The use of hedge funds in financial portfolios has grown dramatically since the start of the 21st century. A hedge fund is just a fancy name for an investment partnership that has freer rein to invest aggressively and in a wider variety of financial products than most mutual funds. It's the marriage of a professional fund manager, who is often known as the general partner, and the investors, sometimes known as the limited partners. Together, they pool their money into the fund. This article outlines the basics of this alternative investment vehicle.

Key Takeaways

  • Hedge funds are financial partnerships that use pooled funds and employ different strategies to earn active returns for their investors.
  • These funds may be managed aggressively or make use of derivatives and leverage to generate higher returns.
  • Hedge fund strategies include long-short equity, market neutral, volatility arbitrage, and merger arbitrage.
  • They are generally only accessible to accredited investors.

The First Hedge Fund

A former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co. launched the world's first hedge fund back in 1949. Jones was inspired to try his hand at managing money while writing an article about investment trends in 1948. He raised $100,000 (including $40,000 out of his own pocket) and tried to minimize the risk in holding long-term stock positions by short selling other stocks.

This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance returns. In 1952, he altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner.

As the first money manager to combine short selling, the use of leverage shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.

Hedge Fund Partnerships

A hedge fund's purpose is to maximize investor returns and eliminate risk. If this structure and objectives sound a lot like those of mutual funds, they are, but that's where the similarities end. Hedge funds are generally considered to be more aggressive, risky, and exclusive than mutual funds. In a hedge fund, limited partners contribute funding for the assets while the general partner manages the according to its strategy. 

The very name hedge fund derives from the use of trading techniques that fund managers are permitted to perform. In keeping with the aim of these vehicles to make money, regardless of whether the stock market climbs higher or declines, managers can hedge themselves by going long (if they foresee a market rise) or shorting stocks (if they anticipate a drop). Even though hedging strategies are employed to reduce risk, most consider their practices to carry increased risks.

Hedge funds took off in the 1990s when high-profile money managers deserted the mutual fund industry for fame and fortune as hedge fund managers. Since then, the industry has grown substantially with total assets under management (AUM) valued at more than $3.25 trillion according to the 2019 Preqin Global Hedge Fund Report. According to Barclays, the total number of AUM for hedge funds jumped by 2,350% between 1997 and 2019.

The number of operating hedge funds has grown as well. There were around 2,000 hedge funds in 2002. Industry estimates suggest there were about 10,000 active hedge funds in 2019, according to research firm Hedge Fund Research.

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How To Legally Form A Hedge Fund

Aim and Characteristics of Hedge Funds

A common theme among most mutual funds is their market direction neutrality. Because they expect to make money whether the market trends up or down, hedge fund management teams resemble traders more than classic investors. Some mutual funds employ these techniques more than others, and not all mutual funds engage in actual hedging.

There are several key characteristics that set hedge funds apart from other pooled investments—notably, their limited availability to investors.

Accredited or Qualified Investors

Hedge funds investors have to meet certain net worth requirements—generally, a net worth exceeding $1 million or an annual income over $200,000 for the previous two years.

Hedge fund investors require a net worth that exceeds $1 million.

Wider Investment Latitude

A hedge fund's investment universe is only limited by its mandate. A hedge fund can invest in anything—land, real estate, derivatives, currencies, and other alternative assets. Mutual funds, by contrast, usually have to stick to stocks or bonds.

Often Employ Leverage

Hedge funds often use leverage or borrowed money to amplify their returns, which potentially exposes them to a much wider range of investment risks—as demonstrated during the Great Recession. In the subprime meltdown, hedge funds were especially hard-hit due to increased exposure to collateralized debt obligations and high levels of leverage.

Fee Structure

Hedge funds charge both an expense ratio and a performance fee. The common fee structure is known as two and twenty (2 and 20)—a 2% asset management fee and a 20% cut of generated gains.

There are more specific characteristics that define a hedge fund, but because they are private investment vehicles that only allow wealthy individuals to invest, hedge funds can pretty much do what they want—as long as they disclose the strategy upfront to investors.

This wide latitude may sound very risky, and it certainly can be. Some of the most spectacular financial blow-ups have involved hedge funds. That said, this flexibility afforded to hedge funds has led to some of the most talented money managers producing some amazing long-term returns.

Two and Twenty Structure

What gets the most criticism is the other part of the manager compensation scheme—the 2 and 20, used by a large majority of hedge funds.

As mentioned above, the 2 and 20 compensation structure means that the hedge fund’s manager receives 2% of assets and 20% of profits each year. It's the 2% that gets the criticism and it's not difficult to see why. Even if the hedge fund manager loses money, he still gets a 2% AUM fee. A manager who oversees a $1 billion fund could pocket $20 million a year in compensation without lifting a finger. Worse yet is the fund manager who pockets $20 million while his fund loses money. They then have to explain why account values declined while they got paid $20 million. It's a tough sell—one that doesn't usually work.

In the fictional example above, the fund charged no asset management fee and instead took a higher performance cut—25% instead of 20%. This gives a hedge fund manager an opportunity to make more money—not at the expense of the fund's investors, but rather alongside them. Unfortunately, this no-asset-management-fee structure is rare in today's hedge fund world. The 2 and 20 structure still prevails, although many funds are starting to go to a 1 and 20 setup.

Types of Hedge Funds

Hedge funds can pursue a varying degree of strategies including macro, equity, relative value, distressed securities, and activism. A macro hedge fund invests in stocks, bonds, and currencies hoping to profit from changes in macroeconomic variables such as global interest rates and countries’ economic policies. An equity hedge fund may be global or country-specific, investing in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices. A relative-value hedge fund takes advantage of price or spreads inefficiencies. Other hedge fund strategies include aggressive growth, income, emerging markets, value, and short selling.

Popular Hedge Fund Strategies

Among the most popular hedge fund strategies are:

Long/Short Equity: Long/short equity works by exploiting profit opportunities in both potential upside and downside expected price moves. This strategy takes long positions in stocks identified as being relatively underpriced while selling short stocks that are deemed to be overpriced.

Equity Market Neutral: Equity market neutral (EMN) describes an investment strategy where the manager attempts to exploit differences in stock prices by being long and short an equal amount in closely related stocks. These stocks may be within the same sector, industry, and country, or they may simply share similar characteristics such as market capitalization and be historically correlated. EMN funds are created with the intention of producing positive returns regardless of whether the overall market is bullish or bearish. 

Merger Arbitrage: Merger Arbitrage or risk arb involves simultaneously purchasing and selling the stocks of two merging companies to create riskless profits. A merger arbitrageur reviews the probability of a merger not closing on time or at all.

Global Macro: A global macro strategy bases its holdings primarily on the overall economic and political views of various countries or their macroeconomic principles. Holdings may include long and short positions in equity, fixed income, currency, commodities, and futures markets.

Volatility Arbitrage: Volatility arbitrage attempts to profit from the difference between the forecasted future price-volatility of an asset, like a stock, and the implied volatility of options based on that asset. It may also look to volatility spreads to either widen or narrow to predicted levels. This strategy employs options and other derivative contracts.

Convertible Bond Arbitrage: Convertible bond arbitrage involves taking simultaneous long and short positions in a convertible bond and its underlying stock. The arbitrageur hopes to profit from movement in the market by having the appropriate hedge between long and short positions. 

Another popular strategy is the fund of funds approach which involves mixing and matching other hedge funds and pooled investment vehicles. This blending of strategies and asset classes aims to provide a more stable long-term investment return than those of any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds.

Notable Hedge Funds

Notable hedge funds today include the Paulson Funds, a group of hedge funds founded by John Paulson who became famous after his fund reaped billions from betting against mortgages back in 2008. Paulson has other hedge funds, including one that invests solely in gold.

Pershing Square is a highly successful and high-profile activist hedge fund run by Bill Ackman. Ackman invests in companies he feels are undervalued with the goal of taking a more active role in the company to unlock value. Activist strategies typically include changing the board of directors, appointing new management, or pushing for a sale of the company. Carl Icahn, a well-known activist investor, leads a prominent and successful hedge fund. In fact, one of his holding companies, Icahn Enterprises (IEP), is publicly-traded and gives investors who can't or don't want to directly invest in a hedge fund an opportunity to bet on Icahn's skill at unlocking value.

Regulating Hedge Funds

Hedge funds face little regulation from the Securities and Exchange Commission, (SEC) compared to other investment vehicles. That's because hedge funds mainly take money from those accredited or qualified investors—high-net-worth individuals who meet the net worth requirements listed above. Although some funds operate with nonaccredited investors, U.S. securities laws dictate that at least a plurality of hedge fund participants are qualified. The SEC deems them sophisticated and affluent enough to understand and handle the potential risks that come from a hedge fund's wider investment mandate and strategies, and so does not subject the funds to the same regulatory oversight.

But hedge funds have gotten so big and powerful—by most estimates, thousands of hedge funds are operating today, collectively managing over $1 trillion—that the SEC is starting to pay closer attention. And with breaches such as insider trading occurring much more frequently, activity regulators are coming down hard.

Significant Regulatory Change

The hedge fund industry experienced one of the most significant regulatory changes after the Jumpstart Our Business Startups Act (JOBS) was signed into law in March 2012. The basic premise of the JOBS Act was to encourage the funding of small businesses in the U.S by easing securities regulation.

The JOBS Act also had a major impact on hedge funds. In September 2013, the ban on hedge fund advertising was lifted. The SEC approved a motion to lift restrictions on hedge fund advertising, though they still can only accept investments from accredited investors. Giving hedge funds the opportunity to solicit would in effect help the growth of small businesses by increasing the pool of available investment capital.

Form D Requirements

Hedge fund advertising deals with offering the fund's investment products to accredited investors or financial intermediaries through print, television, and the internet. A hedge fund that wants to solicit investors must file a Form D with the SEC at least 15 days before advertising begins. Because hedge fund advertising was strictly prohibited prior to lifting this ban, the SEC is very interested in how advertising is being used by private issuers, so it changed Form D filings. Funds also need to file an amended Form D within 30 days of the offering's termination. Failure to follow these rules will likely result in a ban from creating additional securities for a year or more.

Advantages of Hedge Funds

Hedge funds offer some worthwhile benefits over traditional investment funds. Some notable benefits of hedge funds include:

  • Investment strategies that can generate positive returns in both rising and falling equity and bond markets 
  • The reduction of overall portfolio risk and volatility in balanced portfolios
  • An increase in returns
  • A variety of investment styles that provide investors the ability to precisely customize an investment strategy
  • Access to some of the world's most talented investment managers

Pros

  • Profits in rising and falling markets

  • Balanced portfolios reduce risk and volatility

  • Several investment styles to choose from

  • Managed by the top investment managers

Cons

  • Losses can be potentially large

  • Less liquidity than standard mutual funds

  • Locks up funds for extended periods

  • Use of leverage can increase losses

Disadvantages of Hedge Funds

Hedge funds, of course, are not without risk as well:

  • Concentrated investment strategy exposes them to potentially huge losses.
  • Hedge funds tend to be much less liquid than mutual funds.
  • They typically require investors to lock up money for a period of years.
  • The use of leverage or borrowed money can turn what would have been a minor loss into a significant loss.

Example of a Hedge Fund at Work

Let's set up a hypothetical hedge fund called Value Opportunities Fund, LLC.  The operating agreement states that the fund manager can invest anywhere in the world and receives 25% of any profits over 5% every year.

The fund starts with $100 million in assets—$10 from ten different investors. Each investor fills out the investment agreement with a check to the fund administrator. The administrator records each investment on the books, then wire the funds to the broker. The fund manager can then begin investing by calling the broker with attractive opportunities.

The fund goes up by 40% after a year, making it worth $140 million. According to the fund's operating agreement, the first 5% belongs to the investors. So the capital gain of $40 million is reduced by $2 million—or 5% of $40 million—which is distributed evenly among the investors. That 5% is known as a hurdle rate—a hurdle the fund manager must reach before earning any performance compensation. The remaining $38 million is split—25% to the manager and 75% to investors.

Based on the first-year performance, the fund manager earns $9.5 million in compensation in a single year. The investors get the remaining $28.5 million along with the $2 million hurdle rate for a capital gain of $30.5 million. But imagine if the manager was responsible for $1 billion instead—they'd take home $95 million with investors netting $305 million. Of course, many hedge fund managers get vilified for earning such exorbitant sums of money. But that's because those doing the finger-pointing fail to mention that my investors made $305 million. When is the last time you heard hedge fund investors complain that their fund manager was getting paid too much?

The Bottom Line

A hedge fund is an official partnership of investors who pool money together to be guided by professional management firms—just like mutual funds. But that's where the similarities end. Hedge funds aren't regulated as much and operate with far less disclosure. They pursue more flexible and risky strategies in the hopes of netting big gains for investors, which, in turn, result in big profits for fund managers. But perhaps what sets them apart from mutual funds the most is that they have much higher minimum investment requirements. The majority of hedge fund investors are accredited, meaning they earn very high incomes and have existing net worths in excess of $1 million. For this reason, hedge funds have earned the dubious reputation of being a speculative luxury for the rich.