Define: Hedge Fund

Quick Summary of Hedge Fund

The term hedge funds refer to the monetary capital collected from investors and then the proceeds from these funds are used to buy bonds and stocks. Hedge funds decrease the portfolio risk that arises from movements in broad markets as they take short and long positions in assets. A fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, arbitrage, and derivatives. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals. They are restricted by law to no more than 100 investors per fund, and as a result, most hedge funds set extremely high minimum investment amounts, ranging anywhere from $250,000 to over $1 million. As with traditional mutual funds, investors in hedge funds pay a management fee; however, hedge funds also collect a percentage of the profits (usually 20%).

A hedge fund is capable of taking short positions in case of certain assets and long positions in other stock in such a manner that the portfolio beta is near the zero-mark. This means that the portfolio remains comparatively unaffected by the broad market movement.

Hedge funds are defined by using their structural characteristics, not through their “hedged” nature. These are assets, which are meant to produce returns.

In the US, the SEC regulates the hedge fund sector minimally. The number of investors in a hedge fund is limited, and any individual investor in a hedge fund must be an accredited investor. Critically, the hedge fund avoids the SEC’s prohibition against the asset manager’s compensation is linked to the fund’s performance, as is the case with, for instance, a mutual fund. For this reason, the hedge fund is often regarded as primarily an innovation in fund manager compensation. The hedge fund has no restrictions on investment strategy. The hedge fund can change its strategy at will, but many characterize themselves according to a fixed style they do best. Example hedge fund styles include short selling and risk arbitrage or “risk-arb”. Performance aside, the key measure of a hedge fund’s size is assets under management.

For most individuals, investing in a hedge fund is only possibly indirectly, through a so-called fund of funds, which invests in multiple hedge funds.

Hedge funds are popularly perceived as small, secretive investment funds run by financial gurus who earn extraordinary returns managing money for the super-rich. Another perception is provided by Forbes Magazine, which describes hedge funds as “the sleaziest show on Earth … a business rife with exorbitant fees, phoney numbers and outright thievery.” What is undeniable is the fact that hedge funds have proliferated since 1996, and investors are pouring money into them. This article explores what hedge funds are and why they have become popular.

There is no precise definition of what is or is not a hedge fund. The term generally refers to a limited partnership or corporation that manages investments and is structured in a manner that largely exempts it from financial regulation. Hedge funds generally take leveraged positions in publicly traded equity, debt, foreign exchange and derivatives. For this reason, venture capital funds, private equity funds, commodity pools and real estate partnerships are not generally considered hedge funds.

Hedge fund’s charge investment fees that typically include a management fee, which is calculated as a fixed percentage of assets under management, and an incentive fee, which is calculated as a percentage of the fund’s returns. Other “administrative” fees may also be charged. A fund might charge a 2% management fee and a 0.4% administrative fee in addition to a 20% incentive fee. If this fund managed USD 100 million and earned USD 18 million in income and capital gains over a year, the combined fee for the year would be:

(.024) (USD 100MM) + .20 (USD 18MM) = USD 6MM [1]

For ease of exposition, this example assumes fees are paid annually. In practice, they are charged monthly or quarterly.

The incentive fee may be subject to a hurdle rate or high-water mark provision. With the former, the performance fee is paid on only returns in excess of some hurdle rate. If there were a 5% hurdle rate in the above example, the total fee would be reduced to

.024 (USD 100MM) + .20 (USD 18MM – USD 5MM) = USD 5MM [2]

A hurdle rate may also be set to be equal to some variable index, such as Libor. About one in five hedge funds employs a hurdle rate of some sort.

With a high water mark, a hedge fund must recover any losses—return to the last high-water mark—before incentive fees can be charged. For example, if a hedge fund loses USD 10 million one year but earns USD 12 million the next, any performance fee for the second year will be based on only the USD 2 gain in excess of the prior year’s loss. Since investors may join the fund at different times, high watermarks must be tracked individually for each investor. About four out of five hedge funds employ a high-water mark provision.

The origins of even the word “hedge fund” are obscure. Hedge funds play more the role of speculators than of hedgers. The name may have arisen to reflect the fact that many hedge funds focus on market-neutral trading strategies. By putting on long-short positions, they seek to hedge themselves against broad market moves while profiting from changes in the relative value of the instruments they go long or short.

This was largely the strategy pursued by Alfred W. Jones, who was a pioneering hedge fund manager. He launched his fund, A.W. Jones & Co., in 1949 and ran it continuously through the early 1970s. He put on leveraged long and short positions in equities. While he didn’t follow a strict market-neutral strategy, his main source of returns was relative bets made between individual equities. Jones is purported to have achieved excellent returns with his strategy.

Today, hedge funds pursue a variety of investment or trading strategies. These go by various names, and there is some overlap between strategies. Generally, they fall into three categories:

Directional strategies involve taking positions that will benefit from broad market rises or declines.

Market-neutral strategies involve taking offsetting long and short positions within a specific market. The goal is to avoid net exposure to the overall market while benefiting from changes in the relative value of individual instruments within that market.

Event-driven strategies seek to exploit temporary mispricing associated with some corporate event, such as a merger or divestiture.

Many of the strategies employed by hedge funds entail (directly or indirectly) providing liquidity to markets and earning a liquidity spread when they do so. In effect, the hedge fund provides a service to the market, and this allows them to make money fairly consistently. Of course, simply earning liquidity spreads won’t make anyone wealthy. To make attractive returns, hedge funds leverage themselves. For example, over any year, a USD 100 million hedge fund might earn USD 1 million by deploying its capital to provide liquidity to markets. If liquidity risk were the only risk it took, the fund would also earn a risk-free return on its capital. Suppose, for this example, that the risk-free rate is 3%. Then the hedge fund would earn a total of USD 4 million a year—a 4% annual return. To boost this, the hedge fund might leverage itself. If it borrowed USD 900MM, it would have USD 1,000MM to deploy and would earn USD 10MM, providing liquidity to markets. Add this to the same USD 3MM, it would still earn by investing its capital at the risk-free rate, and the fund would earn USD 13MM a year. On USD 100 million in capital, that is a respectable annual return of 13%. After fees, investors might earn 9%.

This, in a nutshell, is how many hedge funds make their returns. They earn liquidity spreads and leverage themselves to make the returns attractive. For an experienced trader, this is all quite mundane. It also entails considerable risk. When you provide liquidity to markets, you are, in essence, accepting positions that will be difficult to unwind in an emergency. You are agreeing to be the party left “holding the bag” when things fall apart. That is why markets compensate liquidity providers in the first place! Seen in this light, the returns these hedge funds earn are not leveraged profits so much as leveraged insurance premiums. The hedge funds are like unregulated insurance companies, writing insurance policies for other market participants and pocketing the insurance premiums. When markets crash, they tend to lose money. Because they are highly leveraged, they can lose enormous sums of money. It is not atypical for hedge funds to lose most, if not all, of their capital. This is what happened to the hedge fund Long Term Capital Management (LTCM) back in 1998. Other spectacular hedge fund failures can be attributed to excessive leverage, including:

• David Askin’s Granite Fund lost all its USD 600 million in capital in February 1994 when the Federal Reserve raised interest rates and the fund’s leveraged CMO positions plummeted.
• John Koonmen’s Japan-based Eifuku Master Fund was heavily leveraged with just a few concentrated positions when it lost essentially all its USD 300 million capital over a one-week period in 2002.
• Nicholas Maounis’ massive Amaranth Advisors fund folded after losing USD 6.5 billion—70% of its capital—betting on natural gas prices in 2006.

Fraud is another problem with hedge funds. Because they avoid most financial regulation, there is little oversight of hedge fund activities. Some don’t release audited financial statements. Their positions are often illiquid and difficult to mark to market. Combine this with the generally secretive nature of hedge funds—the so-called transparency issue—and there is little to stop a fund manager from misleading his investor, should he choose to do so.

This is what happened with Michael Berger’s Manhattan Fund, which shorted technology stocks between 1996 and 2000 when those stocks were soaring. Berger and his investors perceived that a bubble was forming, but their timing was off. The fund lost money consistently. Berger falsified brokerage statements, so the fund’s audited financial statements reported annual returns of between 12% and 27%. Based on those claims, the fund continued to attract new investments, and Berger used them to pay his mounting margin calls. In August 1999, Berger reported to investors that the fund had a net capital of USD 426 million when, in fact, it had only USD 28 million. In January 2000, Berger failed to meet his margin calls, and the fund collapsed. Investors lost about USD 400 million. Following his arrest, Berger skipped bail and was placed on the FBI’s most-wanted list.

Fraud has played a role in the collapse of many other hedge funds, including

David M. Mobley, Sr., manager of the Maricopa funds, invested fund assets in his own businesses, most of which failed. He also tapped fund assets to make donations to charities and to pay for a luxurious lifestyle for himself and his family. Between 1993 and 2000, he reported annual returns of about 50% after his 30% fee. In 2000, he claimed the funds had assets of USD 450 million when they really had only USD 33 million. Authorities intervened shortly thereafter.

Lipper & Co.’s Lipper Convertible Fund lost heavily in convertible arbitrage trading between 1996 and 2002. The fund’s manager, Edward Strafaci, falsified returns during much of that period. He claimed a 7.7% return for 2001 when the fund actually lost 40%.

John D. Barry and the other managers of Beacon Hill Asset Management lied about losses in their market-neutral hedge funds during 2002. SEC filings claim they also defrauded hedge fund investors by transacting trades at off-market prices between the hedge funds and other accounts they managed. Between August and October 2002, the hedge funds lost 54% of their value.

Michael Lauer’s Lancer Offshore Fund invests in distressed small-cap stocks. It was successful for a while but suffered heavy losses during the bear market of 2000–2003. Lauer reported gains to investors while the fund’s capital plunged to USD 571 million.

Today, hedge funds are increasingly being promoted to institutional investors, who insist on better disclosures. In this context, the mystique of hedge funds as exclusive firms secretly earning spectacular returns can no longer be maintained. Instead, hedge funds are promoted as exclusive firms secretly earning returns that

• offer an attractive risk-reward trade-off, and
• are largely uncorrelated with returns on traditional stock or bond portfolios, making them an excellent means for diversifying institutional portfolios.

Reported hedge fund returns would seem to justify the claims.

Most providers have some vested interest in the success of the hedge fund industry, and that vested interest may colour the decisions they make about how to construct their indexes. Also, hedge funds aren’t required to contribute their performance data to anyone. They will have a natural inclination to contribute their data to those providers that they perceive as most friendly to the hedge fund industry. Here are some biases that affect some or all hedge fund indexes.:

backfill bias: When a hedge fund is added to an index, the fund’s past performance may be “backfilled” into the index. For example, if the fund has been in business for two years at the time it is added to the index, past index values are adjusted for those two years to reflect the fund’s performance during that period. Not all indexes backfill, but those that do introduce a bias. Usually, a hedge fund will start contributing data to an index to draw attention to recent strong performance. One of the oldest tricks in investment management is to launch multiple investment funds and then market those that happen to perform well. The practice is also common among hedge funds, which report the winners to indexes while closing down the losers. Also, index providers generally have criteria for adding a new fund to an existing index. This may include a minimum asset under management requirement, and successful funds are more likely to satisfy this criteria than unsuccessful ones. In summary, successful funds are more likely to be added to an index than unsuccessful ones, so this biases indexes that backfill. While backfilling is obviously a questionable practice, it is also quite understandable. When a provider first launches an index, they have an understandable desire to go back and construct the index for the preceding few years. If you look at the time series of hedge fund index performance data, you will often note that indexes have had very strong performance in the first few years, and this may be due to backfilling.

survivorship bias: When a fund is dropped from an index, past values of the index may be adjusted to remove that dropped fund’s past data. Inevitably, a fund will be dropped from an index if it stops providing its performance data to the index provider, and a fund will be more likely to do so following poor performance than good. Also, providers may have criteria for dropping a fund, and this may naturally cause poor performers to be dropped more often than good performers.

liquidation bias: Due to their considerable leverage, hedge funds can fail suddenly. In the midst of such a calamity, the managers are going to have more important things on their minds than reporting their mounting losses to index providers. An index provider will have little choice but to drop the fund from the index. They may go back and purge the index of that fund’s past performance, or they may not. Either way, the index will not reflect the fund’s staggering losses.

Fraud bias: One hedge fund that misrepresents its performance can severely bias an index. Suppose an index is based on 25 hedge funds. One is fraudulent and misrepresents a 30% loss as a 20% gain. That one misrepresentation will bias the index return by about 2%.

mark-to-market bias: Many hedge funds hold illiquid positions that are difficult to value. Inevitably, there is some subjectivity in how they choose to market those positions. Natural human optimism—as well as incentive fees and egos on the line—will create a natural tendency for managers to overvalue rather than undervalue those positions.

All these factors tend to bias returns upward. There is also a problem with the volatilities of hedge fund indexes, which can bear little resemblance to the volatilities of the funds that comprise those indexes. Several of the above biases may contribute to the problem. Liquidation bias obviously does, and fraud bias and mark-to-market bias may also do so. The bigger problem is diversification. Because indexes include multiple hedge funds, their volatility is substantially lower than what would be experienced with a single hedge fund. In theory, because they entail no systematic risk, the volatility of market-neutral hedge funds can be completely diversified away. Take another look at Exhibits 1 and 2. The hedge fund strategies that have extraordinarily low volatility are equity market neutral, convertible arbitrage, merger arbitrage, and fixed-income arbitrage. All are generally implemented as market-neutral strategies. For this reason, the volatility of those indexes reflects more the degree to which the indexes are diversified than they do the volatilities of the individual hedge funds that comprise the indexes.

As a practical matter, institutional investors do diversify across multiple hedge funds, but this can be expensive because the incentive fees on those hedge funds don’t diversify. As a simple example, suppose an institution invests in two hedge funds, both of which have a 20% incentive fee. Suppose one fund earns USD 10 million while the other loses USD 10 million. The investor has realised a 0% return, but they still have to pay a USD 2 million incentive fee to the successful hedge fund.

This is a serious problem with funds. These are hedge funds that invest exclusively in other hedge funds. They are marketed to investors as an easy way to diversify across multiple hedge funds. Not only do funds of funds pose the incentive fee non-diversification problem mentioned above, but they layer their own fees on top of the fees charged by the hedge funds they invest in. Typically, a fund of funds might charge a 1.5% management fee along with its own 5% or 10% incentive fee. This is on top of the perhaps 2% management fee and 20% incentive fee charged by the typical hedge fund in its portfolio.

Financial regulators tend to view the concept of funds as abusive due to layering of fees. In the mutual fund industry, funds of funds faced regulatory restrictions, although these have been loosened. This is not an issue for hedge funds since they are largely unregulated. Now, so-called F-3 hedge funds are being formed. These are funds of funds.

Why did hedge funds suddenly become popular after being a fringe industry for so many decades? The National Securities Markets Improvement Act, which Congress passed in 1996, may be the primary reason. Up until its passage, hedge funds had received exemption from regulation under Section 3(c)(1) of the 1940 Investment Company Act. To protect the investing public, that section placed severe restrictions on the nature and number of investors a hedge fund might have. The Improvement Act added a new Section 3(c)(7). This liberalised those restrictions, dramatically increasing opportunities for hedge funds to attract investors. Large brokerage firms have helped hedge funds exploit this opportunity.

Hedge funds are frenetic traders who generate brokerage commissions out of proportion to their assets under management. While a typical institutional investor generates trading commissions that total less than 1% of their assets under management, for a hedge fund, that number can easily exceed 3%. Brokerage customers like these get red carpet treatment. Brokers don’t just execute and clear trades for hedge funds. They offer bundled services called prime brokerage. Typically, a hedge fund selects a firm to be its prime broker, and that firm provides services, including

• support in launching the hedge fund,
• marketing,
• office space, and
• running funds of funds that invest in the hedge fund.

Prime brokers make it surprisingly easy to launch and run a hedge fund. The marketing they provide is critical. Due to their regulatory status, hedge funds are not allowed to publicly advertise. In the past, this seriously hampered a hedge fund’s ability to raise capital. Prime brokers solve the problem by providing hedge funds with introductions to their clients. A typical large broker has an enormous client base that includes institutional investors and high-net-worth individuals. Introductions comprise more than a name and a phone number. Prime brokers are known for hosting lavish “introduction parties” at exclusive resorts.

By 2005, hedge funds accumulated a trillion dollars in total capital. That translates into perhaps 30 billion dollars a year in brokerage commissions. This is a huge sum of money for prime brokers. The 1996 Improvement Act opened the door, but it is marketing muscle from those prime brokers that is fueling the hedge fund industry’s explosive growth.

Fees In Hedge Funds

There are certain fees that are applicable in case of a hedge fund. These fees are collected by managers of hedge funds. Those may be enumerated as below:

• Management fees
• Withdrawal or redemption fees
• Performance fees

Hedge Fund Strategies

Hedge fund strategies are basically various trading methods and tactics that are employed by hedge fund managers. A noticeable aspect of hedge fund strategies is that they comprise several important elements of trading.

Following are some important hedge fund strategies:

• Global macro
• Relative value
• Directional
• Miscellaneous
• Event-Driven

Hedge Fund Risks

There are certain risks that a hedge fund is exposed to. Some important risks faced by a hedge fund may be enumerated as below:

• Leverage
• Lack of transparency
• Short selling
• Lack of regulation
• Appetite for risk

Major Hedge Funds

Leading hedge funds are as follows:

• RAB Special Situations Fund (RAB Capital, London)
• Atticus European Fund (Atticus Management, New York)
• The Children’s Investment Fund (The Children’s Investment Fund Management, London)
• Gradient European Fund A (Gradient Capital Partners, London)
• Highland CDO Opportunity Fund (Highland Capital Management, Dallas)
• Polar Capital Paragon Absolute Return Fund (Polar Capital Partners, London)
• BTR Global Opportunity Fund, Class D (Salida Capital, Toronto)
• Paulson Enhanced Partners Fund (Paulson & Co., New York)
• SR Phoenicia Fund (Sloane Robinson, London)
• Firebird Global Fund (Firebird Management, New York)

A Brief History of Hedge Funds

In 1949, Alfred Winslow Jones started the first hedge fund. He went long and short and used leverage to increase returns. In 1952, he started keeping 20% of the profits for himself. By 1968, there were about 215 funds, including those run by George Soros, Warren Buffett, and Michael Steinhardt. By 1984, there were only about 68 hedge funds left (most were wiped out during the market crash of the early 1970s). By the late 1990s, there were approximately 4,000 funds with $300 billion in capital, including Julian Robertson and George Soros. In 2007, there were about 9,000 hedge funds with approximately $1.1 trillion in assets.

Disclaimer

This site contains general legal information but does not constitute professional legal advice for your particular situation. Persuing this glossary does not create an attorney-client or legal adviser relationship. If you have specific questions, please consult a qualified attorney licensed in your jurisdiction.

This glossary post was last updated: 9th April 2024.