Hedge Funds, How They Work, Who Invests, Risks and Returns

Should You Invest in Hedge Funds?

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Hedge funds are privately-owned companies that pool investors' dollars and reinvest them into complicated financial instruments. Someone may start a hedge fund with the goal of outperforming the market, by a lot. They are expected to be smart enough to create high returns regardless of how the market does. 

More than 8,000 hedge funds managed $2.8 trillion in 2014, according to HFR Inc. That's triple the amount managed in 2004. Although hedge funds have outperformed the stock market over the past 15 years, including during the financial crisis, they've underperformed since 2009. The Standard & Poor’s 500 index rose 137 percent, including dividends, since then compared to a 50 percent rise for hedge funds.

Most of this growth goes to the super-large funds. More than $75 billion were added to funds in 2014, but 90 percent went to funds that managed $1 billion or more. One reason is that institutional investors and others who invest in hedge funds are more confident in going with tried-and-true names. It's too risky to invest with a start-up firm. As a result, 864 firms closed in 2014, averaging only $70 million each in assets.

The term "hedge fund" was first applied in the 1940s to alternative investor, Alfred Winslow Jones. He created a fund that sold stocks short as part of his strategy. He did that to hedge against the risk that his long positions on stocks would lose value.

How Hedge Funds Work

Hedge funds are set up as limited partnerships or limited liability corporations that protect the manager and investors from creditors if the fund goes bankrupt. The contract describes how the manager is paid. It may sometimes outline what the manager can invest in, but there are no limits.

Some hedge fund managers must meet a hurdle rate before getting paid. The investors receive all profits until the hurdle rate is reached, then the manager receives a percentage of profits. Most hedge funds operate under the "two and 20 rule." This states that they earn 2 percent of assets in good times and bad, that there's no hurdle rate, and that they receive 20 percent of profits. Recently, pension funds and other institutional investors have paid at least newer hedge funds less: "1.4 and 17."

Hedge Funds Rewards

Hedge funds offer more financial reward because of the way their managers are paid, the types of financial vehicles they can invest in, and their lack of financial regulation.

Hedge fund managers are compensated as a percentage of the returns they earn. This attracts many investors who are frustrated by the fact that mutual funds are paid fees, regardless of fund performance. Thanks to this compensation structure, hedge fund managers are driven to achieve above-market returns.

Hedge fund managers specialize in using sophisticated derivatives, such as futures contractsoptions, and collateralized debt obligations. Derivatives allow hedge fund managers to profit even when the stock market is going down. Hedge fund managers can use put options, or can sell stocks short. Basically, these products all do two things: they use small amounts of money, or leverage, to control large amounts of stocks or commodities. Second, they pay out by a particular point in time. The combination of leverage and timing means that managers make outsize returns when they correctly predict the market's rise or fall.

Since hedge funds aren't as well regulated as the stock market, they have free rein to invest in these high return, but speculative, financial vehicles. The SEC Bulletin on Hedge Funds gives a primer on hedge funds and how to choose a hedge fund manager.

Hedge Fund Risks

Hedge funds are very risky. It is exactly this risk that attracts many investors who believe higher risk leads to higher return. The same three characteristics that allow hedge funds to promise greater rewards also makes them very risky. First, hedge funds managers are paid a percentage of their funds' returns. What happens if the fund loses money? Do they pay the fund a percentage of that loss? No, the managers get zero no matter how much money they lose. This structure means hedge funds managers are very risk tolerant. This makes the funds very risky for the investor, who can lose all the money they invested in the fund.

Second, hedge funds invest in derivatives that are very risky because of leverage. Options must be delivered within a certain window of time. If a "black swan," or completely unexpected, economic event happens during that time period, even if the manager is correct about the long-term trend, he could lose the investment. In that sense, hedge fund managers are trying to time the market, which some would say is very difficult, if not, impossible to do.

Unlike mutual funds, whose owners are public corporations, hedge funds traditionally weren't regulated by the Securities and Exchange Commission. The lack of regulation means that hedge fund earnings aren't reported to the SEC or any other regulatory body. Although hedge funds are still prohibited from fraud, this lack of oversight creates additional risk. Besides, hedge fund investors are also part owners of the LLC. This means they could lose their investment if the hedge fund goes bankrupt as a business, even if the investments do OK. 

Who Invests in Hedge Funds

Institutional investors provide 65 percent of the capital invested in hedge funds. They manage pension funds and sovereign wealth funds. They also handle the cash assets of insurance companies, corporations, and trust funds. They don't put more than 10 to 20 percent of their assets into hedge funds.

They understand how leveraging works. They should be good judges of character. Most hedge funds don't reveal what they do to get their returns. That lack of transparency means they can actually be Ponzi schemes, such as the one run by Bernie Madoff.

Hedge funds require them to have at least $1 million in net worth. They need this cushion to weather significant downturns in their portfolios. Some are still trying to recover losses incurred during the crash of 2008.They keep their money tied up for the three or more months required by hedge funds. In fact, more than half have a three-year time frame. They often must be willing to pay 2 percent of the assets they invested and 20 percent of any profits.

They aren't looking for higher-than-average returns. Only 6 percent thought they could achieve 10 percent or more annual returns. They just aren't willing to endure the risk that entails. Instead, 67 percent are looking for annual returns of between 4 percent and 6 percent. That's probably because they have to report to boards who might fire them if they sustain losses.

Instead, they are looking for an investment that is uncorrelated with the rest of their investments. This means that, if the stock market loses value, the hedge fund investment will rise. In other words, they use hedge funds to increase their diversification. They know that a diversified portfolio will increase total returns over time by reducing overall volatility. For that reason, these investors don't compare the performance of their hedge fund investments to standard indices like the S&P 500, the NASDAQ or the Dow Jones.

Family trust funds use hedge funds to gain access to the best minds in the investment. Why do hedge funds attract the smartest investors? Because they pay the most. But 22 percent of investors said high fees are why they limit, or even avoid, hedge funds.

How Hedge Funds Contributed to the Financial Crisis

Hedge funds contributed to the 2008 financial crisis in three ways. First, they have an outsized, and largely hidden, impact on the economy. Since they aren't as regulated as the stock, bond, or commodities markets, it's difficult to find out what they actually buy or sell. It's estimated they own between 10 and 50 percent of some stock exchanges and make up half of daily trading volume. Their growth has accelerated since 2000 and so has volatility in many investment classes. 

Second was their unregulated use of derivatives. They bought lots of mortgage-backed securities. When housing prices started to decline in 2006, the underlying mortgages defaulted. Hedge fund managers thought they were protected from that risk because they owned credit default swaps, a type of derivative insurance. But, the sheer number of mortgage defaults overwhelmed issuers of the swaps, like the American International Group. These insurers needed a federal government bailout to stay in business and make good on the swaps. As a result, the market for this type of insurance collapsed. Banks were then not willing to lend without them, making it difficult to get new credit.

Third, many banks also had hedge fund sub-divisions. They often tried to increase their returns by investing in derivatives through these hedge funds. When these risky investments went south, banks like Bear Stearns went to the federal government for bailouts. When the government didn't bail out Lehman Brothers in September 2008, its bankruptcy sent global stock prices plummeting. That event kicked off the financial crisis of 2008.

New Hedge Fund Regulations

In 2010, the Dodd-Frank Wall Street Reform Act started regulating some aspects of hedge funds. Those above $150 million must now register with the SEC. The Act also created the Financial Stability Oversight Council, which looks for hedge funds and other financial companies that are growing too large. If they become too big to fail, the Council can recommend that the Federal Reserve regulate these funds.

Dodd-Frank limits the amount of hedge fund investments banks can make. Banks can use hedge funds on behalf of their customers only, not to boost their own corporate profits.

Dodd-Frank also calls for regulation of derivatives under the SEC. Hedge fund managers must now be registered. They must also disclose their risk metrics, strategies and products, and performance. The SEC also requires them to reveal the positions held by the hedge fund itself, the overall credit exposure they hold, how many assets are traded using computer algorithms, and their debt-to-equity ratio.

How They Affect You

If you own any publicly-traded securities, either outright or through your 401(k), Individual Retirement Account, or pension plan, you are affected by hedge funds. Hedge fund traders have dramatically lowered the cost of oil. That's had a huge impact on the economy. Oil prices are a component of inflation, which affects consumers’ ability to purchase. Since consumer products are almost 70 percent of the U.S. economy, the expansion of consumer buying power has boosted domestic growth. On the other hand, U.S. manufacturers are being hit by the strong dollar. That's lowered export growth. 

Hedge funds have also affected the banking industry. Large banks are focusing more and more on the largest hedge fund customers. For example, Citi receives its biggest trading commissions from the "Focus Five." These are the largest hedge fund companies: Millennium Management, Citadel, Surveyor Capital, Point72 Asset Management, and Carlson Capital. Smaller businesses are having a more difficult time getting financing. (Sources: “What’s in a Name? Funds Hedge,” The Wall Street Journal, March 27, 2015. "You Paid Us Only $1 Million? Get in Line," Bloomberg, March 23, 2016.)