Hedge Funds Explained: What’s A Hedge Fund Exactly?

Introduction

Okay, let’s talk hedge funds for a second. Or to be more specific: What they are. What they do. And what most people get wrong about them.

And there’s a lot people get wrong.

Some of it, because there’s just a lot of bad info out there. And some of it, because the term “hedge fund” has been diluted so much over the years that it has lost most of its meaning. To the point where people will use it to describe all sorts of alternative investment strategies that have nothing to do with what hedge funds actually do.

And I mean, zip zero on the diddly squat scale.

Which is why it’s important to first define what a hedge fund is, so we are all on the same page.

Hedge Fund Definition

In its most basic form, a hedge fund is nothing more than a private investment partnership that aims to generate positive returns across all economic cycles, while at the same time trying to protect its capital from markets risk.

Or, to put it more simply, hedge funds want to make money for their investors in both good and bad markets. Regardless if prices are going up or down.

That’s it.

That’s the primary goal of a hedge fund.

Simple and easy. At least in theory. Not so much in practice. Especially over long periods of time.

Which brings us to our second question: What do hedge funds actually do?

The thing that makes a hedge fund, a hedge fund, is the hedge. Or the process of reducing the risk of financial losses.

And while there are different ways of doing this, the most popular approach is to buy, or go long, shares of a company that’s expected to increase in value, while at the same time selling, or shorting, borrowed shares of a company that’s expected to decrease in value.

This strategy is known as long/short equity and is the oldest hedge fund strategy and has been around since the 1950s.

In short, the term “hedge fund” actually comes from the investment strategy itself.

Hedge Fund Strategies

Clearly, markets have changed a lot in the last 60 years and so have hedge funds and their investment strategies. Besides the long/short equity strategy, there are basically four key hedge fund strategies: Credit, Event driven, Relative value, and Macro.

Credit strategies involve debt securities and focus on the arbitrage of risk, including default risk, credit spread risk and liquidity risk.

Event driven strategies can involve both debt and equity, and focus on changes that happen before or after corporate events, such as mergers, acquisitions, spinoffs, bankruptcies, or a change in management.

Relative value strategies are another form of arbitrage that focus on mispricings between two correlated securities.

Macro strategies are unique in that they involve all major markets and liquid asset classes, such as equities, debt, currencies, and commodities to navigate the geopolitical and economic events around the world and the market swings that follow them.

There are also a few funds that have set up so-called “side pockets” to invest not just in public markets but also private markets, such as venture capital, private, equity, real estate, and some of the more esoteric corners of finance, including film financing, litigation financing, royalty fees, and so on. Or in the case of multi strategy funds, they are set up to combine different hedge fund strategies within a single fund.

But overall, the key point that ties all these different hedge funds together, and makes an investment fund a hedge fund, is that they all hedge against market risks.

Or at least, they used to.

Hedge Fund Fees (2 & 20)

When people use the term hedge fund today, they are, in most cases, not referring to any particular investment strategy anymore, but a compensation structure.

The famous 2 and 20.

This fee structure goes back to the early days of hedge funds when it was common for hedge funds to charge a management fee and a performance fee.

The management fee aims to cover the costs of running the fund and is charged on the assets under management or AUM.

The performance fee, on the other hand, is charged on the fund’s annual profits above a certain level of return, or hurdle rate, to incentivize the fund manager to focus on maximizing performance rather than assets under management for the sake of running a large fund.

This dual fee structure is generally referred to as 2 & 20 since the industry standard used to be a two percent management fee and a twenty percent performance fee.

And while the two and twenty is what captures most media attention, there are other aspects that set hedge funds apart from other investment funds.

Hedge Fund Regulation

Most hedge funds are subject to regulation that prevents them from marketing to the general public, which is why they tend to be structured as private partnerships that raise money from institutional investors and high net worth individuals.

This is also one of the reasons hedge funds seem so secretive to the general public, because in most cases it just doesn’t make much sense for a hedge fund to maintain a public profile above and beyond what’s required by regulators and policy makers.

Even so, one way to learn more about hedge funds, their strategies, their portfolio positions or leverage is to dive into their regulatory filings, which is a valuable and free resource that every investor interested in hedge funds should utilize.

And while we are on the subject of leverage, it’s important to stress the risks of using margin loans as it will not only amplify your potential profits, but also your potential losses. To the point where it can result in the liquidation of the entire fund to meet a margin call.

And that’s not the only risk.

Short Selling Risks

Short selling opens an investor up to risks that can result in massive losses that long-only investors do not face. The reason is that when you buy shares in a company, and the share price goes to zero, your loss is limited to whatever amount you invested, while your potential profit is in theory unlimited.

So worst case, you lose your entire investment, but you cannot lose more than what you put in if you’re not using any margin loan.

In the case of short selling, however, this dynamic works in reverse. As the price of the shares goes up, your losses increase. And if, for whatever reason, the share price starts to spike, your losses will go super sonic.

This financial nightmare is called a “short squeeze” and is something you want to avoid if you can.

Basically, what happens is that as the stock price starts to increase, the short seller is forced to add more collateral or cover the short position altogether by buying back the borrowed shares, which in turn sends the stock price up even higher.

Portfolio Concentration Risks

A short squeeze can be especially devastating for funds that run concentrated portfolios because as the position goes against you, it becomes a bigger position in the portfolio compared to a losing long position, which is actually becoming a smaller position within the portfolio.

Moreover, there is also the risk that as the portfolio grows in size and value, entering and exiting investments can start to become a challenge in less liquid or developed markets.

To address this issue, hedge funds tend to ask investors to lock up their capital for a set period of time that can range from a few months to several years.

What this means is that investors will not be able to take their money out of the fund until their lock-up period expires. This is meant to help the fund unwind positions in a manner that minimizes any potential impact that could adversely affect the other investors in the fund.

Conclusion

All this is pretty interesting stuff and at first glance can seem complex and confusing, but I hope I got clear up some of the confusion surrounding hedge funds.

This post is meant to be a good starting point but if you are interested in learning more about hedge funds, check out some of the other hedge fund articles. Just remember: Not every investment fund that’s called a hedge fund these days will actually be a hedge fund.