Hedge funds are alternative investments that use pooled funds and employ different strategies to achieve active returns or alpha for their investors. Hedge funds are typically aggressively managed or use derivatives and leverage in domestic and international markets to achieve high returns (either in absolute terms or relative to an established market benchmark).
It is important to note that hedge funds are typically available only to accredited investors, as they require less SEC regulation than other funds. One aspect that distinguishes the hedge fund industry is that hedge funds face less regulation than hedge funds and other investment vehicles.
- Hedge funds can be actively managed alternative investments that may employ non-traditional investment strategies or asset classes.
- Hedge funds are more expensive compared to conventional mutual funds and often limit investments to high net worth or other sophisticated investors.
- The number of hedge funds has had an extraordinary growth curve over the last 20 years and has also been associated with several controversies.
- While hedge funds were lauded for outperforming the market in the 1990s and early 2000s, since the financial crisis many hedge funds have underperformed (especially net of fees and taxes).
Understanding hedge funds
Every hedge fund is designed to take advantage of certain identifiable market opportunities. Hedge funds use a variety of investment strategies and, therefore, are often classified by investment style. There are significant differences in risk attributes and investments among the various styles.
From a legal standpoint, hedge funds are typically established as private investment limited partnerships that are open to a limited number of accredited investors and require a high minimum initial investment. Hedge fund investments are illiquid because they often require investors to keep their money in the fund for at least one year, a period known as a lock-up period. Withdrawals may also occur only at certain intervals, such as quarterly or semi-annually.
History of hedge funds
A.W. Jones & Co. of former author and sociologist Alfred Winslow Jones created the first hedge fund in 1949. It was while writing an article on current investment trends for Fortune magazine in 1948 that Jones was inspired to try his hand at money management.
He raised $100,000 ($40,000 of which came out of his own pocket) and decided to try to minimize the risk of holding long-term stock positions by shorting other stocks. This investment innovation is now known as the classic long-short stock model. Jones also used leverage to increase returns.
In 1952, Jones changed the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner. As the first money manager to combine short selling, the use of leverage to share risk by partnering with other investors, and a compensation system based on investment performance. Jones earned a place in investment history as the father of the hedge fund.
In the 1960s, hedge funds dramatically outperformed most mutual funds and gained even more popularity when a 1966 article in Fortune magazine. It highlighted an obscure investment that had outperformed all mutual funds in the market by double digits in the previous year and by high single digits in the previous five years.
However, as hedge fund trends have evolved, many funds, in an effort to maximize returns, have moved away from Jones’ strategy of focusing on security selection along with hedging, and have instead opted for riskier strategies based on long-term leverage. This tactic led to large losses in 1969-70, followed by the closure of several hedge funds during the bear market of 1973-74.3
For more than two decades, the sector was relatively quiet until a 1986 article in Institutional Investor magazine highlighted the double-digit performance of Julian Robertson’s Tiger Fund. When high-yield hedge funds came back to public attention with their stellar results, investors flocked to an industry that now offered thousands of funds and an increasing number of exotic strategies. Such as currency trading and derivatives such as futures and options3.
In the early 1990s, prominent money managers left the traditional mutual fund industry in droves to seek fame and fortune as hedge fund managers. Unfortunately, history repeated itself in the late 1990s and early 2000s, when several prominent hedge funds, including Robertson’s, failed miserably.
Since then, the hedge fund industry has grown considerably. Today, the hedge fund industry is huge: according to Preqin’s 2018 Global Hedge Fund Report, total assets under management in the industry are valued at more than $3.2 trillion. According to statistics from research firm Barclays hedge, the total number of hedge fund assets under management increased by 2,335% between 1997 and 2018.
The number of operational hedge funds has also increased, at least in some periods. In 2002, there were approximately 2,000 hedge funds. Estimates of the number of hedge funds currently operating vary. At the end of 2015, the number exceeded 10 000. However, losses and underperformance have led to their liquidation. At the end of 2017, there were 9 754 hedge funds, according to Hedge Fund Research. In 2019, the number of funds worldwide will reach 11,088, according to Statistica; 5,581 were in North America.
Main characteristics of hedge funds
They are only open to “accredited” or qualified investors.
Hedge funds can only accept money from “qualified” investors: individuals whose annual income in the last two years exceeds $200,000 or whose net worth exceeds $1 million, excluding their primary residence. Therefore, the SEC considers qualified investors to be sufficiently suitable to manage the potential risks arising from the broader investment mandate.
They offer greater investment discretion than other funds.
The investment universe of a hedge fund is limited only by its mandate. A hedge fund can invest in virtually anything: land, real estate, equities, derivatives, and currencies. Mutual funds, on the other hand, must basically limit themselves to stocks or bonds and are usually only long-term.
They usually use leverage
Hedge funds often use borrowed money to increase their returns and, depending on the fund’s strategy, it also allows them to take aggressive short positions. As we saw during the 2008 financial crisis, leverage can also destroy hedge funds.
Rate structure 2 and 20
Instead of charging only an expense ratio, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as “two-and-twenty”: a 2% asset management fee and then a 20% share of the profits earned.
There are more specific characteristics that define hedge funds, but basically, because they are private investment vehicles that only allow wealthy individuals to invest, hedge funds can essentially do whatever they want, as long as they disclose the strategy to investors in advance.
This wide latitude may seem very risky, and sometimes it can be. Some of the most notable financial downturns have involved hedge funds. However, this flexibility available to hedge funds has led some of the most talented money managers to achieve amazing long-term returns.
It is important to note that “hedging” is actually an effort to reduce risk, but the objective of most hedge funds is to maximize investment returns. The name is mostly historical because early hedge funds sought to protect against the risk of a downward market decline by taking short positions (mutual funds do not typically take short positions as one of their primary objectives).
Today, hedge funds use dozens of different strategies, so it is not accurate to say that hedge funds merely “hedge risk.” In fact, because hedge fund managers make speculative investments, hedge funds can carry more risk than the market as a whole.
The following are some of the risks unique to hedge funds:
The concentrated investment strategy exposes hedge funds to potentially large losses.
Hedge funds often require investors to tie up their money for several years.
The use of leverage, or borrowed money, can turn what would be a small loss into a significant loss.
Remuneration structure of hedge fund managers
Hedge fund managers are notorious for their typical 2 and 20 fee structure, where the fund manager receives 2% of assets and 20% of profits each year.1 It is the 2% that is the subject of criticism, and it is not hard to see why. Even if a hedge fund manager loses money, he or she still receives 2% of the assets. For example, a manager overseeing a $1 billion fund can get $20 million in annual fees without lifting a finger.
However, there are mechanisms in place to help protect those who invest in hedge funds. Fee caps, such as maximum allowable returns, are often used to prevent portfolio managers from charging twice for the same returns. Caps on fees may also be set to prevent managers from taking on excessive risk.
How to choose a hedge fund
With so many hedge funds in the investment world, it is important for investors to know what they are looking for in order to streamline the due diligence process and make timely and appropriate decisions.
When searching for a quality hedge fund, it is important for investors to identify the metrics that are important to them and the performance required for each. These benchmarks can be based on absolute values, such as returns in excess of 20% per annum over the past five years, or they can be relative, such as the five best performing funds in a particular category.
For a list of the world’s largest hedge funds, see “What are the world’s largest hedge funds?”.
Guidelines for absolute fund performance
The first guideline an investor should set when choosing a fund is the annualized rate of return. Let’s say we want to find funds with a five-year annualized return that exceeds the Citigroup World Government Bond Index (WGBI) return by 1%. This filter would exclude any fund that underperforms the index over the long term and could be adjusted based on the performance of the index over time.
This guide will also reveal funds with much higher expected returns, such as global macro funds, long/short oriented funds, and several others. However, if these are not the types of funds an investor is looking for, you should also set a guide for the standard deviation. Again, we use the WGBI to calculate the standard deviation of the index over the previous five years. Suppose we add 1% to this result and set this value as the standard deviation guideline. Funds with a standard deviation greater than the guideline value can also be excluded from consideration.
Unfortunately, high returns do not necessarily help identify an attractive fund. In some cases, a hedge fund may have used a strategy that was popular, making the performance above normal for its category. Therefore, after identifying some funds as high performing, it is important to identify the fund’s strategy and compare its performance to other funds in the same category.
To do this, an investor can establish benchmarks by first benchmarking similar funds. For example, the 50th percentile can be set as a guide for filtering funds.
The investor now has two benchmarks that all funds must meet in order to be considered. However, the use of these two benchmarks still leaves too many funds that cannot be evaluated in a reasonable amount of time. More benchmarks need to be established, but they do not necessarily apply to the entire remaining pool of funds. For example, the guidelines for a merger arbitrage fund will differ from those for a market-neutral long-short fund.
Guidelines for relative fund performance
To help investors find high-quality funds that meet not only initial return and risk guidelines, but also strategy-specific guidelines, the next step is to establish a set of relative guidelines. Relative performance indicators should always be based on specific categories or strategies. For example, it would not be fair to compare a leveraged global macro fund to a market-neutral equity long/short portfolio.
To establish guidelines for a particular strategy, an investor can use an analytical software program (e.g., Morningstar) to first identify a universe of funds using similar strategies. Subsequently, the analysis of comparable funds will reveal many statistics broken down into quartiles or deciles for that universe.
The threshold for each guideline can be the result of each metric meeting or exceeding the 50th percentile. An investor can relax a guideline using the 60th percentile or tighten it using the 40th percentile. Using the 50th percentile on all metrics typically filters out all but a few hedge funds, which require additional consideration. In addition, guidelines set in this manner allow flexibility to adjust the guidelines as the economic environment may affect the absolute returns of some strategies.
Among the factors used by some hedge fund advocates are:
- Five-year annualized return
- Standard deviation
- Moving standard deviation
- Months to recovery/maximum reduction
- Descent deviation
These guidelines will help to exclude many funds from the pool and to determine a usable number of funds for further analysis.
Other guidelines for the evaluation of funds
Investors may consider additional guidelines that may further reduce the number of funds to analyze or identify funds that meet additional criteria that may be relevant to the investor. Examples of additional guidelines include:
Fund size/company size: Depending on the investor’s preferences, the size guideline can be a minimum or maximum value. For example, institutional investors often invest such large amounts that a fund or company must have a minimum size in order to make a large investment.
For other investors, a fund that is too large may be problematic in the future if it uses the same strategy to match past successes. This may be the case for hedge funds investing in the small-cap stock sector.
Track record: If an investor requires a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate all new funds. However, sometimes a fund manager leaves and creates his or her own fund, and even if the fund is new, the manager’s performance can be tracked over a much longer period of time.
Minimum investment: this criterion is very important for small investors, as many funds have a minimum investment that can hinder proper diversification. A fund’s minimum investment can also give a clue about the types of investors in the fund. Higher minimum investments may indicate a higher proportion of institutional investors, while low minimum investments may indicate a higher number of retail investors.
Redemption terms: These terms affect liquidity and are very important if the overall portfolio is highly illiquid. Longer lock-up periods are more difficult to incorporate into the portfolio, and redemption periods longer than one month may pose some problems during the portfolio management process.
A guideline can be set to exclude funds that have a lock-up period if the portfolio is already illiquid, while this guideline can be relaxed if the portfolio has sufficient liquidity.
Taxation of hedge fund returns
If a U.S. hedge fund returns profits to its investors, that money is subject to capital gains tax. The short-term capital gains tax rate applies to gains on investments held for less than one year and is the same as the investor’s ordinary income tax rate.
For investments held for more than one year, the rate is a maximum of 15% for most taxpayers, but can be as high as 20% in high tax brackets. This tax applies to both U.S. and foreign investors.
An offshore hedge fund is established outside the United States, usually in a low-tax or tax-free country. It accepts investments from foreign investors and tax-exempt U.S. entities. These investors do not have to pay U.S. taxes on distributions9.
Ways hedge funds avoid taxes
Many hedge funds are structured to take advantage of carried interests. Under this structure, the fund is treated as a partnership. The founders and managers of the fund are general partners, while the investors are limited partners. The founders also own the management company that manages the hedge fund. The managers receive a performance fee of 20% of the participation as general partners of the fund.9
Hedge fund managers are compensated on this carried interest; their income from the fund is taxed as investment income, not as salary or compensation for services rendered. The incentive fee is subject to a long-term capital gains tax rate of 20%, as opposed to the ordinary income tax rate, whose maximum rate is 39.6%. This represents a significant tax saving for hedge fund managers.
This business arrangement has its detractors, who argue that this structure represents a loophole that allows hedge funds to avoid paying taxes. So far, the carried interest rule has not been repealed, despite several attempts by Congress to do so. It became a hot-button issue during the 2016 primary election. And President Biden’s tax plan includes a repeal of the carried interest provision.
Many major hedge funds use hedge funds in Bermuda as another way to reduce their tax liability. Bermuda does not charge corporate income tax, so hedge funds set up their own reinsurance companies in Bermuda. The hedge funds then send money to Bermuda hedge funds. These hedge funds in turn invest the funds in the hedge funds.
All hedge fund profits go to Bermuda, where they do not pay corporate income tax. Profits from hedge fund investments grow tax-free. Taxes are only paid after investors sell their hedge fund shares.
The Bermuda business must be an insurance business. Any other type of business could result in penalties by the U.S. Internal Revenue Service (IRS) for passive foreign investment companies. The IRS defines the insurance business as an active business. To be considered an active business, a reinsurance company must not have much more capital than it needs to back the insurance it sells. It is unclear what this standard is because the IRS has not yet defined it.11
The controversy over reinsurance pools
Since 2008, several hedge funds have been embroiled in insider trading scandals. One of the most well-known cases of insider trading is that of the Galleon Group, led by Raj Rajaratnam.
At its peak, Galleon Group managed more than $7 billion before being forced out of business in 2009. The company was founded in 1997 by Raj Rajaratnam. In 2009, federal prosecutors charged Rajaratnam with multiple counts of fraud and insider trading. In 2011, he was convicted on 14 counts and began serving an 11-year sentence. Many Galleon employees were also convicted in the scandal.12
Rajaratnam was caught obtaining confidential information from Goldman Sachs board member Rajat Gupta. Before the news became public, Gupta reportedly passed on the information that Warren Buffett had invested in Goldman Sachs at the height of the financial crisis in September 2008. Rajaratnam managed to buy a considerable amount of Goldman Sachs shares and made a large profit on them in a single day.
Rajaratnam was also convicted on other insider trading charges. Throughout his tenure as a fund manager, he cultivated a group of industry insiders to gain access to important information.
Hedge fund regulation
Hedge funds are so big and powerful that the SEC is starting to pay more attention to them, especially as violations such as insider trading and fraud appear to be more prevalent. But a recent law has really loosened up the way hedge funds can offer their instruments to investors.
In March 2012, the Jump-start Our Business Startups Act (JOBS Act) was enacted into law. The basic premise of the JOBS Act was to encourage small business financing in the U.S. by easing securities regulation. The JOBS Act also had a significant impact on hedge funds: in September 2013, the ban on hedge fund advertising was lifted.
In a 4-1 vote, the Securities and Exchange Commission approved a proposal that allows hedge funds and other companies that do private offerings to advertise to whomever they want, although they can only accept investments from accredited investors. Hedge funds are often key providers of capital to startups and small businesses because they have broad investment freedom.
Allowing hedge funds to provide capital would actually help small businesses grow by increasing the amount of investment capital available.
Hedge fund advertising consists of offering the fund’s investment products to accredited investors or financial intermediaries through print, television, and the Internet. A hedge fund wishing to solicit (advertise) to investors must file a “Form D” with the Securities and Exchange Commission at least 15 days prior to advertising.
Since hedge fund advertising was strictly prohibited before this ban was lifted, the SEC is very interested in how advertising is used by private issuers and has therefore made changes to the Form D filing.
Funds that engage in public advertising will also be required to file a revised Form D within 30 days of the closing of the offering. Failure to comply with these rules will likely result in a ban on new securities for one year or more.
After 2008: the pursuit of the S&P index
Since the 2008 crisis, the hedge fund world has entered another period of less than stellar returns. Many funds that had previously enjoyed double-digit returns for an average year have seen their returns significantly reduced.
In many cases, the funds failed to match the returns of the S&P 500 index. For investors considering where to put their money, it is an increasingly easy decision: why suffer the high fees and initial investment, higher risk and choice restrictions of hedge funds when a safer, simpler investment such as a mutual fund can offer the same or, in some cases, even higher returns?
There are many reasons why hedge funds have struggled in recent years. These reasons range from geopolitical tensions around the world to the overconfidence of many funds in certain sectors, including technology, to the Fed’s interest rate hikes. Many prominent fund managers have made well-publicized bad bets that have cost them not only money, but also their reputation as astute fund leaders.
David Einhorn is an example of this approach. Einhorn’s firm, Greenlight Capital, bet on Allied Capital early on and on Lehman Brothers during the financial crisis. These high-profile bets were successful and earned Einhorn a reputation as a shrewd investor.
But the firm posted losses of 34% in 2018, the worst year in its history, thanks to shorts against Amazon, which recently became the second trillion-dollar company after Apple, and its holdings in General Motors, which posted a less-than-stellar performance in 2018.
Surprisingly, the overall size of the hedge fund industry (in terms of assets under management) did not decline significantly during this period and continued to grow. New hedge funds are continually being created, although there have been a record number of hedge fund closures over the past decade.
Amid this growing pressure, some hedge funds are rethinking aspects of their organisation, including the “twenty-two” fee structure. According to data from Hedge Fund Research, the average management fee fell to 1.48% in the last quarter of 2016, while the average incentive fee fell to 17.4%. In this sense, the average hedge fund is still much more expensive than, for example, an index or mutual fund, but the fact that the fee structure is changing on average is remarkable.
The main hedge fundsThe main hedge funds
In mid-2018, data provider HFM Absolute Return compiled a ranking of hedge funds by total assets. This list of top hedge funds includes some companies that have more AUM in areas other than the hedge fund arm. However, the ranking only takes into account hedge fund operations in individual companies.
Paul Singer’s Elliott Management Corporation had assets of $35 billion at the time of the survey. This fund, founded in 1977, is sometimes referred to as a “vulture fund” because about a third of its assets are focused on distressed securities, including the debt of bankrupt countries. In any case, the strategy has worked well for several decades.
New York-based Two Sigma Investments, founded in 2001 by David Siegel and John Overdeck, tops the hedge fund rankings with more than $37 billion in assets under management. The firm was designed not to rely on a single investment strategy, allowing it to respond flexibly to market changes.
One of the world’s most popular hedge funds is James H. Simon’s Renaissance Technologies. This $57 billion fund was founded in 1982, but has revolutionized its strategy in recent years with technological changes. Renaissance is now known for its systematic trading based on computer models and quantitative algorithms. Thanks to these approaches, Renaissance has been able to offer investors consistently high returns, despite the recent turbulence in the hedge fund industry in general.
AQR Capital Investments is the world’s second largest hedge fund, overseeing just under $90 billion in assets at the time of HFM’s survey. Headquartered in Greenwich, Connecticut, AQR is known for employing both traditional and alternative investment strategies.
Ray Dalio’s Bridgewater Associates remains the world’s largest hedge fund, managing just under $125 billion in AUM as of mid-2018. The Connecticut-based fund employs about 1,700 people and focuses on a global macroeconomic investment strategy. Bridgewater counts foundations, endowments and even foreign governments and central banks among its clients.
|Fund||Year of Foundation.||Focus.||Portfolio.|
|Backrock Advisors||1984||Not determined||$1.900.000.000.000|
|AQR Capital Management||1998||Mutual Funds||$388.800.000.000|
|Bridgewater Associates||1975||Pure Alpha, which focuses on an active investment strategy.|
Pure Alpha Major Markets, The Pure Fund is focused on a subset of opportunities in which the Pure Fund invests. Alpha
All Weather, The EU uses an asset allocation strategy
Optimal portfolio, which combines aspects of the All Weather Fund with active management.
|Renaissance Technologies||1982||Mathematical and statistical methods to discover the technical indicators that drive your automated trading strategies.||154.000.000.000|
|Man Group||1784||It began as an exclusive supplier of rum to the Royal Navy, and later began trading in sugar, coffee and cocoa.||123.600.000.000|
|Elliott Management||1977||Virtually all types of assets: distressed securities, equities, hedging and arbitrage positions, commodities, real estate-related securities, etc.||73.500.000.000|
|Two Sigma Investments||2002||Mathematical strategies based on historical price patterns and other data.||68.900.000.000|
|Millenium Management||1989||Discretionary advisory services for private funds.||42.000.000.000|
|Davidson Kempner Capital Management||1987||It focuses on bankruptcies, convertible arbitrage, merger arbitrage, distressed investments, event-driven actions, and restructuring situations.||34.800.000.000|
|Citadel Advisors||1987||He focuses on equities, fixed income, macro, commodity, credit and quantitative strategies.||33.100.000.000|
Frequently Asked Questions
What is a hedge fund?
A hedge fund is a type of investment vehicle that is designed for creditworthy individuals, institutional investors, and other accredited investors. The term “hedge” is used because hedge funds originally focused on strategies that hedged the risks faced by investors, for example, by simultaneously buying and selling stocks as part of a long-short strategy. Today, hedge funds offer a very wide range of strategies in virtually every available asset class, including real estate, derivatives, and non-traditional investments such as fine art and wine.
How do hedge funds compare with other investment vehicles?
As a type of actively managed investment fund, hedge funds are similar to other investment vehicles such as mutual funds, private equity funds and joint ventures. (ETF)However, hedge funds are known for several distinctive features. First, they are less regulated than competing products such as mutual funds or exchange-traded funds, which gives them virtually unlimited flexibility in terms of the strategies and objectives they can pursue. Secondly, hedge funds have a reputation for being more expensive instruments than others, as many of them use a “2 and 20” fee structure.
Why do people invest in hedge funds?
Because of their diversity, hedge funds can help investors achieve a variety of investment objectives. For example, an investor may be attracted to a particular hedge fund because of the reputation of its managers, the specific assets in which the fund invests, or the unique strategy it employs. In some cases, techniques used by hedge funds — for example, combining leverage with complex derivative transactions — may not be permitted by regulators if used by a mutual fund or another type of investment vehicle.