Hedge funds

General characteristics

We previously discussed the term ‘hedge,’ often used as a synonym for ‘protection’ or ‘insurance.’ It would seem reasonable to assume a hedge fund offers protection in some form - however, this is not true of most modern hedge funds. The term was originally coined by Alfred Jones, who in 1949 formed the first ever ‘hedge fund’ that invested in common stocks and offset risk by utilizing short positions. While many of the structural characteristics set by Mr. Jones still exist in modern hedge funds today, these investment vehicles are no longer known for protection-based strategies.

Hedge funds share many characteristics with other funds (e.g., mutual funds and ETFs) - they are pooled accounts of investor capital that portfolio managers oversee. The portfolio manager maximizes shareholder return while abiding by the fund’s investment objectives and is compensated for their services. Shareholders realize returns when they receive periodic fund distributions and their shares are redeemed at higher values than their original cost.

There are some clear differences too. The biggest relates to regulation - while most pooled investment vehicles are highly regulated, hedge funds are not. The lack of regulation allows portfolio managers to engage in riskier strategies that publicly available funds are forbidden from engaging in. This includes heavy use of leverage (investing borrowed funds), short-selling securities, and investments in speculative investments or assets (e.g., currencies and commodities).

Most hedge funds require a minimum investment of $1 million (or more) and restrict investments to accredited investors*. By doing so, hedge funds avoid many regulations that publicly available investment pools are subject to. The term ‘accredited’ comes from Regulation D, a subsection of the Securities Act of 1933. “Reg D” allows the use of an exempt transaction for securities offered primarily to accredited investors, resulting in little Securities and Exchange Commission (SEC) (regulatory) oversight and no registration requirements. Assume most securities are subject to a registration process involving significant investor disclosures and regulatory oversight, and that hedge funds avoid this process. We’ll learn more about SEC registration in a future chapter.

*Investors meeting certain requirements tied to wealth or investment experience are defined as accredited investors according to Regulation D.

Fees

With little supervision and regulation, hedge fund portfolio managers seek investments with unique risks and returns. Often, these financial professionals are compensated based on the gains made in the fund, creating an incentive to take on significant risk in hopes of making large returns. A typical hedge fund structure is “2 and 20,” meaning the fund collects 2% of AUM (assets under management), plus keeps 20% of the gains it makes for its investors. This is the fee structure for several Bridgewater Associates hedge funds, which is one of the largest hedge fund companies in the world with an approximate portfolio size of $150 billion (as of November 2022). Without including the 20% gains they keep, 2% of $150 billion is $3 billion. Bottom line: hedge funds make a considerable amount of money.

Unique investments

Some hedge funds follow exotic strategies with bizarre and unique investments. For example, some hedge funds made significant gains on Madoff claims. If you don’t remember, Bernie Madoff created a Ponzi scheme that defrauded investors of nearly $60 billion. Mr. Madoff’s defrauded investors were eligible for claims against his assets, which a bankruptcy court handled. However, bankruptcies are notoriously slow-moving with no guarantee of a payout. Some hedge funds purchased these claims from Mr. Madoff’s victims at deep discounts and waited until a settlement was reached. For example, a person with a $100,000 claim against the Madoff estate sells their claim to a hedge fund for $10,000. If it paid out, the hedge fund would make a 10x return.

Another interesting investment hedge fund managers gravitate to is special purpose acquisition companies (SPACs), also known as blank check companies. These organizations operate without a defined business plan when investors fund them with capital. Instead, SPACs pledge to acquire or merge with other businesses within a short period (usually two years or less). Investors “buy in” to the vision of the SPAC executives but don’t know exactly what their money is being invested in.

A blind pool investment is another popular hedge fund investment similar to a SPAC but a little more transparent. SPACs do not disclose the businesses or industries they intend to target, while blind pool investments typically reveal the industries or sectors they target.

Funds of hedge funds

While hedge funds are not available to the general public for many reasons, funds of hedge funds are more attainable for the average non-accredited investor. These funds typically comprise a dozen or more hedge funds, providing diversification to the investor. Additionally, funds of hedge funds have lower investment minimums (usually around $25,000). Although extra diversification reduces risk and lower minimums make them more affordable, funds of hedge funds are still risky investments that are only suitable for aggressive investors. Also, funds of hedge funds charge additional management fees on top of the fees charged by the hedge funds in the portfolio, making this type of investment costly.