What Are Hedge Funds?

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A hedge fund is basically a fancy name for an investment partnership. It's the marriage of a fund manager, which can often be known as the general partner, and the investors in the hedge fund, sometimes known as the limited partners. The limited partners contribute the money and the general partner manages it according to the fund's strategy. A hedge fund's purpose is to maximize investor returns and eliminate risk, hence the word "hedge." If these objectives sound a lot like the objectives of mutual funds, they are, but that is basically where the similarities end.

The name "hedge fund" came into being because the aim of these vehicles was to make money regardless of whether the market climbed higher or declined. This was made possible because the managers could "hedge" themselves by going long or short stocks (shorting is a way to make money when a stock drops).

Key Characteristics

1. Only open to "accredited" or qualified investors: Investors in hedge funds have to meet certain net worth requirements to invest in them - net worth exceeding $1 million excluding their primary residence.

2. Wider investment latitude: A hedge fund's investment universe is only limited by its mandate. A hedge fund can basically invest in anything - land, real estate, stocks, derivatives, currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds.

3. Often employ leverage: Hedge funds will often use borrowed money to amplify their returns. As we saw during the financial crisis of 2008, leverage can also wipe out hedge funds.

4. Fee structure: Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. The common fee structure is known as "Two and Twenty" - a 2% asset management fee and then a 20% cut of any gains generated.

There are more specific characteristics that define a hedge fund, but basically be! cause they are private investment vehicles that only allow wealthy individuals to invest, hedge funds can pretty much do what they want as long as they disclose the strategy upfront to investors. This wide latitude may sound very risky, and at times it can be. Some of the most spectacular financial blow-ups have involved hedge funds. That said, this flexibility afforded to hedge funds has led to some of the most talented money managers producing some amazing long-term returns.

A Hedge Fund at Work - A Fictional Example

To better understand hedge funds and why they have become so popular with both investors and money managers, let's set one up and watch it work for one year. I will call my hedge fund "Value Opportunities Fund, LLC." My operating agreement - the legal document that says how my fund works - states that I will receive 25% of any profits over 5% per year, and that I can invest in anything anywhere in the world.

Ten investors sign up, each putting in $10 million, so my fund starts with $100 million. Each investor fills out his investment agreement - similar to an account application form - and sends his check directly to my broker or to a fund administrator, who will record his or her investment on the books and then wire the funds to the broker. A fund administrator is an accounting firm that provides all the administration work for an investment fund. Value Opportunities Fund is now open, and I begin managing the money. Once I find attractive opportunities, I call my broker and tell him what to buy with the $100 million.

A year goes by and my fund is up 40%, so it is now worth $140 million. Now, according to the fund's operating agreement, the first 5% belongs to the investors with anything above that being split 25% to me and 75% to my investors. So the capital gain of $40 million would first be reduced by $2 million, or 5% of $40 million, and that goes to the investors. That 5% is known as a "hurdle" rate, because you have to first achieve that 5% "hurdl! e" rate! return before earning any performance compensation. The remaining $38 million is split 25% to me and 75% to my investors.

Based on my first-year performance and the terms of my fund, I have earned $9.5 million in compensation in a single year. The investors get the remaining $28.5 million along with the $2 million hurdle rate cut for a capital gain of $30.5 million. As you can see, the hedge fund business can be very lucrative. If I were managing $1 billion instead, my take would have been $95 million and my investors, $305 million. Of course, many hedge fund managers get vilified for earning such exuberant sums of money. But that's because those doing the finger pointing - often the newspapers - fail to mention that my investors made $305 million. When is the last time you heard an investor in a hedge fund complain that his fund manager was getting paid too much?

Compensation Criticism - 2 and 20

From our fictional fund example above, it's evident that hedge fund managers earn a lot of money. But what perhaps gets the most criticism is the most popular compensation scheme in the hedge fund world: it's called the "2 and 20," and it is used by a large majority of hedge funds currently in operation.

The 2 and 20 compensation structure means that the hedge fund's operating agreement calls for the fund manager to receive 2% of assets and 20% of profits each year. It's the 2% that gets the criticism, and it's not difficult to see why. Even if the hedge fund manager loses money, he still gets 2% of assets. A manager overseeing a $1 billion fund could pocket $20 million a year in compensation without lifting a finger. Worse yet is the fund manager who pockets $20 million while his fund loses money. He or she then has to explain to investors why their account values declined while justifying getting paid $20 million. It's a tough sell and one that doesn't usually work. In the fictional example above, my particular fund charged no asset management fee and instead took a higher perf! ormance c! ut - 25% instead of 20%. This gives a hedge fund manager an opportunity to make more money - not at the expense of the fund's investors, but rather alongside them. Unfortunately, this no asset management fee structure is rare in today's hedge fund world. The 2 and 20 structure still prevails, although many funds are starting to go to a 1 and 20 setup.

Hedge Funds Today and Strategies

By most estimates, thousands of hedge funds are operating today, collectively managing over $1 trillion. Hedge funds can pursue a varying degree of strategies including macro, equity, relative value, distressed securities and activism. A macro hedge fund invests in stocks, bonds and currencies in hopes of profiting from changes in macroeconomic variables such as global interest rates and countries' economic policies. An equity hedge fund may be global or country specific, investing in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices. A relative-value hedge fund takes advantage of price or spread inefficiencies. Other hedge fund strategies include aggressive growth, income, emerging markets, value and short selling.

Another popular strategy is the "fund of funds" approach in which a hedge fund mixes and matches other hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk and volatility can be controlled by the mix of underlying strategies and funds.

Notable hedge funds today include the Paulson Funds, a group of various hedge funds founded by John Paulson. Paulson became famous after his fund reaped billions from betting against mortgages back in 2008. Paulson has other specific hedge funds, including one that invests solely in gold, for example.

Pershing Square is a highly successful and high-profile activist hedge fund run by Bill Ackman. Ackman invests in companies that he feels are undervalued with the goal of taking a more active role in the company to unlock value. Activism typically includes changing the board of directors, appointing new management or pushing for a sale of the company. Carl Icahn, a well-known activist, also heads up very successful activist hedge funds. In fact, one of his holding companies, Icahn Enterprises (Nasdaq:IEP), is publicly traded and gives investors who can't or don't want to directly invest in a hedge fund an opportunity to bet on Icahn and his skill at unlocking value.

New Regulations for Hedge Funds

One aspect that has set the hedge fund industry apart for so long is the fact that hedge funds face little money-management regulation. Compared to mutual funds, pension funds and other investment vehicles, hedge funds are the least regulated. That's because hedge funds are only allowed to take money from "qualified" investors - individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million excluding their primary residence. As such, the Securities and Exchange Commission deems qualified investors suitable enough to handle the potential risks that come from a wider investment mandate.

But make no mistake, hedge funds are regulated, and recently they are coming under the microscope more and more. Hedge funds are so big and powerful that the SEC is starting to pay closer attention. And breaches such as insider trading seem to be occurring much more frequently, an activity regulators come down hard on.

In September 2013, the hedge ! fund industry experienced one of the most significant regulatory changes to come along in years. In March 2012, the Jumpstart Our Business Startups Act (JOBS Act) was signed into law. The basic premise of the JOBS Act was to encourage funding of small businesses in the U.S by easing securities regulation. The JOBS Act also had a major impact on hedge funds: In September 2013, the ban on hedge fund advertising was lifted. In a 4-to-1 vote, the SEC approved a motion to allow hedge funds and other firms that create private offerings to advertise to whomever they want, but they can only accept investments from accredited investors. While hedge funds may not look like small businesses, because of their wide investment latitude they are often key suppliers of capital to startups and small businesses. Giving hedge funds the opportunity to solicit capital would in effect help the growth of small businesses by increasing the pool of available investment capital.

Hedge fund advertising deals with offering the fund's investment products to accredited investors or financial intermediaries through print, television and the internet. A hedge fund that wants to solicit (advertise to) investors must file a "Form D" with the SEC at least 15 days before it starts advertising. Because hedge fund advertising was strictly prohibited prior to lifting this ban, the SEC is very interested in how advertising is being used by private issuers, so it has made changes to Form D filings. Funds that make public solicitations will also need to file an amended Form D within 30 days of the offering's termination. Failure to follow these rules will likely result in a ban from creating additional securities for a year or more.

Not For Everyone

It should be obvious that hedge funds offer some worthwhile benefits over traditional investment funds. Some notable benefits of hedge funds include:

· 1. Investment strategies that have the ability to generate positive returns in both rising and falling equity an! d bond ma! rkets.

· 2. Hedge funds in a balanced portfolio can reduce overall portfolio risk and volatility and increase returns.

· 3. A huge variety of hedge fund investment styles – many uncorrelated with each other – provide investors the ability to precisely customize investment strategy.

· 4. Access to some of the world's most talented investment managers.

Of course, hedge funds are not without risk as well:

· 1. Concentrated investment strategy exposes hedge funds to potentially huge losses.

· 2. Hedge funds typically require investors to lock up money for a period of years.

· 3. Use of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss.

The Bottom Line

Just as with any investment strategy, investors must look at their own specific goals and needs and decide whether hedge funds fit their current investment needs.