A hedge fund is an alternative investment vehicle available to sophisticated/accredited investors that can be either institutional or wealthy individual investors. This pooled investment structure can take the form of a limited liability company or a limited partnership. These investment structures have a limited amount of investors ranging from 100 to 500 and are not heavily regulated such as mutual funds do. Although hedge funds are not allowed to advertise to the public, many of them choose to register with the SEC to be able to increase their investor base and decrease the minimum capital requirements of investor entry.
The main idea behind the formation of hedge funds is that these types of investment funds are supposed to perform under a positive or a negative market environment and preserve the invested capital from market uncertainty. Therefore, as a hedge fund aims to perform regardless of what the market is doing, its performance is measured in terms of absolute returns unlike the relative-to-benchmark returns of the mutual funds.
Hedge funds are also famous for two more characteristics: The first is their high level of flexibility when it comes to the structure of their investment strategies. They resemble mutual funds in the sense that they are both professionally managed portfolios that can invest in traditional securities such as stocks and bonds, but they offer managers substantial space for maneuver due to the lack of restrictions while forming and executing their investment policy. The hedge fund manager faces fewer investment constraints than the mutual fund manager and can adjust or change completely the investment strategy based on the circumstances. Hedge fund managers can also use short selling, derivative products and leverage techniques that aim at the maximization of returns. They can also invest in various other alternative asset classes in various geographies. There are numerous hedge fund strategies with the most common of them being the Event-driven strategy, long/short equity, global macro, managed futures strategy, statistical arbitrage, convertible arbitrage, fixed income arbitrage, equity market neutral, emerging markets, and distressed securities among others. Of course, there are various combinations of these strategies and also the fund of funds strategies that aim at a further diversification of risk and locking-in a pre-determined return range.
The second characteristic is the traditional fee structure that hedge funds charge. The well-known “two-twenty” rule states that hedge funds earn two percent of net assets per year under any market condition plus the 20% of profits (always above a specified hurdle rate). Of course, this payment structure has its limits and in the case that a hedge fund faces serious losses, cannot earn any additional payment unless it makes up for the losses. This is the fee structure that most hedge funds operate although there have been reductions to it during the last years mainly driven by pension funds and other institutional investors requests. The “Alignment of Interests Association” (which represents pension funds, foundations, endowments, and family offices in the US) has questioned this model and has proposed several changes like a tiered management fee. Moreover, several recent studies suggest that the average management fee has reached closer to 1.5 percent which indicates a shift in the industry standards.
There are several reasons why investors choose hedge funds in their overall investment context. Mainly investors prefer hedge funds as most of the times, hedge fund founders have made a significant capital investment in their fund and provide a successful track record accompanied with a highly sophisticated proprietary model. As a result, the level of certainty is raised for the potential investors. Hedge funds also provide a good diversification level for an investor as the returns of the fund usually do not correlate with the returns of the stand-alone traditional asset classes. Investors of hedge funds also like the downside protection that these investments offer. Long-only portfolios like mutual funds, don’t provide this protection layer as they cannot take short positions in order to benefit from a declining market as hedge funds do. Also despite the fact that market efficiency is considered to be present, in real situations what hedge funds are trying to do is to exploit in the best way possible any market inefficiency that may arise. They form their strategies in such a way that will add “alpha” due to their active management.
Hedge funds can be chosen as an investment in both bull and bear markets. However, they tend to perform better in volatile times. An accredited investor should always study well the fund’s track record before deciding to invest in a hedge fund strategy and have a very clear outline of what to expect from each strategy. After all, hedge funds are not all the same; thus they don’t provide the same safety (downside protection) and upside potential to their investors. Some of them thrive whereas some of them fail. What hedge fund history has shown us is that those funds that have continuity on their performance over the years are those that considerably evaluate their market risk, liquidity and leverage exposures.