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Hedge Funds: Definition, Examples, and How They Work

December 15, 2021
8
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Hedge funds are for the wealthy and big institutions, and getting into them requires more money, tolerance for risk, and patience than most investors have.

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Anyone who watches Axe go all-in on Billions or reads financial news is probably familiar with hedge funds. They have taken on an aura of greatness, with supposedly genius investment returns that beat market averages. 

That said, such funds have had a mixed record in the past several decades. From 1980 through 2008, hedge fund returns were less than half the 12.5% annual average of the stock market benchmark, the Standard & Poor’s 500 Index. And from 2009 to 2019, hedge funds outperformed in one year, and that was only by losing less than the index. Here is a primer on hedge funds for the average investor.

What is a hedge fund?

A hedge fund is a private pool of money collected from an assortment of wealthy individuals and institutions such as trusts, college endowments, and pension funds. The pool is managed by a financial professional who invests the money in a variety of securities and financial contracts.

“They’re basically ways for very wealthy people and pools of capital to get wealthier,’’ says Titan analyst Vincent Ning.

The first hedge fund was started in 1949 by Alfred W. Jones, who began with $100,000 and combined long-term stock investments with short sales to offset, or hedge, some of the risk of the long-term holdings. This became known as the classic long-short hedging model.

“The idea behind it was: If you are clever in how you position your portfolio with your main assets and your hedges, you should have a portfolio that makes money whether the market goes up or down,” Ning explains.

Jones also used borrowed money (leverage) to try to boost the fund’s returns and established the now-common practice in which managers receive 20% of the investment gains above a minimum threshold.

Among the most prominent hedge funds in the last few decades are:  

  • Bridgewater Associates, founded by Ray Dalio
  • AQR Capital Management, founded by Clifford Asness
  • Renaissance Technologies, founded by James Simons

Hedge funds can specialize in different approaches and strategies. Some can be so-called quants: funds that use complex mathematical analysis in making buy and sell decisions. AQR and Renaissance are most notable for their data-driven investment strategy.

Other funds may have an activist approach, focusing on undervalued companies in which the fund manager wants to take an active role through representation on the board, campaigning for new management, or possibly a sale of the company. Bill Ackman at Pershing Square Capital Management is a notable activist investor, as is Carl Icahn.

Key hedge fund characteristics

Hedge funds tend to have specific characteristics and features.

  • They require wealth to participate. Hedge funds typically require an investor to have a liquid net worth (excluding a primary home) of at least $1 million, or annual income of more than $200,000 for the two most recent years. Some funds may set higher thresholds.
  • They often borrow money to use in an investment. This is known as leverage, and it can magnify a fund’s returns if the investment turns out right. On the other hand, leverage magnifies losses if the investment is wrong.
  • They can invest in a wide variety of securities and assets. For example, a hedge fund could invest in derivatives, commodities, real estate—even art and antiques. It may also engage in short sales—profiting when an asset loses value—to hedge its long investment positions.
  • They pay managers handsomely. The typical compensation for a hedge fund manager is known as the 2/20 package: The manager is paid 2% of the fund’s asset value, plus an incentive fee of 20% of any profits above an agreed minimum, known as the hurdle rate. So if the fund manages $1 billion and it generates a 25% return ($250 million), the manager is paid 2% of $1 billion ($20 million), plus 20% of the returns exceeding a 5% hurdle, or $40 million. This is how successful managers of big hedge funds become billionaires.

Hedge funds by type or strategy

Hedge funds fall into several broad categories based largely on how they invest:

  • Long-short equity. With this approach, the manager looks to buy stocks with long-term growth potential while short-selling stocks that may be overvalued and poised for a decline. The strategy is meant to profit in good or bad markets, or at least not to lose in bad markets.
  • Equity market-neutral. Similar to long-short equity as a good times/bad times strategy, equity market-neutral tries to profit from pairs trading—buying an amount in one company and selling short an equal amount in a related company. For example, the fund manager might buy $1 million of shares in ABC Pharmaceuticals Inc. because it’s the leader in the industry while shorting XYZ Pharma Orp. because it’s a laggard.
  • Merger arbitrage. This focuses on pending mergers and takeovers. The fund manager typically will buy shares of the company being acquired and simultaneously short the shares of the acquiring company. The hedge fund is gambling on how long the merger will take to be completed and on any change in price between announcement and completion.
  • Global macro. As the name implies, this strategy looks to bet on macroeconomic shifts, such as changes in interest rates set by central banks, trade balances between countries, or currency exchange rates. Global-macro strategies often use large amounts of leverage, which can result in spectacular gains or huge losses.
  • Volatility arbitrage. This approach tries to capture gains from the difference in expected price volatility of a financial asset and the implied volatility of options on that asset. Stocks are the asset of choice for such a strategy.
  • Convertible-bond arbitrage. Some companies issue bonds that give the holder, at certain times, the option to convert the bond’s face value into a number of company shares. The hedge fund manager tries to profit from temporary pricing discrepancies in the convertible bond relative to the underlying stock.

Who invests in hedge funds?

Hedge funds tend to seek out so-called accredited or sophisticated investors, meaning those who:

  • Have the wealth and income required to participate
  • Fully understand the risks as well as potential rewards
  • Don’t require the protection of securities regulations
  • Can commit to leaving their money in the fund for a certain period of time without needing to withdraw

Requirements and costs of investing in hedge funds

Hedge funds are usually formed as limited partnerships, and each investor is a limited partner. Minimum investments can vary among hedge funds—as little as $25,000 or as much as $1 million. Investors also must commit to leaving their money with the hedge fund for a certain amount of time, known as the lockup. Lockups usually are at least one year, sometimes several years.

Comparing hedge funds with other funds

Mutual funds and exchange-traded funds (ETFs) are similar to hedge funds in theory because they are investment pools managed for the benefit of the investors. However, they differ in their investments—mutual funds are more conservative and generally stick to stocks and bonds. They may do some limited short sales. ETFs are often designed to track stock market indexes.  

Hedge fund managers can be more aggressive in their investment strategies than mutual fund managers. Also, hedge funds are lightly regulated, whereas mutual funds and ETFs operate under US securities regulations.

Hedge funds can invest in a wider array of assets, including derivatives, real estate, natural resources, venture capital—even exotic things such as royalty income from copyrighted music or films. And they can be more aggressive in their efforts to produce returns that exceed market averages—for instance, beating the benchmark Standard & Poor’s 500 Index.

Advantages of investing in hedge funds

Depending on the hedge fund and an investor’s financial plan, there are advantages to keep in mind:

  1. Hedge funds use strategies to try to profit whether stock and bond markets are rising or falling.
  2. They strive for returns above market averages.
  3. They seek to reduce risk and volatility in their mix of investments.
  4. They can employ a variety of investment styles for the investing partners, tailoring specific strategies for them.
  5. Hedge funds have attracted some of the most talented and successful managers, some of whom have produced incredible gains.

Risks and drawbacks of investing in hedge funds

Hedge funds come with some drawbacks to consider, including the following:

  1. Hedge-fund investors surrender control of their money during the lockup. They must be patient and trust the fund manager.
  2. Hedge funds are much less liquid than mutual funds and ETFs, which can be bought or sold daily.
  3. They make big bets on relatively few things, so if any of the bets fails, hedge funds can face very large losses. In this respect, hedge funds belie their name, as such concentrated bets could be seen as speculation rather than hedging.
  4. Hedge funds’ use of leverage is a double-edge sword; it can magnify losses as well as gains.  

The bottom line

Hedge funds are for the wealthy and big institutions, and getting into them requires more money, tolerance for risk, and patience than most investors have. They tend to do best for investors during fluctuating or declining markets, by avoiding or minimizing losses. During long bull markets, they have done worse than market averages, sometimes by significant margins.

If you’re ready to start growing your capital, Titan is ready for you. Our team of exceptional investment analysts manage hundreds of millions of dollars, investing our clients in actively-managed, long-term strategies with an eye on massive growth potential. Through our award-winning app, you’ll ride shotgun with some of the smartest investment minds in the business. Sign-up takes minutes: get started today.
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