Complete Guide to Hedge Funds
Hedge funds are alternative investments that pool investors’ sums of money and invest them into various financial instruments. It is known that there are around 2 trillion dollars of hedge funds managed globally. A Hedge Fund pools resources from investors and uses its funds in domestic and global markets to generate high profit and long-term returns.
Hedge funds employ riskier but more rewarding investment strategies than other funds. While the success of these funds is measured by the positive returns they earn, the success of traditional mutual funds is measured by the achievement of predetermined, stable earnings targets.
What Are Hedge Funds?
A hedge fund is a private investment fund that uses the funds collected from wealthy individuals and large institutions to buy and sell financial assets created to generate returns and evaluate capital.
Hedge funds, also called “hedging funds,” are investment instruments that can provide extra profit to individual investors with high capital. The USA is home to the world’s most significant hedge funds. Investors who want to provide high risk and high returns use hedge funds.
A hedge fund raises money from investors to purchase securities or other types of investments. But hedge funds’ investments are not like mutual funds or exchange-traded funds (ETFs), for the most part. They use aggressive investment strategies such as leveraged, debt-backed investing, and short selling. Hedge funds can buy types of assets such as real estate, art, and money that other mutual funds cannot.
Definition Of A Hedge Fund
In the simplest terms, “hedging” a financial position means taking a reverse position that will protect that position from risk. However, hedge funds are not generally used for hedging purposes, and many fund management companies prefer risky and highly leveraged investments in terms of markets. Hedge funds can invest in any number of strategies and they are perhaps most readily identifiable by their structure, which is typically a limited partnership.
In fact, “hedge” means to manage risk. A hedge fund manager may make a speculative investment; Immediately after, he can make a new movie with a sell decision or a new buy decision, in order to prevent a negative result from the speculative move. This process can be described as a risky and unexpected process for a standard investment manager, but all these moves will be the hedge fund manager’s position to take risks and hedge when necessary.
Brief History Of Hedge Funds
Hedge funds are similar to other mutual funds in the way they are managed and pooled. Historically, the first example of a hedge fund is the long and short-term mutual fund created on stocks by investment consultant Alfred Winston Jones in 1949. From the 1990s to the global crisis in 2008, hedge funds experienced a boom period. It is even known that hedge funds are one of the causes of the worldwide crisis, and the total amount of funds before the crisis exceeded 2 trillion dollars. Hedge Funds have turned successful fund managers into big investors because their earnings increase based on the number of money participants have invested in the fund. Warren Buffett made his first million by running a hedge fund.
It has been observed that hedge funds were used for hedging purposes in the 1950s when they became widespread. Still, especially in the 2000s, with the globalization in the financial markets, the facilitation of fund flow, and the diversification of investment instruments, they turned to different investment strategies with the target of high returns.
When the 2008 crisis took place, the number of these funds had exceeded ten thousand. As a result of the Bernard Madoff scandal, which came on top of credit problems, and the “due diligence” panic created by this scandal, hedge funds’ rules and fundraising methods have completely changed.
Hedge funds have historically underperforming stock market indices. From January 2009 to January 2019, hedge funds were more profitable only in 2018 compared to S&P 500 stocks. However, this statistic is average. Hedge funds, which close the year with very profitable investments, emerge almost every year. The share of hedge funds in the world financial market is estimated to be around 3%.
Are Hedge Funds Controlled?
Like investment banks, hedge funds are seen as an elite fixture on Wall Street. They also get scapegoated for a variety of market problems ranging from manipulation to a lack of transparency.
Hedge fund managers tend to earn whopping sums of money.
Hedge funds are known as unregulated investment pools where high-risk investments are made. Almost all of these funds are subject to regulations such as the patriot act and the rules of some organizations such as NFA etc. Hedge funds are not registered with the SEC (Securities and Exchange Commission). They avoid registration by accrediting investors by limiting the number of investors and requiring them to meet a certain level of return.
Hedge Funds: Pros & Cons
Probably the most significant benefit of investing in hedge funds comes from the ability to partner with some of the best investment managers in the world and generate returns that are incompatible with the market. Hedge funds can help diversify a portfolio – and when the overall market is struggling, hedge funds using the right strategy can still deliver good returns.
Hedge funds have benefits in the market, apart from investors; for example, they provide liquidity to the financial system. Hedge funds determine the demand for assets in the market, help determine prices and use information effectively. Hedge funds offer diversification in global portfolios, not just in one country.
Hedge funds provide high returns for investors who take high risks. They can bring high returns even when the economy is bad. It is one of the best investment tools for long-term investment. But high risk means a big loss if things don’t go well. In particular, investments made in the form of leverage can cause large profits or losses as they contain more than the real budget of the investor.
Hedge funds are designed to perform well in all market conditions. As long as good fund managers manage them, risks are brought under control, and they get high returns. However, losses may occur due to crises that even the most foresighted and knowledgeable managers cannot predict. Economic and political crises, such as the 2008-2009 financial crisis, the trade wars between China and the USA, can always be experienced.
In terms of cons, hedge funds require investors to lock up money for long periods of time and also tend to charge substantial fees. Finally, the use of leverage can magnify small losses, and a lack of diversification in a particular fund can lead to more massive losses.
Hedge Funds vs. Mutual Funds
Hedge funds are sometimes confused by investors as mutual funds are very similar. There are essential differences between them. While hedge funds can be bought and sold, traditional mutual funds only buy. While hedge funds have high risk and high returns, conventional mutual funds have percentage success. One of the main features that distinguish these funds from mutual funds is the fee structure. They charge both a flat fee and a management fee.
Mutual funds are regulated investment products offered to the public and available for daily trading. Hedge funds are private investments that are only available to accredited investors.
While investment strategies differ from fund to fund, hedge funds typically aim to generate a profit regardless of whether the market is going up or down. In contrast, mutual funds cannot take such highly leveraged positions, making them less risky and limiting their potential returns.
- Hedge funds charge a performance fee from Profit (usually 15%-20%)
- Hedge funds are only open to high net worth and large investors
- Hedge funds make deductions from investors in the name of management (typically 2%) and performance fees (typically 15-20%).
- Hedge funds can make high-risk investments.
- Hedge funds outperform mutual funds.
- Mutual Funds does not take a share of the profits
- Mutual Funds are available to all investors.
- Mutual Funds only charge management fees (typically 1-2%)
- Mutual Funds do not make high-risk investments
- Mutual Funds make safer, risk-free investments, so they are less profitable than hedge funds.
Top Hedge Funds
In the high-competitive, dog-eat-dog world of Wall Street, it’s really hard to be the best. It’s even harder to stay on top all the time. According to a ranking released by Institutional Investor, hedge fund managers tend to earn whopping sums of money, and in 2019, the 25 highest earners pocketed a collective $20.2 billion. In 2019 Chris Hohn and James Simons made the most cash with almost $1.8 billion each, followed by Ken Griffen and Izzy Englander, who got $1.5 billion.
According to the Bloomberg Billionaires Index, the biggest winner, Chase Coleman, gained $3 billion personally in 2020. Jim Simons and Izzy Englander followed suit. The funds, which entered the top 15 in the ranking in 2020, provided a return of 38%, exceeding the average 9.5% hedge fund return. The growth of this type of funds in 2020 shows that people find it safer to entrust their money to investors rather than investing their money in a business in times of crisis.
Hedge funds, which constitute approximately ¼ of the approximately 6.5 trillion dollars in motion in the world, not only offer high earnings to their investors but also are effective in the sudden change of direction of capital movements. Investment decisions of top hedge funds are important not only for companies but also for the economies of different countries as they can invest on a global scale.
What fees do hedge funds charge?
Two and twenty (or “2 and 20”) is a fee arrangement that is standard in the hedge fund industry and is also common in venture capital and private equity.
Hedge Funds managers or companies charge two types:
A management fee: Hedge funds typically have an asset management fee of 2% of the assets.
A performance fee: It’s also called an incentive fee. A performance fee is a reward for positive returns. Performance fees are an average of 20% of the fund’s profits.
Who Invests in Hedge Funds?
The primary investors in hedge funds are institutional investors. Investors in hedge funds are generally accredited investors, pension funds, foundations, insurance companies, private banks, individuals, and families with huge net incomes.
To invest in hedge funds as an individual, ideal investors should be institutional investors, like a pension fund or an accredited investor. For accredited investors, hedge funds may set different minimum investment amounts. The minimum amount for investment in hedge funds operating in the USA varies between 100,000 – 2,000,000 USD.
An essential piece of information that people and institutions who want to invest in hedge funds should know is the concept of the lock-in period. For this reason, it would be more appropriate for investors who want to invest in highly liquid funds to choose different investment tools such as mutual funds.
Types of Hedge Funds
1. Equity Focused Hedge Funds
a) Equity Hedge Funds: The peculiarity of such funds is that they are insensitive to the market. They aim to provide returns without any correlation with traditional markets such as the capital and money markets.
b) Trading Funds: Trading funds cover the buying or selling of a particular financial asset, depending on the company’s outlook or the market. Trading strategies are a combination of buy (long) and sell (short) positions.
c) Event-Driven/Special Situations: Such hedge funds seek opportunities to make a profit by investing in financial assets that have recently been affected by certain circumstances. They try to predict future price changes of the financial assets in question.
d) Activist Hedge Funds: Activist funds often buy a sizable portion of the company to participate in management and decision-making. Activists often invest for short-term price and dividend gains.
2. Arbitrage Funds / Risk Arbitrage
a) Merger Arbitrages Fund: Merger arbitrages generally involve trading merging firms rather than selling firms. Here, the direction of the arbitrage trade changes depending on whether the company that wants to merge makes an offer above or below the market price to buy the target company to be merged.
b) Distressed/Capital Structure Arbitrage: The financial expert hedge fund team calculates the current position of a firm in financial distress and its market value after financial problems are resolved. If they find an undervalued company or stock due to mispricing, they invest in turning that mispricing into Profit.
c) Statistical Arbitrage: Statistical arbitrage also shows the mispricing of derivatives and the resulting arbitrage opportunities.
3. Non-Equity Focused Funds
a) Global Macro and Emerging Markets Fund: The trading of macro hedge funds is dependent on global macroeconomic situations. These funds usually buy and sell fixed-income financial assets, derivatives, commodities, foreign exchange, and stocks.
b) Offshore Hedge Funds: Many hedge funds trade offshore to take advantage of the tax benefits. For example, most hedge fund portfolio managers have settled in offshore regions in the country where they live. The reason for this is to reduce the tax they pay.
c) Fixed Income Funds: Fixed income funds show parallelism with stock strategies. The trading of fixed income financial assets is mainly concerned with the value of the spread.
Features of Hedge Funds
- Hedge funds are private funds. While small investors can participate in mutual funds, hedge funds are only open to limited and selected institutional investors and qualified individual investors.
- Managed by enterprising investment strategies based on financial leverage
- It is known for its high return potentials.
- Although hedge funds are called hedge funds, they involve high risk. The most important part of their risk is that they work with high leverage for increased profits.
- The money deposited for the fund must be kept in the fund account for a certain period and is a minimum of 1 year.
- The hedge fund may consist of pension funds, banks, brokerage houses, insurance companies, foundations, companies, and individual investors.
- Investment portfolios can be in a wide variety of products. They can invest in foreign exchange, various securities, stock market, futures, commodities, and bonds,
- The entire performance of the hedge fund depends on the hedge fund manager. The people who manage the hedge fund are the fund’s partners. Apart from the fund management fee, there are performance-based bonuses.
- Unlike mutual funds, they do not have percentage return or comparative return targets. They aim for total and independent returns.
- It works with complex principles and moves with three basic investment strategies: market trend, event-based, arbitrage.
- Although hedge funds are subject to various controls, they are pretty liberal compared to mutual funds. They are mostly established in countries called offshore due to tax advantages.
- In mutual funds, investors can exit the fund at any time. In contrast, the investor has to continue his investment in hedge funds without withdrawing his capital from the fund in 6-month or annual periods (lock-up period). With these structures, hedge funds provide themselves with the opportunity to make long-term investments.
- Fund management gets a share of the profits. This rate is usually around 15% – 20%. The so-called asset management fee is usually between 1% and 2% of the fund’s net assets and is usually charged monthly or quarterly.
Hedge Fund Strategies
There are three basic investment strategies in hedge funds. We will talk about seven different strategies based on these investment strategies in the rest of our article. The first of the investment strategies The market trend strategy includes investment strategies based on macro developments.
On the other hand, an event-based investment strategy covers buying, selling, and investment movements according to positive or negative results for a company. Arbitrage strategies are investment strategies applied to take advantage of the difference in return between instruments with the same risk but different returns. Funds that employ an absolute return strategy but by focusing only on the long side of the markets they invest in.
After dividing the investment strategies into three basic parts, we will examine the strategies of hedge funds under seven sub-titles:
a) Global Macro Hedge Fund Strategies
Global macro strategy hedge funds take investment decisions by analyzing the political and economic situation of various countries. Before investing in this type of strategy, the countries’ short- and long-term economic trends are evaluated. The digitalization of the financial world, the ease of access to all world markets, stock markets, and banking transactions have made the use of global macro strategies widespread.
b) Long & Short Hedge Fund Strategies
Long & Short is the most commonly used strategy and would cover establishing a long and short position in equities while using derivative securities. Hedge Funds will include using fundamental and quantitative techniques when making an investment decision. Typically, a fund will seek to take a long position in undervalued securities and short overvalued securities. Fund managers based on Long & Short strategies determine their investments with a long-term perspective.
- c) Market Neutral Hedge Fund Strategies
Market-neutral funds aim to generate above-market returns with lower risk. In this strategy, choosing securities to buy and sell and
Complex numerical techniques are used to analyze price data to find relationships among securities and accurate information about future price movements. Leverage is often used to increase the return on buy and sell positions. The goal of market-neutral funds is to keep low net exposure compared to the rest of the market.
d) Merger Arbitrage Hedge Fund Strategies
Merger arbitrage funds aim to profit from the merger of two or more publicly traded companies. They aim to take advantage of price discrepancies that might occur before and after the merger. The main purpose of this type of strategy is that the stock price of the acquired company rises, and the stock price of the acquiring company decreases. These strategies, which are built on the acquisition or merger transaction probabilities, are called ‘Merger arbitrage.’
e) Convertible Arbitrage Hedge Fund Strategies
Convertible arbitrage aims to take a long position in a company’s convertible securities while at the same time taking a short place in the company’s common shares. Convertible arbitrage involves the simultaneous purchase of convertible securities and the quick sale of the same issuer’s common stock.
f) Capital Structure Arbitrage Hedge Fund Strategies
Capital structure arbitrage seeks to exploit price inefficiencies between the various security classes issued from the same company. Mispricing opportunities often happen between equity and debt-issued securities.
g) Fixed Income Arbitrage Hedge Fund Strategies
Fixed income strategies aim to exploit inefficiencies in fixed income securities. Fixed-income arbitrage strategies are the popular methods used to profit from minor pricing differences in diverse asset classes. Invests in fixed income securities and/or fixed income arbitrage opportunities, usually along with the use of leverage. Basic fixed-income arbitrage strategies are; swap-spread arbitrage, yield curve arbitrage, and capital structure arbitrage.
h) Event-Driven Arbitrage Hedge Fund Strategies
Event-driven strategies seek to exploit pricing opportunities that may arise due to specific corporate events. Fund managers follow events such as company splits, asset sales, and mergers. A separate strategy, merger arbitrage, is an event-driven strategy that can also involve distressed companies.