We previously discussed the term “hedge,” which is often used as a synonym for “protection” or “insurance.” It’s easy to assume a hedge fund must offer protection in some form. Most modern hedge funds don’t.
The term originally came from Alfred Jones, who in 1949 formed the first “hedge fund.” His fund invested in common stocks and reduced risk by using short positions. Many structural features from Jones’s approach still show up today, but hedge funds are no longer defined by protection-based strategies.
Hedge funds share several features with other funds (for example, mutual funds and ETFs):
There are important differences as well. The biggest is regulation: most pooled investment vehicles are highly regulated, while hedge funds generally are not. With fewer regulatory constraints, hedge fund managers can use strategies that publicly available funds are typically prohibited from using, including:
Most hedge funds require a minimum investment of $1 million (or more) and restrict participation to accredited investors*. By limiting investors this way, hedge funds can avoid many regulations that apply to publicly available investment pools.
The term “accredited” comes from Regulation D, a subsection of the Securities Act of 1933. Regulation D allows certain securities offerings to be conducted as an exempt transaction when they’re offered primarily to accredited investors. The result is limited Securities and Exchange Commission (SEC) regulatory oversight and no registration requirement.
In contrast, most securities offerings go through a registration process that includes significant investor disclosures and regulatory review. Hedge funds typically avoid that process. We’ll cover 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.
Because hedge funds operate with relatively little supervision and regulation, managers often pursue investments with unusual risk/return profiles. Many hedge fund managers are paid based partly on the fund’s gains, which can create an incentive to take on significant risk in pursuit of large returns.
A common fee structure is “2 and 20,” meaning:
This is the fee structure for several Bridgewater Associates hedge funds, one of the largest hedge fund companies in the world, with an approximate portfolio size of $150 billion (as of November 2022). Ignoring the 20% performance fee, 2% of $150 billion is $3 billion. Bottom line: hedge funds can generate considerable fee revenue.
Some hedge funds use exotic strategies and invest in unusual assets. For example, some hedge funds made significant gains by buying Madoff claims. Bernie Madoff ran a Ponzi scheme that defrauded investors of nearly $60 billion. Defrauded investors could file claims against his assets through a bankruptcy court process.
Bankruptcies are often slow and there’s no guarantee of a payout. Some hedge funds bought these claims from victims at deep discounts and then waited for a settlement. For example, someone with a $100,000 claim against the Madoff estate might sell that claim to a hedge fund for $10,000. If the claim ultimately paid out, the hedge fund could earn a 10x return.
Another investment hedge fund managers may pursue is special purpose acquisition companies (SPACs), also called blank check companies. These organizations raise money from investors without having a defined operating business at the time of the offering. Instead, the SPAC commits to acquiring or merging with another business within a short period (usually two years or less). Investors are essentially buying into the SPAC executives’ plan, even though they don’t yet know the specific company their money will be invested in.
A blind pool investment is another hedge fund investment that resembles a SPAC, but is typically more transparent. SPACs don’t disclose the businesses or industries they intend to target, while blind pool investments usually disclose the industries or sectors they plan to target.
While hedge funds aren’t available to the general public for several reasons, funds of hedge funds are more accessible to the average non-accredited investor. These funds typically invest in a dozen or more hedge funds, which can provide diversification.
Funds of hedge funds also tend to have lower minimum investments (often around $25,000). Even with diversification and lower minimums, they’re still risky investments and are generally suitable only for aggressive investors. Another key drawback is cost: funds of hedge funds charge their own management fees on top of the fees charged by the underlying hedge funds.
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