What is a Hedge Fund?

Jun. 22

KEY POINTS

Hedge funds utilize innovative investment techniques not available to traditional funds
Complex trading strategies incorporate leverage, derivatives, and alternative asset classes
Due diligence is critical to understanding a hedge fund’s unique risks
Discover feeder funds and gain exposure to hedge funds at a lower cost

Hedge funds continue to capture the headlines and our imaginations. Some see them as an unfair advantage for the rich. Others consider hedge funds an unregulated casino and blame them for the occasional financial crisis.

Are these extremes justified?

Are hedge funds only for the top 1%?

Let’s dig in.

A Brief History of Hedge Funds

Alfred W. Jones is often credited with creating the first hedge fund in 1949. He employed a long / short equity strategy.

The 1970s and 1980s saw the hedge fund industry experience a substantial increase in the number of funds, assets under management, and strategies employed. Such strategies extended beyond long / short equities, and came to include global-macro, event-driven, and arbitrage strategies.

The 1990s hedge fund boom was fueled by institutional investors, family offices, and high-net-worth individuals seeking alternative investment options for diversification and enhanced returns. Access to increasing amounts of leverage and advancing technologies provided hedge fund managers with better tools for achieving alpha related returns.

The 2000s were a period of increasing regulation. Such regulation accelerated significantly due to the 2008 global financial crisis. Regulations were imposed with the aim of mitigating systematic risk.

The hedge fund industry has rebounded from the 2008 crisis and continues to adapt to meet the ever-changing demands of regulatory bodies and investors. The investment landscape continues to evolve and provides new opportunities and challenges. Some examples include environmental, social, and governance (“ESG”), artificial intelligence, machine learning, and robo-advisors.

What is a Hedge Fund?

Hedge funds are managed by professional investment managers and primarily offered to institutional investors and accredited investors.

Not all hedge funds actually hedge / mitigate risk.

A hedge fund can typically invest in a wide variety of securities including bonds, stocks, options, warrants, futures contracts, swap contracts, and forward contracts. Leverage is often utilized and derived from short selling, or the intrinsic leverage provided by the respective derivatives deployed.

Hedge Fund vs. Mutual Fund

Most investors are familiar with mutual funds. Therefore, comparing hedge funds to mutual funds can help illustrate the nuances related to hedge funds.

The following chart highlights the comparison of their key traits.

SEC Regulation

Unlike a mutual fund manager, a hedge fund manager may not need to register with the Securities and Exchange Commission (“SEC”), or similar regulatory body in another jurisdiction (e.g., Financial Conduct Authority (“FCA”) in the United Kingdom), and file the requisite public reports.

However, like mutual funds managers, hedge fund managers must adhere to securities law, and they owe a fiduciary duty to the funds they manage. They are subject to SEC oversight and enforcement with respect to fraud.

Such securities law / regulation includes insider trading, market manipulation, and the dissemination of false and misleading information.

Hedge fund managers must also adhere to anti-money laundering regulations and implement appropriate policies and procedures related to customer due diligence, transaction monitoring, and the reporting of suspicious activities.

Hedge funds operating in the United States are regulated by the Commodity Futures Trading Commission.

Transparency

Transparency refers to the degree to which hedge funds publicly disclose information pertaining to their investment strategies, holdings, and performance.

Regulatory bodies (e.g., SEC, FCA) may impose reporting requirements on hedge funds; however, such falls short of that required by mutual funds. Some managers may voluntarily disclose additional information to investors, whereas some take a more guarded approach and only disclose the bare minimum.

Investors should carefully review the fund’s offering documents and all publicly available disclosures. Investors can also perform due diligence procedures directly with the hedge fund or hire a company that offers such services.

Investment Restrictions

Restrictions can be imposed related to the fund’s investment mandate, diversification requirements, use of derivatives and leverage, holding of illiquid securities, and more.

Hedge funds often set investment mandates that are broader in nature than those of mutual funds. For example, global macro mandates are common and signal the manager has a wide array of investment strategies to choose from.

Speculative Practices

Hedge funds may exhibit higher risk than mutual funds by holding less diversified portfolios with more concentrated positions. Such risk can be amplified by utilizing more leverage via derivatives and short selling. Hedge funds can also hold more illiquid securities for longer periods than mutual funds are typically permitted.

Investor Restrictions

Hedge funds are typically only available to financial institutions and accredited investors. The SEC defines the criteria utilized to determine who qualifies as an accredited investor.

SEC Accredited Investor Criteria

An accredited investor is primarily subject to two qualifying tests: net income, and net worth.

The income test requires an individual to have an annual minimum income of $200,000 for each of the past two years (or $300,000 combined income with a spouse), with the expectation of maintaining a minimum income of $200,000 in the current year.

The net worth test requires a minimum net worth of $1,000,000 (individual or combined with spouse). Such excludes the value of the primary residence.

Minimum Subscription Amounts

Hedge fund minimum subscription amounts can vary widely by fund and range from $25,000 to over $1,000,000. The high minimums help ensure the accredited investor threshold noted above is met while also ensuring the investor base is committed to the fund.

Investors that cannot meet the hedge fund’s minimum subscription amount can consider gaining access to hedge funds through feeder funds. Financial institutions may create a feeder fund which invests directly into the underlying hedge fund.

The feeder fund combines the net subscription proceeds from its numerous retail investors to meet the high subscription minimum of the underlying hedge fund. The feeder fund then makes the investment into the hedge fund in nominee name.

The financial institution managing the feeder fund should perform due diligence on the underlying hedge fund prior to investing. Be sure to thoroughly question your investment advisor prior to investing as due diligence practices can vary widely by financial institution.

Feeder funds are separate and distinct investments that will have their own offering documents and risks. Their structures may vary by jurisdiction. Be sure to read and understand all publicly available information.

The feeder fund will have its own set of fees (e.g., management fee, incentive fee, etc.). The added layer of fees from the feeder fund will reduce your overall return.

Some investors may question the appropriateness of some feeder fund charging an incentive fee on top of that charged by the underlying hedge fund manager. Such is part of your due diligence and asset allocation process.

Fee Structure

Fees charged by individual hedge funds and mutual funds can vary substantially.

Hedge funds typically charge a management fee equal to 1-2% of assets under management versus 0.5-1.0% charged by mutual funds.

Hedge funds also typically charge performance fees (a.k.a. incentives fees) equal to 20-30% of net profits. The theory behind performance fees is that such aligns the interests of the investment manager with those of the investors.

Performance fees should never be based on the current year’s return in isolation. They should only be paid when the fund exceeds its high-water mark.

High-water Mark

A high-water mark is the fund’s highest value as measured on specified dates (usually the fund’s year-end). If the fund value drops below the high-water mark, the manager does not earn performance fees on any future increase in value until the fund’s value surpasses the high-water mark.

Ideally, the fund should calculate a separate high-water mark for each investor based on the amount and timing of their respective subscriptions into the fund. Such is a complicated and administratively challenging process. Alternatively, many funds choose to calculate the high-water mark at the fund level (i.e., all investors have the same blended high-water mark).

We provide the following table as an example based on a 20% performance fee.

The initial investment of $100 becomes the investor’s initial high-water mark.

In year 1, no performance fee is earned as the $80 fund value does not exceed the $100 high-water mark.

In year 2, the fund earned $10. However, no performance fee is earned as the $90 fund value does not exceed the $100 high-water mark.

In year 3, the fund earned $20. A performance fee is earned as the $110 fund value exceeds the high-water mark of $100. The performance fee would be $2 ((110-100)*20%).

You will notice the fund earned $20 in year 3, but a performance fee was only paid based on $10. Such is because the first $10 of performance made up for the prior year’s negative performance, and the second $10 of performance represented new profits generated by the manager.

Hurdle Rates

Hedge funds will often include a hurdle rate in the calculation of their performance fees. A hurdle rate is a return or profit threshold the manager must attain before an incentive fee is earned.

Benchmarks utilized in the hurdle rate will be disclosed in the fund’s offering documents. Some examples include returns based on, a straight percentage, an index, treasury rates, and more.

For example, if the fund has a hurdle rate of 5% and the fund earns a rate of return of 15%, the manager will earn performance fees based on 10% (15%-5%).

Your due diligence should ensure the benchmark used for the hurdle is appropriate. You should also clarify if the hurdle rate is retroactive as such means the manger would receive a performance fee on the entire 15% in the example above as opposed to only the 10% above the hurdle.

Ideally, the performance fee calculation will include a high-water mark and a hurdle rate that is not retroactive.

Liquidity

Hedge funds are significantly less liquid than mutual funds and may possess the following attributes (all of which should be disclosed in their respective offering documents).

Lock-up Period

A fund may impose a lock-up period during which redemptions cannot be made. Such a period may be a few months or extend to a year or more.

Notice Period

An investor may be required to provide written notice well in advance of the desired redemption date. Such a period may range from 30 days to several months.

Frequency

Hedge funds may limit redemptions to monthly, quarterly, semi-annually, or longer. When combined with an extended notice period, as noted above, the manager is better able to manage the fund.

Gate Provisions

The manager may limit the number of redemptions during a given redemption period. Such provision provides the manager with an important tool to limit redemptions during periods filled with redemption pressures.

Investors should be aware that the underlying securities in the portfolio may have varying degrees of liquidity. Redemption risk increases with the illiquidity levels of the underlying securities.

Suspension

Under extreme circumstances, a fund may suspend redemptions temporarily. Such is distinctly different from a gate provision as absolutely no shares are redeemed during a suspension.

Redemption fees

Some hedge funds will charge a redemption fee based on a percentage (fixed or sliding scale) of the value of the redemption. Theoretically, such fees are designed to protect the remaining investors. The fees should stay in the fund and cover the cost of liquidating sufficient underlying securities to fund the redemption.

Risk

Hedge funds are typically riskier than mutual funds.

The increased risk is attributable to managing complex investment strategies in a less regulated environment. Such strategies are often aggressive and involve leverage, short selling, derivatives, counterparty risk, concentrated positions, illiquid positions, currency risks, technology risk, and more.

Return

Hedge funds measure their performance using absolute returns whereas mutual funds utilize relative returns.

Absolute returns measure an investment’s actual return over a given period. Such measurement is irrespective of how other investments or benchmarks performed.

Relative returns compare an investment’s performance against a benchmark (e.g., S&P 500 Index). If the fund gained 10% and the index gained 3%, the relative return equals 7%.

BOTTOM LINE

Hedge funds are inherently riskier than mutual funds. However, they may provide an attractive risk/reward addition to your portfolio. We encourage you to work with your investment advisor and perform your due diligence prior to making an allocation to this unique asset class.