The word hedge is often used to mean protection or insurance. That makes it tempting to assume a hedge fund is designed to protect investors from losses. Most modern hedge funds don’t work that way.
The term originally came from Alfred Jones, who in 1949 formed the first “hedge fund.” His fund invested in common stocks and reduced (or “hedged”) risk by using short positions. Many structural features from that early model still show up today, but hedge funds are no longer best known for protection-based strategies.
Hedge funds share several characteristics with other funds (for example, mutual funds and ETFs):
There are important differences as well. The biggest difference is regulation. Most pooled investment vehicles are highly regulated; 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 investments 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. “Reg D” allows securities offered primarily to accredited investors to avoid registration, which results in limited Securities and Exchange Commission (SEC) (regulatory) oversight. In general, you should assume most securities are subject to registration, which involves significant investor disclosures and regulatory oversight, but that hedge funds typically 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.
With limited supervision and regulation, hedge fund portfolio managers often pursue investments with unusual risk-and-return profiles. Many managers are compensated based partly on the fund’s gains, which can create an incentive to take on significant risk in pursuit of large returns.
A typical hedge fund fee structure is “2 and 20,” meaning the fund:
This is the fee structure for 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). Even without the 20% performance fee, a 2% AUM fee on $150 billion equals $3 billion collected annually. Bottom line: hedge funds can generate substantial fee revenue.
Some hedge funds use exotic strategies and invest in unusual assets. For example, some hedge funds made significant gains on Madoff claims.
Here’s the background. Bernie Madoff ran a Ponzi scheme that defrauded investors of nearly $60 billion (he was caught in 2008). Defrauded investors were eligible to file claims against his assets, which a bankruptcy court handled. Bankruptcy proceedings can be slow, and payouts aren’t guaranteed. Some hedge funds bought these claims from victims at deep discounts and then waited for a settlement.
For example, an investor with a $100,000 claim against the Madoff estate sells the claim to a hedge fund for $10,000. If the claim ultimately pays out, the hedge fund earns a 10x return.
Another investment hedge fund managers often gravitate toward is special purpose acquisition companies (SPACs), also known as blank check companies. These organizations raise capital without a defined operating business. Instead, they promise to acquire or merge with another business within a short period (usually within 24 months). Investors are essentially buying into the SPAC executives’ plan, even though they don’t yet know which specific company their money will be used to acquire.
A blind pool investment is another popular hedge fund investment that resembles a SPAC but is somewhat more transparent. SPACs don’t disclose the businesses or industries they intend to target, while blind pool investments typically disclose the industries or sectors they plan to target.
While hedge funds aren’t 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, which can provide diversification.
Funds of hedge funds also tend to have lower minimum investments (usually around $25,000). However, they charge additional management fees on top of the fees charged by the underlying hedge funds, which can make this type of investment expensive.
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 rises. The goal is capital appreciation, meaning you redeem shares at a higher value than your original cost. For example, an investor places $1 million in a hedge fund and redeems the investment ten years later for $5 million. Some hedge funds also distribute investment income (e.g., dividends and interest) to shareholders.
Hedge funds can also offer diversification benefits. Many hedge fund portfolios include investments that are unusual and often unavailable to smaller investors. Exposure to these “exotic” investments can diversify a portfolio beyond basic stock-and-bond allocations.
As with other pooled investments, many shareholder risks come from the fund’s underlying assets. For example, a fund with a large allocation to debt securities would likely face high interest rate risk. Hedge funds often invest in more speculative and aggressive assets, but the specific risks vary because each fund is managed differently. In general, hedge fund investors face capital risk, meaning they can lose part or all of their original investment.
Hedge funds can also involve risks that other pooled investments generally avoid, including liquidity risk. Mutual fund redemption requests, for example, must be fulfilled within 7 days of request. Hedge funds are different because many impose lock-up periods that prohibit withdrawals for long stretches of time. For example, some hedge funds only allow redemptions after a five year holding period. This structure lets portfolio managers invest without needing to keep large amounts of cash available for redemptions.
Legislative risk also applies to hedge fund investments. Politicians and regulators have discussed writing rules governing hedge funds for years. If new laws were enacted, administrative and legal costs would likely rise.
Hedge fund investors are generally wealthy and sophisticated due to regulatory requirements. To avoid regulation, hedge funds typically offer investments only to accredited investors. This type of investor is also considered suitable for the high-risk, high-return potential investments held in many hedge fund portfolios.
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). Even so, a fund of hedge funds is still generally considered an aggressive investment with high risk and return potential.
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