What Is A Hedge Fund? Author: Jay Northco
You’ll often see the title ‘hedge fund manager’ in the bios of some of Wall Street’s famous investment gurus. But what exactly is a hedge fund? How is different than any other fund? And how do you get in on the action?
Hedge funds are private investment partnerships that are usually offered to limited number of investors and require a significant initial minimum investment. Hedge funds are normally open to institutional or otherwise accredited investors. Those investors are also required to keep their money in the fund for a minimum period, usually one year.
Basically, hedge funds are mutual funds for the super-rich. They resemble mutual funds in the way investments are pooled and professionally managed, but they are significantly different in the way fund can cooperate.
Hedge funds are lightly regulated private funds that are usually characterized by unconventional investment strategies. These funds are generally more aggressively managed and use advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns. Regular investment funds are usually limited to ‘going long” and buying bonds, equities or money market instruments. Hedge funds also have the ability to "short" those instruments they believe will fall in price. Hedge funds are thus able to create more complex investment structures which can profit in times of market volatility, or even in a falling market.
In general, hedge funds are lightly regulated because it is believed they cater to sophisticated investors who need less protection. In the US, the majority of investors in the fund must be accredited. An accredited investor must earn a set minimum income annually and have a net worth of more than $1 million. Investment companies registered with the US Securities and Exchange Commission (SEC) are subject to strict limitations on the short-selling and use of leverage that are essential to many hedge fund strategies. Although hedge funds fall within the definition of an “investment company,” hedge funds often elect to operate with exemptions from the registration requirements by selling only to “qualified purchasers” or “accredited investors.” Hedge funds are also only sold via private placement and cannot be offered or advertised to the general public. So the funds trade a smaller pool of investors for fewer government restrictions.
While hedging is the practice of attempting to reduce risk, the goal of most hedge funds is to maximize return on investment. The first hedge funds that appeared in the 1950s tried to hedge against the downside risk of a bear market with their ability to short the market. Today, hedge funds use dozens of different strategies, including speculative investments. In fact, in many cases these funds can carry more risk than the overall market.
The hedge fund manager is the general partner or manager and the investors are the limited partners or members respectively. The manager generally makes all the investment decisions based on the strategy it outlined in the offering documents.
In return for managing the investors' funds, the manager will receive a management fee and a performance or incentive fee. Usually this management fee is computed as a percentage of assets under management, and the incentive fee is computed as a percentage of the fund's profits. In some cases the manager does not receive incentive fees unless the value of the fund exceeds a “high water mark.”
Other funds charge no fees until the funds pass specific performance goals. Typical fees for hedge funds are 20 percent of profits plus two percent of assets under management. Famous and successful managers often demand higher fees.
Today, some $1.2 trillion are tied up in some 9,000 hedge funds This is up 19 percent from 2005 and up 300 percent from 2001. At the end of 2004, 55 percent of the number of hedge funds, managing nearly two-thirds of total hedge fund assets, were registered offshore. The most popular offshore location was the Cayman Islands followed by British Virgin Islands and Bermuda. In the US, most funds are located in New York City, Stamford, Connecticut and Greenwich, Connecticut. London is Europe’s leading centre for the management of hedge funds.
Investment companies registered with the U.S. Securities and Exchange Commission (SEC) are subject to strict limitations on the short-selling and use of leverage that are essential to many hedge fund strategies. Although hedge funds fall within the statutory definition of an “investment company,” hedge funds often elect to operate with exemptions from the registration requirements by selling only to "qualified purchasers” or “accredited investors” Hedge funds are also only sold via private placement and cannot be offered or advertised to the general public.
Unlike mutual funds, hedge funds do not have to disclose their activities to third parties. Investors in hedge funds however are entitled to a higher level of disclosure on risks assumed and positions taken, and the investor often has direct access to the fund manager. A byproduct of this privacy is that there are no official hedge fund statistics.
Institutional Investor and Trader Monthly magazine annually ranks top-earning hedge fund managers.
Hedge funds are often targets of criticism. Their secrecy and lack of regulation have led to all kinds of allegations of dodgy dealings. The size of the assets held in these funds has also led to allegations that these funds have adversely affected bond markets on different occasions. US regulators have tried to impose restrictions on these funds but there attempts have been thwarted by the courts and the complexities of the funds and their offshore locations have created a regulatory nightmare for the SEC.
Some writers have concluded that hedge funds have evolved into little more than exclusive, high-fee mutual funds. Warren Buffett has little time for them either pointing out that mangers are rewarded for high variability, rather than high long-term returns.