What Is a Hedge Fund?

Hedge funds are聽alternative investments聽using聽pooled funds聽that employ different strategies to earn聽active聽returns, or聽alpha, for their investors. Hedge funds may be aggressively managed or make use of聽derivatives聽and聽leverage聽in both domestic and international markets with the goal of generating high聽returns聽(either in an absolute sense or over a specified market benchmark).

It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds聽and other investment vehicles.

Key Takeaways

  • Hedge funds are actively managed alternative investments that may also utilize non-traditional investment strategies or asset classes.
  • Hedge funds are more expensive compared to conventional investment funds, and will often restrict investment to high net-worth or other sophisticated investors.
  • The number of hedge funds has had an exceptional growth curve in the last twenty years and has also been associated with several controversies.
  • While the performance of hedge funds as beating the market was lauded in the 1990s and early 2000s, since the financial crisis, many hedge funds have underperformed (especially after fees and taxes).

Introduction To Hedge Funds

Understanding Hedge Funds

Each hedge fund is constructed to take advantage of certain identifiable market opportunities. Hedge funds use different聽investment strategies聽and thus are often classified according to聽investment style. There is substantial diversity in risk attributes and investments among styles.

Legally, hedge funds are most often set up as private investment聽limited partnerships聽that are open to a limited number of聽accredited investors聽and require a large initial聽minimum investment. Investments in hedge funds are聽illiquid聽as they often require investors to keep their money in the fund for at least one year, a time known as the聽lock-up period.聽Withdrawals聽may also only happen at certain intervals such as quarterly or bi-annually.

The History of the Hedge Fund聽

A former writer and sociologist Alfred Winslow Jones鈥檚 company,聽A.W. Jones & Co.聽launched the first hedge fund in 1949.聽It was while writing an article about current investment trends for聽Fortune聽in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by聽short selling聽other stocks. This investing innovation is now referred to as the classic聽long/short equities聽model. Jones also employed聽leverage聽to enhance returns.

In 1952, Jones altered the structure of his聽investment vehicle, converting it from a聽general partnership聽to a聽limited partnership聽and adding a 20%聽incentive fee聽as compensation for the managing partner. As the first聽money manager聽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 funds went on to dramatically outperform most mutual funds in the 1960s and gained further popularity when a聽1966 article in Fortune highlighted an obscure investment that outperformed every聽mutual fund聽on the market by double-digit figures over the previous year and by high double-digits over the previous five years.

However, as hedge fund trends evolved, in an effort to maximize returns, many funds turned away from Jones' strategy, which focused on stock picking coupled with聽hedging and chose instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the聽bear market聽of 1973-74.

The industry was relatively quiet for more than two decades until a 1986 article in聽Institutional Investor聽touted the double-digit performance of聽Julian Robertson's Tiger Fund. With a high-flying hedge fund once again capturing the public's attention with its stellar performance, investors flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic strategies,聽including聽currency trading聽and聽derivatives聽such as聽futures聽and聽options.

High-profile money managers deserted the traditional mutual fund industry in droves in the early聽1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated itself in the late聽1990s聽and into the early聽2000s聽as a number of high-profile hedge funds, including Robertson's, failed in spectacular fashion.锘 Since that era, the hedge fund industry has grown substantially. Today the hedge fund industry is massive鈥攖otal assets under management in the industry are valued at more than $3.2 trillion according to the 2018聽Preqin聽Global Hedge Fund Report.聽Based on statistics from research firm Barclays hedge, the total number of assets under management for hedge funds jumped by 2335% between 1997 and 2018.

The number of operating hedge funds has grown as well. There were around 2,000 hedge funds in 2002. Estimates vary about the number of hedge funds operating today. This number had crossed 10,000 by the end of 2015. However, losses and underperformance led to liquidations. By the end of 2017, there are 9754 hedge funds according to research firm Hedge Fund Research.

Key Characteristics of Hedge Funds

They're only open to "accredited" or qualified investors

Hedge funds are only allowed to take money from "qualified" investors鈥攊ndividuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. As such, the聽Securities and Exchange Commission聽deems qualified investors suitable enough to handle the potential risks that come from a wider investment mandate.锘柯

They offer wider investment latitude than other funds

A hedge fund's investment universe is only limited by its mandate. A hedge fund can basically invest in anything鈥攍and,聽real estate, stocks,聽derivatives, and currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds and are usually long-only.

They often employ leverage

Hedge funds will often use聽borrowed money to amplify their returns and also allow them to take aggressive short positions, depending on the fund's strategy. As we saw during the聽financial crisis of 2008,聽leverage聽can also wipe out hedge funds.

2-and-20 Fee structure

Instead of charging an聽expense ratio聽only, hedge funds charge both an expense ratio and a聽performance fee. This fee structure is known as "Two and Twenty"鈥攁 2% asset聽management fee聽and then a 20% cut of any gains generated.

Special Considerations

There are more specific characteristics that define a hedge fund, but basically, because they are private聽investment vehicles聽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 at times it 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聽money managers聽producing some amazing long-term returns.

It is important to note that "hedging" is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize聽return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the聽downside risk聽of a聽bear market聽by shorting the market. (Mutual funds聽generally don't enter into聽short positions聽as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk." In fact, because hedge fund managers make聽speculative聽investments, these funds can carry more risk than the overall market.

Below are some of the聽unique risks of hedge funds:

  • 聽聽Concentrated investment strategy exposes hedge funds to potentially huge losses.
  • 聽聽Hedge funds typically require investors to lock up money for a period of years.
  • 聽聽nba腾讯体育直播e of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss.

Hedge Fund Manager Pay Structure聽

Hedge fund managers are notorious for their typical 2 and 20 pay structure whereby the fund manager receives 2% of assets and 20% of profits each year.锘 It's the 2% that gets the criticism, and it's not difficult to see why. Even if the聽hedge fund manager聽loses聽money, he still gets 2% of assets. For example, a manager overseeing a $1 billion fund could pocket $20 million a year in compensation without lifting a finger.聽

That said, there are mechanisms put in place to help protect those who invest in hedge funds. Often times, fee limitations such as聽high-water marks聽are employed to prevent聽portfolio managers聽from getting paid on the same returns twice. Fee caps may also be in place to prevent managers from taking on excess risk.

How to Pick a Hedge Fund聽

With so many聽hedge funds聽in the investment universe, it is important that investors know what they are looking for in order to streamline the聽due diligence聽process and make timely and appropriate decisions.聽

When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each. These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the top five highest-performing funds in a particular category.

For a list of the biggest hedge funds in the world read, "What are the Biggest Hedge Funds in the World?"

Fund Absolute Performance Guidelines

The first guideline an investor should set when selecting a fund is the annualized聽rate of return. Let's say that we want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that聽underperform聽the聽index聽over long time periods, and it could be adjusted based on the performance of the index over time.聽

This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and several others. But if these aren't the types of funds the investor is looking for, then they must also establish a guideline for聽standard deviation. Once again, we will use the聽WGBI聽to calculate the standard deviation for the index over the previous five years. Let's assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can also be eliminated from further consideration.

Unfortunately, high returns do not necessarily help to identify an attractive fund. In some cases, a hedge fund may have employed a strategy that was in favor, which drove performance to be higher than normal for its category. Therefore, once certain funds have been identified as high-return performers, it is important to identify the fund's strategy and compare its returns to other funds in the same category. To do this, an investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the聽50th聽percentile as the guideline for filtering funds.聽

Now an investor has two guidelines that all funds need to meet for further consideration. However, applying these two guidelines still leaves too many funds to evaluate in a reasonable amount of time. Additional guidelines need to be established, but the additional guidelines will not necessarily apply across the remaining universe of funds. For example, the guidelines for a聽merger arbitrage聽fund will differ from those for a long-short聽market-neutral聽fund.

Fund Relative Performance Guidelines

To facilitate the investor's search for high-quality funds that not only meet the initial return and risk guidelines but also meet strategy-specific guidelines, the next step is to establish a set of relative guidelines. Relative performance metrics should always be based on specific categories or strategies. For example, it would not be fair to compare a聽leveraged聽global macro fund with a market-neutral, long/short聽equity fund.

To establish guidelines for a specific strategy, an investor can use an analytical software package (such as Morningstar) to first identify a universe of funds using similar strategies. Then, a peer analysis will reveal many statistics, broken down into聽quartiles聽or聽deciles, for that universe.

The threshold for each guideline may be the result for each metric that meets or exceeds the聽50th聽percentile. An investor can loosen the guidelines by using the聽60th聽percentile or tighten the guideline by using the聽40th聽percentile. nba腾讯体育直播ing the聽50th聽percentile across all the metrics聽usually聽filters out all but a few hedge funds for additional consideration. In addition, establishing the guidelines this way allows for flexibility to adjust the guidelines as the economic environment may impact the absolute returns for some strategies.

Factors used by some advocates of hedge funds include:

  • Five-year annualized returns
  • Standard deviation
  • Rolling standard deviation
  • Months to recovery/maximum聽drawdown
  • Downside聽deviation

These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis.

Other Fund Consideration Guidelines

An investor may also want to consider other guidelines that can either further reduce the number of funds to analyze or to identify funds that meet additional criteria that may be relevant to the investor. Some examples of other guidelines include:

  • Fund Size/Firm Size: The guideline for size may be a minimum or maximum depending on the investor's preference. For example, institutional investors often invest such large amounts that a fund or firm must have a minimum size to accommodate a large investment. For other investors, a fund that is too big may face future challenges using the same strategy to match past successes. Such might be the case for hedge funds that invest in the聽small-cap聽equity space.聽
  • Track Record: If an investor wants a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate any new funds. However, sometimes a聽fund manager聽will leave to start their own fund and although the fund is new, the manager's performance can be tracked for a much longer time period.聽
  • Minimum Investment: This criterion is very important for smaller investors as many funds have minimums that can make it difficult to diversify properly. The fund's minimum investment can also give an indication of the types of investors in the fund. Larger minimums may indicate a higher proportion of institutional investors, while low minimums may indicate聽a larger number of individual investors.
  • Redemption Terms: These terms have implications for聽liquidity聽and become very important when an overall聽portfolio聽is highly聽illiquid. Longer聽lock-up periods聽are more difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges during the portfolio-management process. A guideline may be implemented to eliminate funds that have lockups when a portfolio is already illiquid, while this guideline may be relaxed when a portfolio has adequate liquidity.

Taxing Hedge Fund Profits

When a domestic U.S. hedge fund returns profits to its investors, the money is subject to capital gains tax. The short-term capital gains rate applies to profits on investments held for less than one year, and it is the same as the investor's tax rate on ordinary income. For investments held for more than one year, the rate is not more than 15% for most taxpayers, but it can go as high as 20% in high tax brackets. This tax applies to both U.S. and foreign investors.

An offshore hedge fund is established outside of the United States, usually in a low-tax or tax-free country. It accepts investments from foreign investors and tax-exempt U.S. entities. These investors do not incur any U.S. tax liability on the distributed profits.

Ways Hedge Funds Avoid Taxes

Many hedge funds are structured to take advantage of聽carried interest. Under this structure, a fund is treated as a partnership. The founders and fund managers are the general partners, while the investors are the聽limited partners. The founders also own the management company that runs the hedge fund. The managers earn the 20% performance fee of the carried interest as the聽general partner聽of the fund.

Hedge fund managers are compensated with this carried interest; their income from the fund is taxed as a return on investments as opposed to a salary or compensation for services rendered. The聽incentive fee聽is taxed at the long-term聽capital gains聽rate of 20% as opposed to ordinary聽income tax聽rates, where the top rate is 39.6%. This represents significant tax savings for hedge fund managers.

This business arrangement has its critics, who say that the structure is a聽loophole聽that allows hedge funds to avoid paying taxes. The carried interest rule has not yet been overturned despite multiple attempts in Congress. It became a topical issue during the 2016 primary election.

Many prominent hedge funds use reinsurance businesses in Bermuda as another way to reduce their tax liabilities. Bermuda does not charge a聽corporate income tax, so hedge funds set up their own reinsurance companies in Bermuda. The hedge funds then send money to the reinsurance companies in Bermuda. These聽reinsurers, in turn, invest those funds back into the hedge funds. Any profits from the hedge funds go to the reinsurers in Bermuda, where they owe no corporate income tax. The profits from the hedge fund investments grow without any聽tax liability. Taxes are only owed once the investors sell their stakes in the reinsurers.

The business in Bermuda must be an insurance business. Any other type of business would likely incur penalties from the U.S.聽Internal Revenue Service聽(IRS) for聽passive foreign investment companies. The IRS defines insurance as an active business. To qualify as an active business, the reinsurance company cannot have a pool of capital that is much larger than what it needs to back the insurance that it sells. It is unclear what this standard is, as it has not yet been defined by the IRS.

Hedge Fund Controversies聽

A number of hedge funds have been implicated in聽insider trading聽scandals since 2008. One of the most high-profile insider trading cases involves the Galleon Group managed by Raj聽Rajaratnam.

The Galleon Group managed over $7 billion at its peak before being forced to close in 2009. The firm was founded in 1997 by Raj聽Rajaratnam. In 2009, federal prosecutors charged聽Rajaratnam聽with multiple counts of fraud and insider trading. He was convicted on 14 charges in 2011 and began serving an 11-year sentence. Many Galleon Group employees were also convicted in the scandal.

Rajaratnam聽was caught obtaining insider information from聽Rajat聽Gupta, a board member of Goldman Sachs. Before the news was made public, Gupta allegedly passed on information that Warren Buffett was making an investment in Goldman Sachs in September 2008 at the height of the financial crisis.聽Rajaratnam聽was able to buy substantial amounts of Goldman Sachs stock and make a hefty profit on those shares in one day.

Rajaratnam聽was also convicted on other insider trading charges. Throughout his tenure as a fund manager, he cultivated a group of industry insiders to gain access to material information.

Regulations for Hedge Funds

Hedge funds are so big and powerful that the SEC is starting to pay closer attention, particularly because聽breaches such as insider trading聽and fraud seem to be occurring much more frequently. However, a recent act has actually loosened the way that hedge funds can market their vehicles to investors.聽

In March 2012, the聽Jumpstart Our Business Startups Act聽(JOBS Act) was signed into law. The basic premise of the JOBS Act was to encourage聽funding of small businesses聽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. In a 4-to-1 vote, the SEC approved a motion to allow hedge funds and other firms that create private offerings to聽advertise聽to whomever they want, but they still can only accept investments from聽accredited investors. Hedge funds are often key suppliers of capital to startups and small businesses because of their wide investment latitude. Giving hedge funds the opportunity to solicit capital would in effect help the growth of small businesses by increasing the pool of available investment capital.

Hedge fund advertising entails offering the fund's聽investment products聽to accredited investors or聽financial intermediaries聽through print, television, and the internet. A hedge fund that wants to solicit (advertise to) investors must file a 鈥Form D鈥 with the SEC at least 15 days before it starts advertising. 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聽issuers, so it has made changes to聽Form D聽filings. Funds that make public solicitations will also need to file an amended Form D within 30 days of the offering鈥檚 termination. Failure to follow these rules will likely result in a ban from creating additional securities for a year or more.

Post-2008: Chasing the S&P

Since the 2008 crisis, the hedge fund world has entered into another period of less-than-stellar returns. Many funds that had previously enjoyed double-digit returns during an average year have seen their profits diminish significantly. In many cases, funds have failed to match the returns of the S&P 500. For investors considering where to place their money, this becomes an increasingly easy decision: why suffer the high fees and initial investments, the added risk, and the withdrawal limitations of hedge funds if a safer, simpler investment like a mutual fund can produce returns that are the same or, in some cases, even stronger?

There are many reasons why hedge funds have struggled in recent years. These reasons run the gauntlet from geopolitical tensions around the globe to an over-reliance among many funds on particular sectors, including technology, and interest rate hikes by the Fed. Many prominent fund managers have made highly-publicized bad bets which have cost them not only monetarily but in terms of their reputations as savvy fund leaders, too.

David Einhorn is an example of this approach. Einhorn's firm Greenlight Capital bet against Allied Capital early on and Lehman Brothers during the financial crisis. Those high-profile bets were successful and earned Einhorn the reputation of a shrewd investor.

However, the firm posted losses of 34 percent, its worst year ever, in 2018 on the back of shorts against Amazon, which recently became the second trillion dollar company after Apple, and holdings in General Motors, which posted a less-than-stellar 2018.

Notably, the overall size of the hedge fund industry (in terms of assets under management) has not declined significantly during this period and has continued to grow. There are new hedge funds launching all the time, even as several of the past 10 years have seen record numbers of hedge fund closures.

In the midst of growing pressures, some hedge funds are reevaluating aspects of their organization, including the "Two and Twenty" fee structure. , the last quarter of 2016 saw the average management fee fall to 1.48%, while the average incentive fee fell to 17.4%. In this sense, the average hedge fund is still much more costly than, say, an index or mutual fund, but the fact that the fee structure is changing on average is notable.

Major Hedge Funds

In mid-2018, data provider HFM Absolute Return created a ranked list of hedge funds according to total AUM. This list of top hedge funds includes some companies which hold more in AUM in other areas besides a hedge fund arm. Nonetheless, the ranking factors in only the hedge fund operations at each firm.

Paul Singer's Elliott Management Corporation held $35 billion in AUM as of the survey. Founded in 1977, the fund is occasionally described as a "vulture fund," as roughly one-third of its assets are focused on distressed securities, including debt for bankrupt countries. Regardless, the strategy has proven successful for multiple decades.

Founded in 2001 by David Siegel and John Overdeck, New York's Two Sigma Investments is near the top of the list of hedge funds by AUM, with more than $37 billion in managed assets. The firm was designed to not rely on a single investment strategy, allowing it to be flexible along with shifts in the market.

One of the most popular hedge funds in the world is James H. Simon's Renaissance Technologies. The fund, with $57 billion in AUM, was launched in 1982, but it has revolutionized its strategy along with changes in technology in recent years. Now, Renaissance is known for systematic trading based on computer models and quantitative algorithms. Thanks to these approaches, Renaissance has been able to provide investors with consistently strong returns, even in spite of recent turbulence in the hedge fund space more broadly.

AQR Capital Investments is the second-largest hedge fund in the world, overseeing just under $90 billion in AUM as of the time of HFM's survey. Based in Greenwich, Connecticut, AQR is known for utilizing both traditional and alternative investment strategies.

Ray Dalio's Bridgewater Associates remains the largest hedge fund in the world, with just under $125 billion in AUM as of mid-2018. The Connecticut-based fund employs about 1700 people and focuses on a global macro investing strategy. Bridgewater counts foundations, endowments, and even foreign governments and central banks among its clientele.