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Hedge Fund

Guide to Understanding Hedge Funds

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Hedge Fund

In This Article
  • What is the definition of a hedge fund?
  • How is the partnership between general partners (GP) and limited partners (LP) arranged?
  • What was the original purpose of hedge funds?
  • Which types of investment strategies are employed by hedge funds?

Hedge Fund Definition

Originally, hedge funds were formed with the objective of hedging the portfolio risk stemming from long positions.

Offsetting long positions on equities with short positions can reduce portfolio risk – i.e. the classic “long/short” strategy still utilized in the present day.

Hedge funds were therefore initially designed to generate stable, non-volatile returns, independent of the prevailing market conditions.

Back then, hedge funds attempted to profit regardless of the market direction, with prioritization set on minimizing correlation to the public markets rather than outperforming the market.

Hedge Fund Partnership Organization

A hedge fund is categorized as active management, rather than passive investing, as the general partner (GP) and the team of investment professionals regularly track fund performance and adjust the portfolio accordingly.

General Partner (GP) Limited Partners (LPs)
  • The money managers of the fund that control the investment strategy.
  • The GP decides how capital is allocated in the portfolio on behalf of the LPs.
  • The LPs are the investors that contribute capital to the fund.
  • LPs have practically no direct impact on the investments in the portfolio.

Investment decisions are grounded upon detailed analysis, research, and forecast models, which all contribute towards 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)

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

Note: Proof that the current income level can be maintained for at least two more years must also be supplied.

Hedge Fund Fee Structure

Historically, the hedge fund fee arrangement was the industry standard “2 and 20” fee structure.

  • Management Fee: The 2% management fee is typically charged based on the net asset value (NAV) of each LPs investment contribution and is used to cover the costs of operating the hedge fund (and employee compensation).
  • Performance Fee: The 20% performance fee – i.e. “carried interest” – functions as an incentive for hedge fund managers to maximize returns.

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.

In recent times, marginal declines in management fees and performance fees have been observed, particularly for large institutional funds:

  • Management Fee: 2% ➝ 1.5%
  • Performance Fee: 20% ➝ 15%

To ensure no pre-emptive performance fees are obtained, LPs 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 – often, 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 that 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 Trends

The modern hedge fund industry has developed into encompassing a vast assortment of investment strategies.

Despite the origins of the hedge fund industry – rooted in the concept of market neutrality – many funds nowadays attempt to outperform the market (i.e. “beat the market”).

Nowadays, hedge funds seek to profit from more speculative, riskier strategies such as using leverage (i.e. borrowed funds to amplify returns).

Still, hedge funds have measures in place for portfolio diversification and risk mitigation (e.g. avoiding over-concentration in a single investment or asset class), but there has certainly been a widespread shift towards becoming more returns-oriented.

Hedge Fund Investing Strategies

Long/Short Equity Funds

The long/short strategy attempts to profit from both upside and downside price movements.

The long/short fund takes long positions in relatively underpriced equities while short-selling stocks that are deemed to be overpriced.

In general, most long/short equity funds hold a “long” market bias, which means that their long positions comprise a greater proportion of the total portfolio.

Equity Market Neutral (EMN) Funds

Equity market neutral (EMN) funds seek to balance their portfolio’s long positions with their short positions. The aim is to achieve a portfolio beta as close to zero as possible by pairing long and short trades to mitigate market risk.

The fund tries 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).

The expected return of a market-neutral fund is the risk-free rate plus the alpha generated by the investments.

Equity market-neutral funds, in theory, consist of the lowest correlation to the broader market – i.e. returns are independent of market movements but have limited upside potential.

Short-Selling Equity Funds

Short-selling funds can specialize exclusively on short selling, which is called “short-only”, or be net short – i.e. the short positions outweigh long positions in the portfolio.

Rather than serving as a portfolio hedge, the short positions are intended to produce alpha.

For that reason, short specialists tend to make fewer investments (i.e. hold onto capital) to capitalize on opportunities such as fraudulent companies (e.g. accounting fraud, malfeasance).

Event-Driven Funds

Event-driven hedge funds invest in the securities issued by companies anticipated to soon undergo significant changes.

The fund attempts to capitalize on a particular event, which can range from regulatory changes to operational turnarounds.

Common examples of “triggering” events are:

Arbitrage Funds

Arbitrage funds pursue pricing inefficiencies and temporary market mispricing (i.e. spread inconsistencies).

Merger arbitrage entails the concurrent purchase and sale of the stocks of two merging companies to profit from and “capture the spread” between the:

  • Current Market Share Price
  • (and) Proposed Acquisition Terms – Offer Price

In a period of uncertainty surrounding the merger or acquisition, the fund capitalizes on the market inefficiencies reflected in the pricing.

Convertible bond arbitrage involves taking both long and short positions in a convertible bond and the underlying stock. The goal is to profit from movement in either direction by having an appropriate hedge set between the long and short positions.

  • If the share price declines, the investor can benefit from the short position taken, and thus there’ll be more downside protection.
  • 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).

Activist Funds

Activist hedge funds influence corporate decisions by vocally exerting their shareholder rights (i.e. direct management on how to increase the value of their investment).

Under some scenarios, activists can be the catalyst that brings positive changes to how the company is managed, as well as potentially get a seat on the board to work together on good terms.

In other cases, activist funds can be hostile with 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.

Global Macro Funds

Global macro strategy funds make investment decisions according to the “big picture” economic and political landscape.

The range of holdings by global macro funds tends to be diverse and can include equity indices, fixed income, currencies, commodities, and derivatives (e.g. futures, forwards, swaps).

The strategy of these funds shift continuously and are contingent on recent developments in economic policies, global events, regulatory policies, and foreign policies.

Quantitative Funds

Quantitative funds rely on systematic software programs to determine investments, 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).

Distressed Funds

Distressed funds specialize in investing in the securities of a troubled company that has declared bankruptcy or is likely to do so in the near future due to deteriorating financial conditions.

The securities of distressed companies are normally undervalued, which creates a high-risk but lucrative purchasing opportunity for the fund.

Often, distressed investing is highly complex, especially considering the long timeline of restructuring processes and the illiquid nature of these securities.

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.”

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