Overview of Hedge Funds

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 to outperform the market. Investors expect them to create high returns regardless of how the market does.

The term "hedge fund" first originated in the 1940s after alternative investor Alfred Winslow Jones created a fund that sold stocks short as part of its investment strategy.

The assets managed by hedge funds have increased over the years, with the estimate reaching $3.0 trillion in the third quarter of 2019. But, since the 2008 financial crisis, hedge funds have not performed well compared to the Standard & Poor’s 500 index (S&P 500). 

This article provides a detailed overview of how hedge funds work, who invests in them, and the risks versus rewards for investors.

How Do Hedge Funds Work?

Hedge funds are set up as limited partnerships or limited liability companies, which offer pass-through tax treatment and limited personal liability for managers and partners. Hedge fund legal documents describe how the fund is structured and may outline what the manager can invest in.

These legal documents also provide information as to how the managers are compensated. Hedge fund managers are paid an annual management fee, and may be paid a performance fee if they meet a benchmark called the hurdle rate. Most managers have been paid pursuant to the "two and 20" rule. That's an annual 2% of total assets for the management fee plus 20% of the profits over the hurdle rate for the performance fee. 

Recently, however, certain investors have begun to pay some of the newer hedge funds a lower amount in fees. They appear to be following the "1.4 and 17" rule, i.e., an annual 1.4% of total assets for the management fee plus 17% of the profits over the hurdle rate for the performance fee. 

Who Invests in Hedge Funds

Hedge funds are limited to wealthier investors, who can afford the higher fees and risks associated with hedge fund investing, and institutional investors. Hedge fund investors generally need to be accredited investors under the federal securities laws, and must meet certain net income or earned income thresholds.

Institutional investors are large firms that make investment decisions on behalf of individual members or shareholders, and some of the most common institutional investors include pension funds, mutual funds, and insurance companies.

Investors invest in hedge funds for varying reasons. Some believe that they can achieve higher-than-average returns, while others seek diversification beyond stocks and bonds.  According to a 2019 institutional investor survey conducted by J.P. Morgan, 73% of all respondents considered portfolio diversification among the top three reasons they invest in hedge funds; 58% indicated access to select or niche opportunities; and 1% noted access to leverage.

That said, while institutional investors have invested heavily in hedge funds, that has begun to change. As of 2016, 65% of the hedge fund industry's capital came from institutional investors. But most recently, these investors have shifted their focus to other investment options, such as exchange-traded funds (ETFs), private equity, and real estate. 

How Hedge Funds Offer Rewards

Hedge funds offer more financial rewards because of the way managers are paid, the types of financial vehicles they can invest in, and the dearth of financial regulation that govern them.

First, since hedge fund managers are compensated based on the returns they earn, they are driven to achieve above-market returns.  This can attract investors who are frustrated by the fact that funds like mutual funds are paid fees regardless of fund performance.

Second, hedge fund managers are able to make outsized returns when they correctly predict the market's rise or fall. Hedge fund managers specialize in using sophisticated derivatives, which enable them to create leverage and profit even when the stock goes down.

Third, since hedge funds are not as well regulated as the stock market, managers have more flexibility with investing in financial vehicles that are speculative but offer higher returns. That said, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), which was enacted in 2010, does regulate some aspects of the hedge fund industry. Among other things, the Dodd-Frank Act:

  • required all hedge fund managers above $150 million to register with the U.S. Securities and Exchange Commission;
  • limited the amount of hedge fund investments banks can make, and prevented banks from using hedge funds to boost their own corporate profits;
  • called for greater regulation of derivatives; and
  • created the Financial Stability Oversight Council, which would look for hedge funds and other financial companies that were growing too large and would need to be recommended to be regulated by the Federal Reserve.

According to certain empirical studies, the hedge fund industry appears to have adjusted well to the heightened requirements under the Dodd-Frank Act.

Risks Associated With Hedge Funds

Hedge funds are subject to greater risk primarily on three grounds.

The rewards associated with investing in hedge funds must be evaluated in relation to the investment's potential risks.

First, hedge funds are able to leverage more speculative positions, which are more subject to losses when the market falls.  Hedge fund managers are more inclined to take such positions, since as explained above, they are paid based on performance.

Second, hedge funds are illiquid investments, and as a result, they may not be redeemable at the investor's option. In other words, investors may not be able to take out the money they invested in the hedge fund at the time they want out.

Third, funds of hedge funds typically invest in several private hedge funds that are not subject to the U.S. Securities and Exchange Commission's registration and disclosure requirements. This lack of oversight creates additional risk.

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