Hedge funds

General characteristics

The term ‘hedge’ is often used as a synonym for ‘protection’ or ‘insurance.’ Therefore, it would seem reasonable to assume a hedge fund offers protection in some form - but, 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 securities offered primarily to accredited investors to avoid registration, resulting in little Securities and Exchange Commission (SEC) (regulatory) oversight. You should assume most securities are subject to registration, which involves significant investor disclosures and regulatory oversight, but that hedge funds avoid this process. We’ll learn more about SEC registration in a future unit.

*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 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, the 2% AUM fee results in $3 billion in annual collections. 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. Quick history lesson - Bernie Madoff created a Ponzi scheme that defrauded investors of nearly $60 billion (he was caught in 2008). 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 within 24 months). 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 pooled investments typically allocate shareholder funds to a dozen or more hedge funds, providing diversification to the investor. Additionally, funds of hedge funds have lower investment minimums (usually around $25,000). However, they assess additional management fees on top of the fees charged by the hedge funds in the portfolio, making this type of investment costly.

Suitability

Benefits

Hedge fund investments provide two primary benefits - capital appreciation and diversification.

Like any other fund, shareholders benefit when the value of the fund’s assets increases overall. The ultimate goal is to attain capital appreciation by redeeming shares at a higher value than the original cost. For example, an investor places $1 million in a hedge fund, then redeems their investment ten years later for $5 million. Some hedge funds also distribute investment income (e.g., dividends, interest) to shareholders.

Hedge funds also provide unique opportunities for added diversification. As discussed above, many investments held in hedge fund portfolios are unusual and typically unavailable to smaller investors. Exposure to these “exotic” investments allows an investor to diversify beyond simple stock and bond allocations.

Risks

Like any other pooled investment, most risks imposed on shareholders are tied to the fund’s assets. For example, a fund with a significant allocation in debt securities would likely be subject to high levels of interest rate risk. Hedge funds often invest in more speculative and aggressive investments, but risks vary because each fund is managed differently. Generally speaking, hedge fund investors are subject to capital risk, which occurs when an investor loses part or all of their original investment.

Hedge funds are also subject to risks that other pooled investments generally avoid, including liquidity risk. If you recall, mutual funds redemption requests must be fulfilled within 7 days of request. Hedge funds are quite different, as most maintain lock-up periods that prohibit withdrawals for lengthy periods. For example, some hedge funds only allow redemptions after a five year holding period. This structure enables portfolio managers to invest fund assets without worrying about keeping cash available for redemptions.

Legislative risk also applies to hedge fund investments. Politicians and regulators have threatened to write rules governing hedge funds for years. New laws would likely result in rising administrative and legal costs if this were to occur.

Typical investor

Hedge fund investors are generally wealthy and sophisticated due to regulatory requirements. To avoid regulation, hedge funds typically only offer investments to accredited investors. This type of investor is also suitable for the high-risk, high-return potential investments held in the fund’s portfolio.

Smaller non-accredited investors may be suitable for funds of hedge funds because of the added diversification (they invest in many hedge funds) and shorter lock-up periods (some have no lock-up period). Regardless, a fund of hedge funds is still considered an aggressive investment with high risk and return potential.