What is a Hedge Fund?
A Hedge Fund is a pooled investment vehicle that uses specialized hedging strategies across various asset classes to generate positive returns uncorrelated with the broader market.
Hedge funds, stated in simple terms, are actively managed investment vehicles that specialize in various strategies and hedging techniques across a broad range of asset classes to generate strong, risk-adjusted returns on behalf of their investor base, or limited partners (LPs).
- A hedge fund is an actively-managed investment vehicle that raises capital from accredited investors to allocate the funds into a wide array of alternative securities.
- A hedge fund frequently relies on riskier strategies and techniques to construct a beta neutral portfolio, where returns are uncorrected with the broader market and unaffected by price fluctuations.
- The main function of a hedge fund is to generate positive returns consistently, on behalf of its limited partners (LPs), irrespective of the prevailing market conditions.
- A hedge fund is expected to periodically deliver outsized returns, but with measures in place to reduce market risk and volatility via hedging techniques and portfolio diversification.
- The different types of hedge fund investment strategies include long-short equity (L/S), relative value arbitrage, event-driven, multi-strategy, short-only, and activist investing.
- The traditional fee structure inherent to the hedge fund industry is termed the “2 and 20” model, which entails a 2% management fee coupled with a 20% performance fee.
How Does a Hedge Fund Work?
Originally, the formation of the hedge fund industry came into fruition from the objective of hedging the portfolio risk stemming from long positions.
Offsetting long positions with short positions can reduce portfolio risk and lead to stable, risk-adjusted returns, which reflects the classic “long-short equity” strategy still utilized as of the present date.
So, what is a hedge fund?
A hedge fund is an investment vehicle designed to generate stable, non-volatile returns, independent of the prevailing market conditions.
The strategic portfolio construction of a hedge fund is intended to reduce the correlation between the returns of the fund and pricing fluctuations in the broader market, with the underlying aim to achieve a zero-beta portfolio.
The priority of hedge fund managers is the consistent generation of risk-adjusted returns on their portfolio uncorrelated with the broader market, albeit certain firms have deviated far from the industry’s origins.
The modern hedge fund business model, however, nowadays operates as firms with far more discretion and optionality in terms of the types of investment strategies utilized, including the asset classes to which to allocate capital.
Why? The consistent generation of alpha in public equities investing has become increasingly difficult, as the information asymmetry between institutional investors and retail investors continues to wane, and there are substantially more investment managers and participants in the public markets compared to the 1980s.
“What are Hedge Funds?” (Source: SEC.gov)
What are the Origins of the Hedge Fund Industry?
Hedge Funds are a form of active management, where various investment strategies are utilized to generate positive risk-adjusted returns uncorrelated with the broader market.
Formerly, most hedge funds strived to profit regardless of the market direction – i.e. in a bull market or bear market – with their priority on minimizing correlation to the public markets, rather than out-performance of the market overall.
The origins of the hedge fund industry are rooted in market neutrality, but many funds nowadays attempt to outperform the market (i.e. “beat the market”), or at least are pressured to do so.
The objective of the hedge fund business model remains the generation of long-term positive returns driven by alpha, rather than the market beta.
- Alpha (α) → The term “alpha” in finance refers to the excess returns generated by a portfolio of investments relative to the benchmark return, which is most often the S&P 500. If a fund strategy achieved positive alpha over a specified period, then the manager effectively “beat the market” given the abnormal returns compared to the broader market.
- Beta ( β) → By definition, the beta of the broader market is 1.0, so a beta >1.0 implies greater volatility risk, and vice versa for a beta <1. While there is much criticism of the validity of beta as a risk measure, the historical price movement is still widely used to estimate the risk profile of securities, which directly influences the return expected by investors.
However, the modern hedge fund industry has gradually developed into encompassing a vast assortment of investment strategies.
Because of that structural shift in the industry, hedge fund managers nowadays seek to profit from more speculative, riskier strategies, such as using leverage to amplify returns, i.e. borrowed funds.
Nevertheless, most hedge funds still have measures in place for portfolio diversification and risk mitigation (e.g. avoidance of over-concentration in a single investment), but there has certainly been a widespread shift towards becoming more returns-oriented.
What is the Structure of a Hedge Fund?
The general partner (GP) and the team of investment professionals regularly track fund performance and adjust the portfolio accordingly, on behalf of the fund’s limited partners (LPs).
|General Partner (GP)||Limited Partners (LP)|
Investment decisions are grounded in detailed analysis, research, and forecast models, which all contribute to formulating a more logical judgment on whether to buy, sell, or hold an asset.
Furthermore, hedge funds are often open-ended, pooled vehicles structured in the form of either:
- Limited Partnership (LP)
- Limited Liability Company (LLC)
What are the Top 10 Hedge Funds in 2023?
The following chart ranks the top ten largest hedge funds in terms of assets under management (AUM) as of June 30, 2022.
|Ranking||Hedge Fund||AUM ($mm)|
|#8||Davidson Kempner Capital Management||$37,450|
|#9||Farallon Capital Management||$37,400|
|#10||TCI Fund Management||$36,200|
Largest Hedge Funds in 2022 (Source: Pensions & Investments)
Largest Hedge Funds List Ranked by AUM (2023)
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How to Invest in a Hedge Fund
For an individual to qualify as a limited partner at a hedge fund, one of the listed criteria must be met:
- Personal Income of $200,000+ Per Year
- Combined Income with Spouse of $300,000+ Per Year
- Personal Net Worth of $1+ Million
Documented proof that the current income level can be maintained for at least two more years must also be supplied.
The investors, or limited partners (LPs), of hedge funds are generally individual and institutional investors seeking to diversify their portfolios, while still retaining the potential to earn outsized returns.
- Institutional Investors → The institutional investor categorization refers to organizations with substantial amounts of capital to allocate across different asset classes. Common examples include pension funds, university endowments, insurance companies, sovereign wealth funds, and certain firms in the banking sector.
- High Net-Worth Individuals → High net-worth individuals are non-institutional, individual investors with significant personal wealth. In the U.S., the criteria to qualify as an “accredited investor”, one must have a net worth that exceeds $1 million, excluding the value of their primary residence, or have an income of $200,000+ each year for the past two years (or $300,000 combined income if married).
- Family Offices → Family offices are essentially private wealth management firms that serve ultra-high-net-worth investors. Unlike traditional wealth management firms, in which the offers are available to any qualified investor, financial and investment management specifically serves an affluent individual (or family), as implied by the name.
- Funds of Funds (FOF) → The fund of funds investment structure invests in other types of funds, including hedge funds. The FOF strategy is oriented around allocating capital across different funds, rather than selecting the equity or debt investments themselves.
The decision to invest in hedge funds carries a substantial risk, and the illiquid nature of the investments, as well as the higher fee structure (“2 and 20”), are drawbacks compared to mutual funds and ETFs.
The higher barrier for investors to qualify to invest in hedge funds is to limit access to more sophisticated investors.
Why? The investors that meet the criteria to become an investor at a hedge fund are assumed to understand the risks presented by the utilized strategies and tactics, with a higher tolerance for risk.
What is the Fee Structure of Hedge Funds?
So, how do hedge funds make money?
Historically, the standard fee structure in the hedge fund industry was the classic “2 and 20” arrangement.
- 2% Management Fee → The 2% management fee is typically charged based on the net asset value (NAV) of each LP’s investment contribution, and is used to cover the costs of operating the hedge fund (and employee compensation).
- 20% Performance Fee → The 20% performance fee (or “carried interest”) is an incentive for hedge fund managers to achieve strong returns, i.e. “beat the market”.
Once the GP has caught up and earned the 20% carry, all fund profits are split 20% to the GP and 80% to the LP.
Following years of underperformance since the 2008 recession, however, the fees charged in the hedge fund industry have declined.
Over the past decade, there has been a notable marginal decline in management fees and performance fees across the industry, particularly for the larger-sized, more institutionalized hedge funds:
- Management Fee → 2.0% to 1.5%
- Performance Fee → 20.0% to 15.0%
To ensure no preemptive performance fees are obtained, the limited partners (LPs) of a hedge fund can negotiate certain provisions:
- Claw-Back Provision → The LP can retrieve fees previously paid for the original percentage agreement to be met, which implies losses were incurred by the fund in subsequent periods.
- Hurdle Rate → A minimum rate of return can be established, which must be surpassed before any performance fees can be collected. Sometimes, once the threshold is met, there is a “catch-up” clause for the GPs to receive 100% of distributions once the agreed-upon split is met.
- High-Water Mark → The highest peak the value of the fund reached – in such a provision, only capital gains in excess of the high-water mark are subject to the performance-based fee.
Hedge Fund Strategies: What are the Different Types?
Before delving in, the following list outlines the most common hedge fund investment strategies.
- Long-Short Equity Strategy (L/S)
- Market Neutral Strategy, i.e. Equity Market Neutral (EMN)
- Short Selling Strategy (Short-Only Funds)
- Event-Driven Investing Strategy (Special Situations)
- Relative Value Strategy (Arbitrage Fund)
- Activist Investor Strategy (Shareholder Activism Funds)
- Global Macro Strategy
- Quantitive Funds (Systematic Trading)
- Distressed Debt Investing Strategy
- Multi-Strategy Funds (Multi-Strat)
- Credit Fund Strategy (Fixed Income)
1. Long-Short Equity Strategy (L/S)
Alfred Winslow Jones is often cited as the pioneer of the long-short fund strategy in the mid-1940s.
The market-neutral portfolio of Jones distinguished between two different types of risk:
- Market Risk (Non-Diversifiable)
- Company-Specific Risk (Diversifiable)
Based upon the understanding of systematic vs. unsystematic risk, the long-short equity strategy (L/S) was derived, wherein an investor strives to profit from the upside and downside movements in stock prices.
Therefore, the long/short fund strategy is taking “long” positions on equities perceived as underpriced, while hedging the downside risk via “shorting” stocks deemed overpriced.
In effect, the long-short strategy is designed to accurately predict upward price movement on its long positions, while limiting potential losses on its short positions, i.e. the short-selling component can partially offset the losses (or in entirety).
- Long Positions → Undervalued Stocks (i.e. Intrinsic Value > Market Price)
- Short Positions → Overvalued Stocks (i.e. Intrinsic Value < Market Price)
Unlike long-only portfolios that can incur steep losses from market volatility, long/short hedge funds often profit from sudden dislocations in the financial markets, i.e. the hedging strategies offset their long positions.
Generally, most long/short equity funds hold a “long” market bias, so the long positions constitute a greater proportion of their total portfolio.
2. Market Neutral Strategy (EMN Fund)
The market-neutral strategy seeks to exploit market mispricings of securities by pairing long and short positions in securities in the same or adjacent industry.
Simply put, the market-neutral fund strategy attempts to exploit differences in share prices by taking both long and short positions in equivalent amounts in closely related stocks with similar characteristics (e.g. industry, sector).
Put together, the paired long and short positions balance the portfolio’s long positions with their short positions, with the core objective of achieving a net portfolio exposure of zero, i.e. a portfolio beta of zero.
In theory, the funds that utilize the market-neutral fund strategy should exhibit returns with minimal correlation to the broad asset classes (e.g. equity, bond, credit).
That said, the returns on a market-neutral fund are structured to be independent of movements of the broader market, with less volatility risk.
However, the trade-off here is that the reduction in market sensitivity causes the upside potential in returns to also decline, even more so than long-short funds (L/S).
The objective of a market-neutral fund is to achieve a portfolio beta as close to zero as possible by pairing long and short trades to mitigate market risk.
3. Short Selling Strategy (Short-Only Fund)
Short-selling funds are specialists in the art of short selling, which is called “short-only”, or net short – i.e. the short positions outweigh long positions in the portfolio.
Short selling is not just intended to reduce risk and capital losses amid periods of declines in market prices but also to capitalize on and profit from such scenarios.
The short positions are intended to produce alpha, rather than serve as a portfolio hedge.
Kynikos Short Fund Business Model
“Kynikos has sometimes been called a “hedge fund,” but it is not a hedge fund following the classic model first established by A.W.Jones & Co. We operate a short fund. With the proliferation of private investment funds, however, the term “hedge fund” is now used so broadly in some quarters to refer to any private investment fund that I do not believe that it accurately describes Kynikos’ business model accurately.”
– Jim Chanos, Kynikos Associates
For that reason, short specialists tend to make fewer investments and are willing to hold onto capital for longer periods to capitalize on opportunities such as fraudulent behavior related to accounting fraud, malfeasance, and more.
Enron Short Selling Example
The collapse of Enron Corporation was a major financial scandal that unfolded in the early 2000s and has become a symbol of corporate fraud and the necessity of independent auditors.
Enron, one of the top energy companies in the U.S. at that time, engaged in fraudulent behavior where management identified loopholes in the system and used special purpose entities to conceal their debt burden while inflating their reported profits.
The scheme, once uncovered, led to the bankruptcy of Enron, the criminal indictment of former Enron executives – most notably, Jeffrey Skilling – and the conviction of former “Big 5” accounting firm Arthur Andersen for their complicity in the fraud.
The conviction of Andersen was later on reversed by the Court, yet the reputational damage and pile of lawsuits was sufficient to put the firm out of business.
The scandal led to the enactment of the Sarbanes-Oxley Act of 2002 to further protect the interests of investors, but also brought Jim Chanos, a short seller and the founder of Kynikos Associates, into the spotlight.
Chanos was one of the earlier skeptics of Enron and publicly questioned the opaque financial statements of Enron. Despite the negative connotation attributed to short sellers, Enron’s downfall is a historical precedent, reflecting the need for research-based short selling and skeptics in the market.
“Hedge Fund Strategies and Market Participation” (Source: SEC)
4. Event-Driven Investing Strategy (Special Situations)
Event-driven hedge funds invest in the securities issued by companies anticipated to undergo significant changes.
The event-driven investing strategy is oriented around timing an investment around “special situations”, wherein a catalyst can soon affect the valuation (and stock price) of the underlying issuer.
The fund attempts to capitalize on a particular event, which can range from regulatory changes to operational turnarounds.
Common examples of catalyst events – often referred to as “special situations” – include the following.
- Mergers and Acquisitions (M&A)
- Tender Offers
- Corporate Spin-Offs
- Rights Offerings
- Corporate Bankruptcies
- Operational Restructuring
- Financial Distress, i.e. Insolvency Risk
- Stock Buybacks
Joel Greenblatt Quote on Special Situations
“Something out of the ordinary course of business is taking place that creates an investment opportunity. The list of corporate events that can result in big profits for you runs the gamut—spinoffs, mergers, restructurings, rights offerings, bankruptcies, liquidations, asset sales, distributions.”
― Joel Greenblatt
5. Relative Value Fund Strategy (Arbitrage Strategies)
A relative value hedge fund uses arbitrage investment strategies and actively pursues temporary mispricing opportunities to exploit and capitalize on.
The price discrepancies, or “spread inconsistencies”, represent opportunities to profit once the stock prices revert to trading at their fair value.
The relative value arbitrage investment strategy starts with identifying pricing differentials between closely-related securities, by simultaneously purchasing and selling different financial instruments based on speculations of near-term price movements.
For instance, the merger arbitrage strategy – a blend of relative-value arbitrage and event-driven investing – entails a hedge fund taking offsetting positions in two companies involved in a pending merger to profit from the pricing inefficiencies that occur before and after the transaction.
Following the announcement of a proposed merger, the stock price of the acquisition target often rises, whereas the stock price of the acquirer can decline.
The merger arbitrage strategy involves the concurrent purchase and sale of the stocks of two companies on the verge of a potential merger (or acquisition).
Oftentimes, M&A transactions fall apart from unexpected events or regulations, such as anti-trust concerns, which represent opportunities to profit and “capture the spread” between the:
- Current Market Share Price (“Normalized” Stock Price)
- Proposed Offer Price per Share
Amid periods characterized by widespread uncertainty surrounding the outcome of a merger or acquisition, the fund exploits and profits from the pricing inefficiencies reflected in the market.
MSFT and ATVI Merger Arbitrage Example
For a real-world example, Microsoft (MSFT) announced its intention to acquire Activision Blizzard (ATVI) around mid-January 2022 for $95.00 per share (Schedule 14-A)
ATVI’s shares rose around 25% on the date of announcement – narrowing the difference between the market price and offer price per share – but in the coming months soon shed a sizable percentage of the gains from the potential acquisition as the regulatory hurdles on the horizon became more apparent.
The share price of ATVI continued to remain mostly around the ~$70 to $80 range until an unexpected decision by the EU’s European Commission to approve the deal in May 2023.
Yet, the optimism in the market soon left right after UK’s CMA restated its unchanged intent to prevent the acquisition on the grounds of anti-trust concerns in cloud gaming.
MSFT must therefore overcome the regulatory hurdle set by the CMA, as well as the FTC.
The uncertainty in the closure of the acquisition is priced into the market’s valuation of ATVI’s equity – which as of the present date – is trading at a hefty discount relative to the offer price per share, reflecting a lucrative (and highly risky) opportunity to investors.
MSFT and ATVI Stock Price Percent Trendline (Source: CapIQ)
6. Activist Investor Fund Strategy (Shareholder Activism)
The activist fund strategy aims to influence corporate decisions by vocally exerting their shareholder rights (i.e. direct management on how to increase the value of their investment).
- Friendly Engagement → Often, the activist investor is the “catalyst” that brings positive changes to how the company is managed, which frequently coincides with obtaining a seat on the board to work with the management team on good terms.
- Hostile Engagement → In other cases, activist funds can be hostile to public criticism of the company to turn market sentiment (and existing shareholders) against the existing management team – often to start a proxy fight to obtain enough votes to force certain actions.
Underperforming companies are ordinarily targeted by activist funds, as it tends to be easier to advocate for changes in such companies or even replace the management team.
The news alone of an investment by an activist investor could cause a company’s share price to increase because investors now expect tangible changes to soon be implemented.
“Do Activist Investors Boost Shareholder Returns?” (Source: Goldman Sachs Research)
7. Global Macro Fund Strategy
The strategy of global macro hedge funds is based on investment decisions based on the broader economic themes and political landscape.
Macro fund managers closely monitor economic variables and indicators to form a thesis on the outlook of macro conditions, e.g. the Federal Reserve, inflation rates, and international developments with implications on global trade.
The strategy of these funds shifts continuously and is contingent on recent developments in economic policies, global events, regulatory policies, and foreign policies, i.e. “directional analysis”.
8. Quantitative Investing Strategy (Systematic Trading)
Quantitative funds rely on systematic software programs to guide investment decisions, as opposed to fundamental analysis (i.e. automated decisions to remove human emotion and bias).
The investing strategy is built on proprietary algorithms, with significant emphasis on compiling historical market data for in-depth analysis, as well as back-testing models (i.e. running simulations)
Systematic trading strategies rely on computerized trading systems and complex mathematical models based on either technical or fundamental factors to identify patterns or trends to capitalize on within the global financial markets.
The systematic aspect of the investment strategy enables such firms to quickly identify investment opportunities and profit from temporary price patterns across different countries, contrary to fundamental investors.
9. Distressed Debt Fund Investment Strategy
The securities of distressed companies often trade at steeply discounted valuations, creating a risky yet lucrative opportunity for the investment firm.
The distressed fund strategy is a riskier form of investing that specializes in purchasing the mispriced securities of a troubled company (the “debtor”) that has filed for bankruptcy protection or is on the verge of doing so in the near future due to a sudden deterioration in its financial state.
Often, an investment in distressed securities can become a complex, long-winded process, since most corporate bankruptcies are in-court restructuring, rather than out-of-court.
Therefore, the time frame for the debtor and the creditors – contingent on the severity of the debtor’s financial state (and in incentives of the creditors) – can require significant time before an amicable solution is reached and approved by the Court.
- Chapter 11 Reorganization → The debtor cannot reorganize without the formal approval from the Court of its plan of reorganization (POR), i.e. the document negotiated with creditors that outlines the debtor’s plans moving forward post-emergence from bankruptcy and an attempt to return to operating on a “going concern” basis.
- Chapter 7 Liquidation → If the Court rules that the debtor’s value after the reorganization does not exceed its liquidation value, the assets belonging to the debtor are liquidated and distributed to its creditors in accordance with the absolute priority rule (APR), which dictates the order at which claims are repaid in full.
Distressed debt funds purchase debt trading at steep discounts because of the uncertainty around the outcome of the bankruptcy, i.e. Chapter 7 liquidation or Chapter 11 reorganization.
In the latter scenario, the reorganization and emergence post-bankruptcy presents the distressed fund with the opportunity to obtain a sizeable stake in the new entity’s equity to generate a strong return, assuming a successful turnaround.
For instance, a distressed fund could invest in the debt of a corporate undergoing a reorganization, where the debt will soon be converted into equity in the new entity (i.e. debt to equity swap) amid the attempt to return to a “going concern.”
10. Multi-Strategy Fund (Multi-Strat Investing)
The investment strategy used by multi-strategy funds is at their discretion, as such firms tend to prioritize capital preservation with a lower appetite for risk.
Multi-strategy funds are seldom risk-averse from the start, but rather prioritize risk management because of the expansion of their assets under management (AUM).
The higher the assets under management (AUM) of an investment firm, the more risk-averse the investor must become, since there is now more capital at risk.
Therefore, multi-strategy firms strive to achieve stable, positive returns regardless of market performance, like most hedge funds, but there is far more capital at stake.
In general, portfolio diversification is the main appeal to multi-strategy investors, where risk is allocated across different investment strategies, asset classes, and geographical locations.
That said, the risk profile attributable to the “multi-strat” fund strategy is on the lower end (and less risk coincides with lower potential returns, per usual).
11. Credit Fund Strategies (Fixed Income Investing)
Credit funds utilize strategies that allocate capital predominately to debt securities, which can range widely in terms of risk-reward profile.
Credit funds strive to exploit opportunities in corporate debt issuances, government bonds, and other types of financial securities.
The following list contains examples of fixed-income securities:
- Corporate Bonds
- Treasury Bills (T-Bills)
- Treasury Notes (T-Notes)
- Treasury Bonds (T-Bonds)
- Municipal Bonds (“Munis”)
- Certificates of Deposit (CDs)
Credit hedge funds can use various strategies to achieve their target returns, such as long/short credit, distressed debt, arbitrage strategies, such as convertible arbitrage (i.e. purchase convertible bonds and short the issuer’s stock to hedge risk), and structured credit (CDOs, CLOs).
Fixed-income credit fund strategies consist of investing in long-term government bonds, corporate bonds with high credit ratings, annuities, and preferred stock, all securities that pay a fixed rate of interest to the bondholder until maturity.
Credit fund managers must have a strong grasp of analyzing the risk profile of a given lending scenario, such as performing diligence on the implied default risk, credit spread risk, and illiquidity risk, to identify and profit from inefficiencies.
Opportunities to profit and the upside potential in monetary gains decline for debt securities higher in the capital structure (and vice versa).
Often, the only method for a credit fund to achieve equity-like returns is to engage in riskier strategies, such as leverage, convertible bond arbitrage, and distressed credit.
Convertible Bond Arbitrage Example
The convertible bond arbitrage is a mixture of credit investing and relative value arbitrage investing.
For instance, a credit fund could take opposing positions in a convertible bond and the underlying stock in the convertible bond arbitrage strategy, i.e. long and short positions in related financial securities.
Here, the credit fund seeks to profit from movements in either direction by setting a contrasting hedge between the long and short positions, in which the two bets reduce the portfolio risk.
- Share Price Decline → If the share price declines, the investor can benefit from the short position taken, and thus there’ll be more downside protection.
- Share Price Increase → If the share price increases, the investor can convert the bond into shares and then sell, earning enough to cover the short position (and again minimize the downside).
Learn More → Fixed Income Securities
Hedge Fund vs. Mutual Fund: What is the Difference?
Hedge funds and mutual funds are distinct investment vehicles, with significant differences in terms of the fund structure, investor qualifications, risk-reward profiles, investing strategies, and regulatory risks.