. Furthermore, an investor that can pull thousands of dollars in emergency funds from other assets can afford a more restrictive hedge fund than one with most of their money vested in said fund.

Pros and Cons of Investing in Hedge Funds ⚖

Considering the number of benefits against the drawbacks associated with investing in a hedge fund, we can see why they still possess great appeal and remain controversial. On the one hand, their freedom to invest in nearly any way the manager sees fit can help them seize opportunities unavailable to most other investment vehicles.

This benefit is compounded by the fact that they are nearly universally institutional investors, which grants them access to otherwise obscure but lucrative trading avenues. Hedge fund managers can increase their earning potential by using leverage—borrowed money—when buying assets.

On the other hand, each of these features also helps make losses suffered by hedge funds staggering. Considering how common the stories of hedge funds losing millions—like Pershing Square dumping Netflix shares to a loss of around $400 million—these dangers are more than worthwhile considering.

Some retail investors might balk at the sound of this and opt for taking matters into their own hands and investing on their own. So long as they’re trading with a leading stock broker, investors can garner significant income without depending on hedge funds. This does, however, require copious amounts of time, research, and trial-and-error.

Another major drawback of hedge funds is their prices. Both the minimum investment and the fund’s operational fees can be downright prohibitively expensive for all but the wealthiest investors and the best-performing funds.

Final Word 🏁

Despite the number of setbacks hedge funds have suffered over the past decade or so, they carry more than enough appeal to remain a major player in the market. While most of these funds are losers in the grand scheme of things, the winners are numerous—and spectacular—enough to ensure a steady stream of new prospecting investors.

Furthermore, the fact that hedge funds tend to outperform the indices in a bearish market might make them more popular than in a decade—numerous experts are warning of a significant looming crash. We’ve already witnessed a surge in the popularity of hedge funds due to the pandemic. Such a trend will likely repeat.

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