What Are Hedge Funds and How Do They Work?

What Are Hedge Funds and How Do They Work?

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Hedge Funds are curious investment vehicles that can evoke an aura of wealth, success, financial sophistication and modernisation. Referred to as ‘alternative investments’, the first Hedge Fund was founded in 1947 by Alfred Winslow Jones, a moment that paved the way for the Hedge Fund industry.

Some of the biggest US Hedge Funds today, with huge Assets Under Management (AUM), are Bridgewater Associates – Ray Dalio, a gentleman of whom many will know, is the Chief Investment Officer of Bridgewater Associates – Citadel, Renaissance Technologies and AQR Capital Management. 

Unquestionably, Hedge Funds are complex; their setup, investor eligibility and strategies are multifaceted. In essence, Hedge Funds pool wealthy investors’ funds and invest in the financial markets to generate a positive return, or ‘absolute return’. This is where Asset Managers and Hedge Funds differ. In asset management – say you’re a US equity asset manager – the fund’s performance is compared against a benchmark, like the S&P 500. As an asset manager, investors would expect you to deliver ‘Alpha’, a return greater than the benchmark (this is referred to as a ‘relative return’). For a Hedge Fund that includes both long and short strategies, this is difficult to benchmark and, thus, aims to deliver a positive return (absolute return – greater than zero), regardless of the current market conditions.

Breaking Down Hedge Funds

Structured as a Limited Partnership, Hedge Fund investors, or ‘Accredited Investors’, become Limited Partners, contributing capital but having limited liability and little say in investment decisions. According to the US Securities and Exchange Commission (SEC), Accredited Investors are defined as high-net-worth individuals with a net worth of over US$1 million and an income of more than US$200,000. The General Partner oversees the fund's operations and investment strategies and has significant control and unlimited liability for the fund's debts and obligations.

Most Hedge Funds operate with management and performance fees (or an incentive fee). A Hedge Fund’s Fee structure is usually organised as ‘2 and 20’: a 2% management fee and a 20% performance fee. However, management fees generally range between 1% and 3%. This aspect can be a point of consideration for investors, as they weigh the potential benefits of investing in Hedge Funds against the higher fees involved and whether these fees justify the additional Alpha and portfolio diversification value. 

Are Hedge Funds successful? Are they a money-printing phenomenon that churns out generous returns year in and year out? Although some of the top funds generate a positive return, most US Hedge Funds fail; over half close shop only after a few years or so in operation. Why many fail depends on several factors, such as the initial capital outlay to start a fund and attract the best talent, the need to invest in infrastructure and technology, contending with regulatory hurdles and employing the right strategies. 

Hedge Fund Trading Strategies

Hedge Funds employ several strategies, usually using leverage. Hedge Funds also invest in various financial instruments, including stocks, bonds (fixed income) and derivatives, such as options and futures. Unlike long-only funds, strategies used at a Hedge Fund depend on the Fund’s objective and often include aggressively leveraged portfolios that execute long and short positions. And given less regulation imposed on Hedge Funds (compared to, say, Mutual Funds which have considerably more oversight), they tend to pursue greater returns.

• Long-Short Strategy:

The Long-Short Strategy is rather straightforward and one of the most popular strategies. It involves scanning the equities universe, entering long undervalued equities and shorting overvalued equities. This essentially hedges one’s portfolio, and, in fact, this is where the term ‘Hedge Fund’ originates from. The Long-Short Strategy may also be sector-specific. 

As a note, short selling in the equities space entails borrowing shares, selling them and repurchasing them later to return to the lender. Profits are generated if the shorted stock price falls.

• Macro Strategies:

As its title implies, Macro Hedge Funds derive their decision-making through macroeconomic indicators and trade/invest in several asset classes, like bonds, equities, currencies and commodities. They essentially attempt to follow and trade based on the economic cycle’s trends, the booms and bust cycles. 

These types of funds are largely directional strategies or relative value.

• Event-Driven Strategies:

Event-Driven Strategies capitalise on corporate events like mergers, acquisitions, restructurings and bankruptcies. For example, a Hedge Fund manager may buy stocks expected to rise due to a positive event or short stocks vulnerable to a negative event.

Hedge Fund FAQs:

1. What is a Hedge Fund?

A Hedge Fund is a managed portfolio open to Accredited Investors that is usually leveraged and takes long and short positions across various financial instruments to generate an absolute return.

2. How are Hedge Funds Structured?

A Hedge Fund is structured as a Limited Partnership. Accredited Investors become Limited Partners, and the General Partner oversees the fund's investment methods and day-to-day operations.

3. What strategies do Hedge Funds employ?

Hedge Funds work with various strategies, including Long-Short Equity Strategies, Macro Strategies and Event-Driven Strategies.