Hedge Fund Definition

What Is a Hedge Fund?

Hedge funds are actively managed investment pools whose managers use a wide range of strategies, often including buying with borrowed money and trading esoteric assets, in an effort to beat average investment returns for their clients. They are considered risky alternative investment choices.

Hedge funds require a high minimum investment or net worth, excluding all but wealthy clients.

Understanding the Hedge Fund

The term « hedge fund » helps tell the story. The manager of any traditional investment fund may devote a portion of the available assets to a hedged bet. That’s a bet in the opposite direction of the fund’s focus, made in order to offset any losses in its core holdings.

For example, the manager of a fund that focuses on a cyclical sector that does well in a booming economy, such as travel, may devote a portion of the assets to stocks in a non-cyclical sector, like food or power companies. If the economy tanks, the returns of the non-cyclical stocks should offset the losses in cyclical stocks.

In modern times, hedge fund managers have taken that concept to an extreme. In fact, their funds have little to do with hedging, except for a few who stick to the original concept of the hedge fund, known as the classic long/short equities model.

Risky Business

Hedge funds are free to use riskier strategies in riskier ways. Notably, they frequently use leverage. That is, they use borrowed money to buy more of an asset in order to multiply their potential returns (or losses). They also invest in derivatives such as options and futures.

In short, they are free to choose esoteric investments that conservative investors won’t touch.

Notably, hedge funds are not as strictly regulated by the Securities and Exchange Commission as mutual funds are.

As might be expected, the appeal of many hedge funds lies in the reputation of their managers, many of whom are seen as stars in the closed world of hedge fund investing.

These money managers don’t come cheap. Hedge funds generally charge a fee of 1%-2% of assets, plus a « performance fee » of about 20% of the profits.

How Hedge Funds Are Categorized

Each hedge fund is designed to take advantage of specific market opportunities. They can be categorized into a number of broad hedge fund strategies such as event-driven investing and fixed-income arbitrage. They are often classified according to the investment style of the fund’s manager.

Legally, hedge funds are often set up as private investment limited partnerships that are open only to a limited number of accredited investors and require a large initial minimum investment.

Investments in hedge funds are illiquid as they often require investors to keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.

The History of the Hedge Fund 

Australian investor and financial writer Alfred Winslow Jones is credited with launching the first hedge fund in 1949 through his company, A.W. Jones & Co. 

He raised $100,000 (including $40,000 out of his own pocket) and set up a fund that aimed to minimize the risk in long-term stock investing by short-selling other stocks. This innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance the returns of his fund.

In 1952, Jones converted his fund from a general partnership to a limited partnership and added a 20% incentive fee as compensation for the managing partner.

As the first money manager to combine short selling, the use of leverage, and a compensation system based on performance, Jones earned his place in investing history as the father of the hedge fund.

The Boom (and Bust) Years

In the 1960s, hedge funds dramatically outperformed most mutual funds. They were relatively unknown to the general public until a 1966 article in Fortune highlighted an obscure fund that outperformed every mutual fund on the market by double-digit figures over the previous year and by high double-digits over the previous five years.

As hedge fund trends evolved, many funds turned away from Jones’ strategy, which focused on stock picking coupled with hedging, and engaged in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74.

The industry pretty much dropped off the radar for more than two decades until a 1986 article in Institutional Investor touted the double-digit performance of Julian Robertson’s Tiger Fund. With a high-flying hedge fund once again capturing the public’s attention, well-heeled investors flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic strategies, including currency trading and derivatives such as futures and options.

High-profile money managers deserted the traditional mutual fund industry in droves in the early 1990s, seeking fame and fortune as hedge fund managers.

Unfortunately, history repeated itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds, including Robertson’s, failed in spectacular fashion.

The Hedge Fund Industry Today

The hedge fund industry has made a comeback since then. Total assets under management grew from about $2.2 trillion in 2012 to about $3.6 trillion in 2019.

The number of operating hedge funds has grown as well, at least in some periods. There were fewer than 5,000 hedge funds in 2002. The number passed 10,000 by the end of 2015. However, losses and underperformance led to liquidations. By 2019, the number of funds worldwide had reached more than 16,000 according to Preqin.

Key Characteristics of Hedge Funds

How do you tell a hedge fund from a mutual fund? Here are a few big differences between the two.

Hedge Funds Exclude Small Investors

Hedge funds can accept money only 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. Some set their minimums higher.

Those rules are imposed by the Securities and Exchange Commission because it otherwise does not strictly regulate hedge funds. It considers qualified investors to be suitable to handle the potential risks that hedge funds are permitted to take. 

Hedge Fund Managers Have a Wide Latitude

A hedge fund’s investment universe is limited only by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies.

Mutual funds, by contrast, stick to stocks or bonds and invest for the long term.

Hedge Funds Often Use Leverage

Hedge funds often use borrowed money to amplify their returns and allow them to take aggressive short positions.

As was seen during the financial crisis of 2008, leverage can wipe out hedge funds, along with other big chunks of the economy.

Hedge Funds Have a ‘2 and 20’ Fee Structure

Mutual funds fees have fallen substantially in the last few years, hitting an average of 0.50% in 2020.

Hedge funds, by contrast, use a fee structure that is called, in shorthand, « 2-and 20. » That’s 2% of the assets under management plus a 20% cut of any profits generated.

Special Considerations on Hedge Funds

All hedge funds are considered risky investments, but some are riskier than others. Here are some steps you should take if you are thinking about putting money into a hedge fund.

First Step in Picking a Hedge Fund 

When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each.

These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the largest hedge funds in terms of assets under management.

In any case, that’s just the first step in your decision-making process.

Fund Absolute Performance Guidelines

Look at the annualized rate of return. Let’s say that you want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that underperform the index over long time periods, and it could be adjusted based on the performance of the index over time. 

This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and others.

But if these aren’t the types of funds you are looking for, you must also establish a guideline for the standard deviation of the index over the previous five years. Let’s assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can be eliminated from further consideration.

Unfortunately, past returns do not necessarily help to identify an attractive fund for the future. A hedge fund may have employed a strategy last year that won’t work well next year.

Comparing Returns

Once certain funds have been identified as high-return performers, it is important to identify the fund’s strategy and compare its returns to other funds in the same category.

An investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the 50th percentile as the guideline for filtering funds. 

Now the investor has two guidelines that all funds need to meet for further consideration.

Applying these two guidelines still leaves too many funds to evaluate in a reasonable amount of time. Additional guidelines need to be established, but the additional guidelines will not necessarily apply across the remaining universe of funds. For example, the guidelines for a merger arbitrage fund will differ from those for a long-short market-neutral fund.

Fund Relative Performance Guidelines

The next step is to establish a set of relative guidelines.

Relative performance metrics should always be based on specific categories or strategies. For example, it would not be reasonable to compare a leveraged global macro fund with a market-neutral, long/short equity fund.

To establish guidelines for a specific strategy, an investor can use an analytical software package such as Morningstar to identify a universe of funds using similar strategies. Then, a peer analysis will reveal many statistics, broken down into quartiles or deciles for that universe.

The threshold for each guideline may be the result for each metric that meets or exceeds the 50th percentile. An investor can loosen the guidelines by using the 60th percentile or tighten the guideline by using the 40th percentile.

Using the 50th percentile across all the metrics usually filters out all but a few hedge funds for additional consideration.

Establishing guidelines this way allows for flexibility to adjust the guidelines as the economic environment may impact the absolute returns for some strategies.

Factors to Consider

Factors used by some advocates of hedge funds include:

• Five-year annualized returns
• Standard deviation
• Rolling standard deviation
• Months to recovery/maximum drawdown
• Downside deviation

These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis.

Other Fund Consideration Guidelines

An investor may also want to consider other guidelines that can either further reduce the number of funds to analyze or identify funds that meet additional criteria that may be relevant to the investor. Some examples:

• Fund Size/Firm Size: This may be a minimum or maximum depending on the investor’s preference. Institutional investors often invest such large amounts that a fund or firm must have a minimum size to accommodate a large investment. For other investors, a fund that is too big may face challenges matching past successes.
• Track Record: If an investor wants a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate new funds. However, sometimes a fund manager will leave to start a new fund, so the manager’s performance can be tracked for a longer time period. 
• Minimum Investment: This is very important as many funds have minimums that can make it difficult for an individual investor to diversify properly. The fund’s minimum investment can also give an indication of the types of investors in the fund. Larger minimums may indicate a higher proportion of institutional investors.
• Redemption Terms: These terms have implications for liquidity. Longer lock-up periods are difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges.

Examples of Major Hedge Funds

In mid-2018, data provider HFM Absolute Return created a ranked list of hedge funds according to total assets under management (AUM). They include the following:

• Paul Singer’s Elliott Management Corporation held $35 billion in AUM as of the survey. Founded in 1977, the fund is occasionally described as a vulture fund, as roughly one-third of its assets are focused on distressed securities, including the debt of bankrupt countries. Regardless, the strategy has proven successful for multiple decades.
• Founded in 2001 by David Siegel and John Overdeck, New York’s Two Sigma Investments is near the top of the list of hedge funds by AUM, with more than $37 billion in managed assets. The firm was designed to not rely on a single investment strategy, allowing it to be flexible along with shifts in the market.
• One of the most popular hedge funds is James H. Simon’s Renaissance Technologies. The fund, with $57 billion in AUM, was launched in 1982, but it has revolutionized its strategy along with changes in technology in recent years. Now, Renaissance is known for systematic trading based on computer models and quantitative algorithms. Thanks to these approaches, Renaissance has been able to provide investors with consistently strong returns, in spite of recent turbulence in the hedge fund space more broadly.
• AQR Capital Investments is the second-largest hedge fund in the world, overseeing just under $90 billion in AUM as of the time of HFM’s survey. Based in Greenwich, Connecticut, it is known for using both traditional and alternative investment strategies.
• Ray Dalio’s Bridgewater Associates remains the largest hedge fund in the world, with just under $125 billion in AUM as of mid-2018. The Connecticut-based fund employs about 1,700 people and focuses on a global macro investing strategy. Bridgewater counts foundations, endowments, and even foreign governments and central banks among its clientele.