Summary: This section of the site looks at hedge funds. They are possibly the invisible hand that drives stock markets and commodity exchanges around the world, and yet so few people know much about them. We start with a hedge fund definition.
There are actually a number of characteristics that help to define a hedge fund, both in terms of structure, location, investment style and fee structure. However, there are a great many variations on these themes which means that there are very few funds - if any - that are identical.
Depending upon your perspective, hedge funds are either a great investment vehicle managed by mathletes and superstar traders looking for alpha and using some of the best traditions of Eugene Fama. Or they are possibly wildy risky investment funds run by spoil masters of the universe that use too much borrowed money to earn a fortune as they put the financial world at risk and avoid paying any taxes. The truth, as ever, is somewhere in between...
It is true that hedge funds use very technical methods of making money. They try to produce something known as an absolute return. Normal funds have very strict limits as to what can and cannot be invested in. This means that if their particular sector or index falls, all they can do is follow the market down.
By chasing absolute return, the funds are focusing on alpha. Alpha is the skill associated with outperformance of a market or index.
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Hedge funds on the other hand are allowed to invest in almost anything that is liquid enough for them. This means that - in theory at least - they ought to be able to generate a profit in any market conditions. If prices are falling, they are able to engage in short selling to profit on the way down.
This fleet-footed mandate means that many funds are actually quite high risk. This risk is then compounded by the use of borrowed money - known as leverage - which will amplify returns. (This is both a gift and a curse, for in a falling market, borrowing helps to make the losses accrue more quickly!)
However, most managers have very high amounts of their own money invested in their fund. This provides a level of clarity of thinking and risk assessment that has been found lacking in other areas of finance. Many funds have gone wrong and 'blown up', but it would be unfair to say that the majority are oblivious to risks being taken. In fact, most focus on risk very closely and seem to do a much better job of managing it than most investment banks.
Some funds use longer term decision making and are macro, meaning that they focus on the big trends underway and make just a few decisions but bet big. Another popular hedge fund strategy is to be momentum driven. This means that the funds follow the current important trends of the day and jump into and out of trades quickly. The press (such as the Wall Street Journal) and politicians have come to regard these funds as the 'hot money' that moves markets and adds to volatility.
Many funds use complex mathematical formulas and powerful computers to make their trades. This is known as algorithmic trading and is such a specialised world that very few people really know for sure what they do. Broadly, it is known as high frequency trading but that can and does cover a wide range of activities.
There are a number of quite standard strategies that are used to generate profits. The most well known is statistical arbitrage. These days there are so many stat arb funds that it is not a particularly profitable strategy - but it was!
The word hedge relates to the fact that these funds will typically take both sides of a trade with an aim to make a small percentage of money if things go well or lose very little if things go badly. This is all about diversifying risk. Often, complex derivatives will be the means by which trades are placed and risk 'managed'.
Location, location, location
Any hedge fund definition also needs to include geographical jurisdictions. This is a minefield, known as regulatory arbitrage where the best terms are selected for business purposes. To be more specific and a little less esoteric, this means that a fund might be domiciled in Bermuda, with a bank account in the Isle of Man, in a bank based in Guernsey, with fund managers resident and personally monitored in London (Mayfair is very popular), investing in assets in stock and currency markets around the world, with investing clients from perhaps 15 or 20 countries.
Such structures are very hard for a regulator to control as it is designed to 'fall through the cracks' in the system. In addition, the large amounts of money at their disposal enable them to retain the best lawyers that can keep things running smoothly.
It might be worth adding that this is all entirely legal, though perhaps not in keeping to the 'spirit of the law'...
The managers themselves are often resident and monitored in either New York or London. This is
partly because they wish to be near their peers and the main markets, but also because the
regulatory systems in the US (the SEC) and UK (the FSA) are well
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The elite of the elite
It is also true to say that many hedge fund managers earn incredible sums of money. In the billions of dollars per year. Many of these managers own a large proportion of their own funds and so are trading in part with their own money. In addition, the fee structure of most hedge funds is designed to reward a manager that performs well. The game is very much designed in their favour.
The level of self-investment has been a key driver to the growth of the
net worth's of the the best managers - not only are they investing
client money and making a profit on the fees, they are also growing
their own wealth at the same time. It is this combination that has helped legends like Carl Icahn and Ray Dalio to become the investment titans that they are. Then there are others, such as George Soros, that have been investing and trading only with their own money for years. At a certain point, the best managers become so successful that they no longer need clients.
The fee structure is typically quite extravagant. a 2% annual management fee is normal, but on top of that will be placed a 20% performance bonus for outperforming some specified and pre-set benchmark. If you are managing a couple of billion dollars and can bring in 20% of just a couple of points of alpha per year, it is possible to earn a lot of money!
It is also worth highlighting that many hedge funds have a very high risk profile and are likely not for an average private investor. In fact, most hedge funds specifically target only very high net worth clients, meaning that the 'man on the street' probably cannot become a client under any circumstances.
Even smaller funds that are looking for more ordinary clients will usually have a minimum investment of $20,000 or $50,000, which is still out reach for most investors. There are a number of analysts and authors that view this as one of the big privileges of wealth - if you have more of it you can pass the minimum entry levels set by the best hedge fund managers and therefore your wealth can (and probably will) grow more quickly and reliably.
Being able to define a hedge fund is clearly not easy. Therefore, the following pages will discuss a number of the issues relating to these little understood investment funds:
What Are The Best Hedge Funds?
How Do You Conduct Hedge Fund Due Diligence?
Is There Any Regulation Of Hedge Funds?
Why Invest In A Hedge Fund Of Funds?
What Do Forex Hedge Funds Do?
How Do Real Estate Hedge Funds Work?
How Risky Are Energy Hedge Funds?
How Can You Learn About Offshore Hedge Funds?
What Can Commodity Hedge Funds Trade?