A hedge fund is basically a pool of investments committed by a small number of partners (investors) and managed by a skilled manager with clear objectives in mind-mainly to maximize returns and reduce risk. And because of their existence, hedge funds are typically only available to eligible (read: well off) investors, but not exclusively-companies, investors with manager-related ties, or even managers themselves also invest too.
Hedge funds also have a wide variety of assets in which they are invested, and not all are expected to file with the United States. The Securities Exchange Commission (SEC) must register with major hedge fund managers and a few other exceptions.
This is usually organized in two ways when the investment structure is created: either as a limited partnership (LP) or as a limited liability company (LLC).
The former is a arrangement in which the partners are only accountable for the sum of money they spend themselves, while the latter is a corporate structure in which creditors can not be held individually responsible (or accountable) for the liabilities of the company.
Regardless of the framework, the hedge fund is run by a manager who invests the capital into different assets to attain the objectives of the fund.
Different types of hedge funds have different targets (like funds that invest in “long-term” equities-purchasing term common stock and not selling short; or private equity-focused ones).
But their target at market direction stability is a common objective for almost all hedge funds-meaning they seek to make money through the up or down fluctuating market. Therefore, hedge fund managers are also more like traders.
Hedge funds got their name from investors in long and short stock investment funds, to ensure that they make money through market volatility (called “hedging”). Yet hedge funds now have several different types of structures with various assets and securities
How does Hedge fund operate?
A hedge fund’s basic structure is an investment or partnership pool in which a fund manager invests in various securities and equities that match the goals of the fund. Hedge fund managers are selling a plan to clients and those investing in are expecting the manager to stick to the plan.
This strategy may include being a hedge fund that is strictly long or short on all of their stocks, or a hedge fund that specializes in any form of investment that may range from common stock to patents.
One of the biggest distinguishers regarding hedge funds, though, is that they’re almost always open only to “accredited investors”-or investors with some money.
To be considered an “accredited investor,” you must qualify for either of the following: if you have an annual personal income of $200,000 or more for yourself alone (not combined-if you are married, the total income must be $300,000 or more per year), you must have a net personal income of more than $1 million (which may be either yourself or total with your spouse), you must have a higher-up income (executive).
According to government regulations, hedge fund managers can welcome only 35 non-accredited investors at any given company or partnership, and are often reserved for people that the manager knows (like friends or family).
Structure of a Hedge Fund
A hedge fund’s principal framework depends on the following fundamental components:
- Usually they are only open to eligible or “accredited” investors (who have a net worth of $1 million or an annual income of $200,000 a year).
- We have a wide variety of investments (including stocks, bonds, and mutual funds, but may also invest in real estate, food, currency, art, or whatever the aims of the fund may include).
- Often they use other assets, such as borrowed money, to try to lift returns (which can increase risk but also increase returns).
- They have a fee structure of “2 and 20,” where they charge an expense ratio and a performance fee.
What does a ‘2 and 20’ mean?
Most hedge funds operate on a manager compensation scheme of “2 and 20” which gives the hedge fund manager 2 percent of the assets and an incentive fee of 20 percent of the income per year. Nonetheless, this arrangement has been widely criticized because the fund manager always gets a comfortable sum out of that 2 percent of the invested assets even though the hedge fund loses money on the gains that year.
For instance, if a hedge fund manager set up a fund and got an investor to invest $1 million, the manager would get 2% of that amount (so $20,000) no matter what-and if the investment went well and the manager could double that amount to $2 million, the manager would go away with an additional $400,000 (20% of 2 million dollars).
Nonetheless, due to their existence, hedge funds also have very ambitious investment targets and are extremely lucrative in generating large profits.
Types of Hedge Funds
As stated before, the main objective of a hedge fund is to reduce risk for its investors and maximize income. There are therefore many different styles of hedge fund approaches that do various things. The hedge fund’s goals would decide its investments. Some of the most famous include global and regional hedge funds and equity funds.
1. Macro Hedge Funds
Such hedge funds, called macro-hedge funds, invest in stocks, shares, futures, options, and occasionally currencies in hopes of leveraging shifts in macroeconomic variables such as foreign trade, interest rates, or policies. Such investment types are usually highly leveraged and highly diversified. Historically though, these kinds of funds have become the biggest bust (like, for example, long-term capital management).
2. Equity Funds
One type of hedge fund, called an equity hedge fund (also known as long / short equity), aims to protect against declines in equity markets by investing in stocks or stock indices, and then shortening (if overvalued) them.
Nevertheless, investors invest in undervalued stocks in a long / short hedge fund, and divide investment between investing long in stocks while shortening other stocks. For example, the fund may have 60 per cent of its funds invested in stocks long and 40 per cent in short stocks, leaving a net exposure of 20 per cent to equity markets (60 per cent-40 per cent= 20 per cent, but keeping gross exposure at 100 per cent to avoid leveraging). Even if the fund manager wants to invest 70% in stocks long and hold 40% in shorting stocks, the gross exposure will grow to 110% (with 10% leverage).
3. Relative value Arbitrage Hedge Funds
These hedge funds usually purchase securities that are expected to rise while concurrently selling short a similar security that is expected to depreciate in value (like a stock or bond from another business in the same sector or the like).
4. Distressed Hedge Funds
Such funds are not in trouble given the title-they are actually mostly involved in loan payouts or restructurings. These funds may also help businesses turn around in hopes they can recover by purchasing some of the securities (like bonds that have lost value due to financial uncertainty within the company). And, distressed hedge funds can buy cheap bonds if they think they can appreciate it early-but, as you can imagine, these kinds of bets can be risky considering that the shares and bonds of the business are not assured of appreciating.
How is Hedge Funds different from Mutual Funds?
Nonetheless, hedge funds and mutual funds sound suspiciously the same-after all, they have the same basic structure (a group of investors placing their money into a common pool that is managed by a fund manager and used to invest in various securities), but some important variations do exist.
First, while hedge funds have investment conditions (such as being an “accredited” investor with a certain amount of net worth or income), usually, mutual funds don’t.
However, while mutual funds have regular liquidity (meaning they can buy or sell their assets instantly without impacting the market value), hedge funds also do not. Many hedge funds only have monthly or even quarterly subscriptions or redemptions (meaning they welcome investors very often).
Nevertheless, hedge funds can invest in a much broader variety of assets than mutual funds do. So, hedge funds can invest in traditional stocks, bonds and other commodities, but they can also invest in things like real estate, the food industry, currencies and more. Hedge funds are often also more volatile than mutual funds because of this (combined with the fact that many hedge funds work on the hedging system described above).
However, making them more volatile or aggressive than mutual funds, hedge funds are capable of short-selling stocks however exploiting more speculative bets that also make money-making simpler even when the market is low. On the contrary, mutual funds are not in a position to work the same way in favor of a more stable modus operandi.
Another distinction is that hedge fund managers gain large income from running the funds, in both a percentage of the assets and generally 20 percent of the fund’s income (realized and unrealized), whereas mutual fund managers normally only get a percentage of assets.
How to invest in Hedge Fund
Before you invest in a hedge fund, you have to ensure that you are prepared and (financially) suitable for the venture. The easiest way to do this is to ensure you follow the “accredited” investor criteria for the aforementioned hedge funds.
Nonetheless, you do need to determine how violent and reckless you want to be, in what you want to spend and what your goals are. When investigating different funds, you should keep these priorities in mind while deciding what best suits your needs and availability of resources. Bridgewater Associates LP, JPMorgan Asset Management, Vanguard Russell 1000 Gro I and Fidelity Sel Defense and Ae are some of the top hedge funds