Hedge Funds: An Overview

Hedge funds are private investment partnerships that use a variety of non-traditional strategies, many of them considered too risky by more conventional fund managers, with the objective of delivering exceptional returns. The risks are reduced by using an approach called—you guessed it—hedging.

Hedge funds are similar to mutual funds and exchange-traded funds. All are pools of money entrusted to a financial professional. But a key difference is the degree of latitude that the hedge fund manager has. Their investment choices are relatively unconstrained and the industry is relatively unregulated.

They are also comparatively expensive in terms of the fees they charge, which usually include both a management fee and a percentage fee of the profits.

Key Takeaways

  • Unlike most mutual funds and exchange-traded funds, hedge funds may invest money in a wide array of investments and use non-traditional investing strategies.
  • The fees for these funds are high, usually combining a management fee and a performance fee.
  • Hedge funds aim for outsized returns. Not all deliver them.

Hedge Funds In Depth

Once viewed as a secretive and risky investing option for the well-heeled, hedge funds have become a growth industry. They aim for higher-than-average returns even in a downtrodden market. But despite the allure of these alternative investment vehicles, individual investors should think twice before taking the hedge fund plunge.

The "hedge" in hedge funds comes from the use of a wide variety of strategies to offset the risks of other investments in the fund.

One such technique is short selling. That is, an investor identifies a stock that looks like it's headed for a price decline, borrows shares of it from another investor, and then sells those borrowed shares. The short seller expects to make money at a later date by buying the shares again at a lower price in order to replace those that were borrowed. The short seller nets a profit only if the share price does, in fact, decline. If not, the short seller loses money on the deal.

Hedge fund managers also may invest in derivatives, options, futures, and other exotic securities.

Generally, hedge funds operate as limited partnerships or limited liability companies and rarely have more than 500 investors each. The minimum investment is high, with a $1 million investment not uncommon. They attract institutional investors as well as high-wealth individuals.

The 2 and 20 Rule

Hedge funds typically charge investors according to the "2 and 20 rule." That's a 2% fee against the amount invested annually plus 20% of the profits.

Arguments for Hedge Funds

Managers of traditional mutual funds generally rely on identifying and buying stocks and other assets that they believe will go up in value over time. For hedge funds, at least in principle, it makes no difference whether the market goes up or down. There's money to be made out there in good times and bad.

Mutual fund managers aim to outperform a particular benchmark, such as the S&P 500 Index. An investor in a mutual fund can see at a glance whether the fund really did outpace the benchmark for the quarter or for the year.

Hedge fund managers disregard benchmarks. They aim instead for absolute returns, the higher the better. In most cases that is a return of a certain percentage in profit, year in and year out, regardless of how well the stock markets are performing or whether the economy is weak or strong.

The argument goes like this: Hedge funds protect their investors' money by not tracking the ups and downs of the stock markets. They chase the money wherever it goes.

Then again, hedge fund managers don't have a leg to stand on if they fall short of the most commonly-tracked indexes.

Several successful hedge funds have demonstrated that hedge funds can generate extremely high returns and extremely high losses. Quantum Fund manager George Soros, for instance, famously "broke the Bank of England" by shorting the British pound in 1992, scoring $1 billion when the currency was devalued. Then, in 1994, he tried a similar gambit, shorting the Japanese yen, and lost hundreds of millions of dollars in one day. In 2011, Soros turned his hedge fund into a family investment vehicle in order to avoid regulatory scrutiny.

In 2020, the average hedge fund underperformed the market indexes, according to a report from Reuters. The best returns came from funds devoted to stock-picking, which scored double-digit returns by choosing the stocks of companies that focus on technology and stay-at-home products.

Why Investors Might Want to Think Again

For starters, there is a catch: Many hedge funds require a minimum investment of $1 million. Granted, investors can now choose from a growing number of hedge funds with more affordable minimum investments. The lowest ones, however, start at $100,000.

What about the risk? High-profile collapses are reminders that hedge funds are not immune to risk. Led by Wall Street trader John Meriwether and a team of finance wizards and PhDs, Long Term Capital Management imploded in the late 1990s. It nearly sank the global financial system and had to be bailed out by Wall Street's biggest banks.

Hedge funds also cost more than most managed investments. The standard hedge fund fees are commonly referred to as "2 and 20," meaning that they charge a fee of 2% of the assets under management plus 20% of the profits above a certain benchmark.

Traditional financial advisors charge a flat fee of about 1% of assets under management. The average mutual fund fee is between 0.5% and 1%.

One final note: Hedge funds are not regulated as closely as mutual funds. In fact, many are not even required to file with the Securities and Exchange Commission or to file public reports.

A Closer Look at the Risks

Choosing a long-term hedge fund can be just as tricky as picking stocks on your own. One of the key risks with hedge funds is the rate of closures (which has been on the rise during the COVID-19 pandemic) for funds.

Management inexperience may explain the high rate of attrition. There were more than 3,600 hedge funds in the U.S. as of June 2020, a dramatic increase from 880 in 1992. Logically, this means that many of the managers may have come from traditional mutual funds and have less experience with the esoteric choices available to hedge funds. They must learn by trial and error.

The high fees also must be taken into account. A fund has to return a stellar performance in order to overcome a fee of 1% to 2% of assets plus 20% of profits. Given the profits that managers take, hedge funds often don't deliver to investors the promise of market-beating performance.

Another sticking point is a lack of transparency. The Securities and Exchange Commission doesn't dictate the same strict rules for hedge funds that it does for traditional mutual funds. Managers can build their portfolios as they please, and there are no rules for providing information about their specific holdings and their individual performance.

Although hedge funds are subject to anti-fraud standards and require audits, you should not assume that managers are more forthcoming than they need to be. This lack of transparency can make it hard for investors to distinguish risky funds from relatively tame ones.

Finally, hedge funds profits can cause a big tax bite for investors. Because managers buy and sell frequently, their investors incur high capital gains, which are normally taxed at the ordinary income tax rate rather than the capital gains rate.

The Bottom Line

The logic behind hedge fund investing is compelling, but before piling in, investors should take their time and do the necessary due diligence on the fund and its managers. Take a close look at the fees. And consider if you wouldn't be better off with an index fund or an ETF.