How can we maximize profitability and minimize risk? This is supposed to be the bread and butter of a Hedge Fund manager. Because they are aggressive funds, and in other words speculative, they tend to invest in traditional securities such as stocks and bonds but resort to non-traditional strategies, such as short positions and derivatives. For this reason, they tend to be riskier than mutual funds and exchange-traded funds, known as ETFs.
What are hedge funds?
When we talk about Hedge Funds, we refer to an alternative investment instrument. Unlike bonds and stocks, which can be easily accessed on the stock market, Hedge Funds are only available to a limited group of people since the minimum investment amount is usually quite high.
As of today, it is estimated that hedge funds are managing more than 3,000 billion dollars in aggregated assets under management (AUM).
Hedge funds are free to choose the products and markets in which they invest (within predefined parameters) and their management methods. These funds usually have high investment minimums. The managers’ compensation depends, in general, on the fund’s performance.
The chart below provides an overview of the characteristics and risk profile of each hedge fund family and category. The degree of risk exposure can vary from a lower exposure (funds of hedge funds, for example) to a higher one (pure hedge funds) that can entail, as in other types of assets, a higher risk of capital loss.
Hedge Fund fees can vary between 1%-2% of fund assets plus 20% of fund returns above a predetermined benchmark.
Advantages and disadvantages of hedge funds
As is the case of every investment vehicle, Hedge Funds have their intrinsic advantages and disadvantages. In the next sections, I’ll be covering them in further detail.
Advantages of Hedge Funds
Hedge Funds have an objective of absolute profitability and low correlation with respect to the evolution of a given traditional asset or index. The strategies carried out by hedge funds to achieve this objective have very different return and risk profiles, potentially allowing returns to be obtained in all phases of the markets (bullish, bearish, or even stable).
When considering the risk of investing in a Hedge Fund, indicators such as volatility (variability or dispersion of returns compared to their mean), and the degree of symmetry or asymmetry with which the returns are distributed with respect to their expected value are commonly evaluated.
Among the main advantages are:
- Hedge Funds can take short positions in addition to holding long positions. The objective of these strategies is to reduce the risk of long-only strategies. Thus, they reduce their exposure to market risk and can use leverage to increase portfolio returns. Long positions are taken in undervalued stocks and short positions in lower-quality assets.
- The use of leveraged derivatives enables them to create more complex strategies.
- Hedge funds allow investors who seek to diversify portfolio risk through alternatives outside the traditional market.
- They use quantitative strategies, where they employ the use of automated trading based on systematic and/or algorithmic data analysis.
- Due to their hedging strategies, Hedge Funds may have lower volatility.
- Hedge Fund investors can access different markets and instruments that traditional investors cannot. Such are short sales, high degrees of leverage, and the use of different derivatives.
- They use event-driven strategies, such as buying shares of companies in distress or going bankrupt, in the hope of profiting when the event occurs.
- They analyze global macroeconomic trends to exploit investment opportunities in this area, such as foreign exchange rates, interest rates, or prices of basic necessities.
Disadvantages of Hedge Funds
Usually not very transparent.
This makes it difficult to track where the money is. The net asset value of these investment funds is not known when the investor decides to subscribe or sell this financial instrument. This happens because it is necessary to make a prior notice before any subscription and redemption operation. Consequently, the net asset value cannot be calculated before the subscription or sale.
Tend to have very little liquidity and have Lockup periods
These investments may have a minimum maintenance term (“lockup”), or penalties if liquidated before the established term ends. This happens because hedge fund portfolio investments have relatively little liquidity as they are long-term products. Subscriptions and redemptions are usually set at a monthly or quarterly frequency.
Finally, considering the complexity of the underlying investments made by these funds, it may be necessary to adjust the net asset value after the approval of the annual accounts. Consequently, certain alternative investment funds may retain part of the investor’s holdings until the approval of the annual accounts if the latter decides to liquidate 100% of his participation.
Usually aimed at institutions
They are investment funds aimed at institutions, such as companies, pension plans, and investment funds. Thus, hedge funds are not normally available to retail investors.
Many of these funds are domiciled in an offshore territory (“offshore funds”) outside the United States, and because of this, their regulation and supervision may be minimal or non-existent. There may be problems or delays in the execution of subscription or redemption orders for some funds, for which the Bank assumes no responsibility. There is no guarantee that legal rights can be exercised.
Differences between a Hedge Fund and a Private Equity Fund
There are several not-trivial differences between hedge funds and private equity funds. Although the limits between both entities are sometimes not so clearly defined, we can highlight the following differences:
- Private equity funds are generally private investment funds of limited partnerships to buy and restructure non-listed companies.
- Private equity investments are usually in companies that can deliver high returns over a longer period.
- Private equity fund investors have the freedom to invest whenever they want.
- Private Equity funds can use leverage but are usually lower risk than Hedge Funds.
- Private Equity Funds are closed investment funds and correlate with the stock market.
- Private Equity investors are active participants.
- Private Equity Funds have better control over operations and capital management.
Differences between a Hedge Fund and a Mutual Fund
The main differences between both investment vehicles are related to the risk profile and the type of investments that both make. In summary, we can highlight the following differences:
- Mutual Funds’ fees range from 0.5% to 5%, and there is no additional performance fee.
- Mutual Funds tend not to use leverage since they generally invest in bonds, stocks, and short-term debt funds.
- Mutual Funds are regulated investment products offered to the public and available for daily trading.
- Mutual Funds are easier to access for private investors.
Frequently Asked Questions
Do hedge funds outperform the market?
Over the past ten years, Hedge Funds have, on average, been vastly outperformed by America’s Top 500 Companies Index.
However, a significant number of articles are trying to explain why Hedge Funds fail to outperform the S&P 500. Below we will explain why that question is wrong and why Hedge Funds do not necessarily have to outperform the S&P 500.
Having said that, not all Hedge Funds have a lower return than the S&P500. Take Renaissance Technology’s Medallion Fund as an example. It obtained a 66-yearly return from 1988 to 2018, even net of its astounding 40% fees.
Unlike the famous 2 and 20 fees Hedge Funds usually charge, the Medallion Fund charged 5% of assets under management and 44% of profits, far above typical hedge funds. Still, it managed to provide positive returns since 1989.
It does not have an elucidated strategy, but it is a quantitative fund that uses mathematical models and algorithms to make investment decisions. The fund was founded by Jim Simons, a mathematical prodigy who knew how to apply his knowledge on the subject to develop a wide array of quantitative strategies.
However, participation is currently limited to Renaissance employees; access to this fund is currently impossible for outside investors.
There are many types of hedge funds, but almost all operate with a beta of less than one. Most of them are substantially less risky than the market, and many have a low or negative correlation.
Most hedge funds are designed to avoid significant correlations with the S&P 500 and other market indices. These returns are valuable to investors because they diversify, or even hedge, the returns of the S&P 500. The question is not which of the two investments works better but to what extent an investor should invest in both vehicles.
Can anyone invest in a hedge fund?
Investing in Hedge Funds is more suitable for institutional investors who are experienced enough to understand all the risks involved. However, certain requirements must be met to invest in a Hedge Fund.
Under Regulation D of the Securities Act of 1933, Hedge Funds can only raise capital from so-called “accredited investors.” In other words, from individuals with a minimum net worth of $1,000,000; or, a minimum income of $200,000 in each of the last two years, with an expectation of achieving the same level of income in the current year.
In 2010, after the Consumer Protection and Reform Act was passed, the SEC acquired the authority to adjust net worth and income standards as it deems appropriate. A minimum of $5,000,000 in total assets is required for corporate entities and banks.
With respect to larger Hedge Fund investors, they must meet the highest standards of qualified purchasers, referring to the Mutual Funds Act of 1940, where individuals are required to have $5,000,000 in investments, while the companies and pension plans have 25,000,000 dollars in investments.
What was the first Hedge Fund in history?
Clearly defining which the first Hedge Fund was is no easy feat. Alfred W. Jones is believed to have founded the first hedge fund in 1949, following a strategy of buying stocks and covering positions with short sales.
Jones thought that he had a poor performance at timing the market but was good at picking stocks. Thus, he theorized that by having an equal number of short and long positions open simultaneously, he could hedge against timing the market by having a market-neutral position. Consequently, his portfolio was mostly uncorrelated to the market but benefited from his outstanding asset selection skills.
His success was considerable. During the first five years of the fund, he outperformed the best-performing mutual fund by 44% (even after charging 20% incentive fees). Additionally, during the first ten years, his fund outperformed the best mutual fund (Dreyfus Fund) by 87% after fees.