Introduction to Hedge Fund

You may have read about hedge funds in the news but are unsure of what they are exactly. They are sometimes called the “mutual funds for the wealthy,” but that isn’t really accurate. While hedge funds and mutual funds both pool money from multiple investors, that is where their similarities stop.

The major difference between mutual funds and hedge funds is that hedge funds are very loosely regulated — having some serious implications. They are generally set up as private investment limited partnerships. So, to become a part of the partnership, you have to be an accredited investor, including a relatively deep knowledge of the investment tools the fund managers could use as well as having a net-worth of at least $1 million.

Since hedge funds are not available to the general public, hedge funds are restricted by law to advertise their services and have much looser regulations of reporting what they do with the money under management. This also means that they are not as flexible to buy in or liquidate as mutual funds. Most hedge funds operate for a set period of time, only allowing withdrawals at set intervals — such as quarterly or annually.

Hedge funds were initially created in the 1940’s to allow fund managers who foresaw downturns in the market to short stock, thus hedging their investments against potential losses. Despite these origins, hedge funds today are far more focused on maximizing returns through high-risk investments and leveraging than they are interested in reducing risk.

Compensation is also very different for mutual fund managers and hedge fund managers. Mutual funds charge a preset Management Equity Ratio (MER) of anywhere from .25% for index funds to over 2% for sector or specialty funds. If a fund had $100 million under management and charged 1% MER, the fund manager would be paid $1 million for managing the fund regardless of how it performed. Even if the fund LOST money, the fund shareholders would pay the same fee and the manager would still be paid for managing the fund.

In stark contrast, hedge fund managers are compensated for how well their fund performs — collecting both a fee for assets under management (AUM) and an incentive fee, a percentage of any profits. A typical fee structure could be 2 and 25. This would mean that the AUM fee would be 2% and the incentive fee would be 25% of any profits that the manager is able to realize.

To help keep fund managers focus on providing real profits to shareholders and to prevent them from taking on excess risk, high-water mark limitations and fee caps may be used also be used in the fee structure.

There are hundreds of types of investment instruments in the marketplace available to investors. With mutual funds, managers are limited to just 3 types: buying stocks, bonds or money market securities. In hedge funds, the full range of financial instruments is at the fund manager’s disposal. Because there are so many tools and strategies available, there are as many strategies as there are funds. Here are a few of the most popular classifications of hedge fund strategies that are used.

• Hedged equity funds identify overvalued (stocks that the manager feels have a stock price that is too high) and undervalued (stocks that the manager feels have a stock price that is too low) equity securities. The fund combines long (buying stock) and short (selling stock you don’t own to buy back later at a lower price) positions. These are the most common type of hedge funds in terms of assets under management.
• Equity market neutral funds are similar to hedged equity except that they attempt to purchase combine long and short positions in equal exposure to minimize exposure to fluctuations in the sector.
• Convertible or fixed-income arbitrage funds exploit mispricings in convertible bonds, warrants, and convertible preferred stock. They buy or sell the securities and then hedge the associated risks, usually by shorting the associated stock as well as collect the coupon on the underlying convertible bond. With fixed-income arbitrage, they focus on identifying overvalued and undervalued bonds based on expected changes in the term structure or anticipated changes to the credit quality of various market sectors.
• Distressed securities provide and opportunity for hedge fund managers to invest in the debt and equity of companies that are in or near bankruptcy. Investors are generally not able to deal with the legalities and negotiations associated with creditors and other claimants in bankruptcy proceedings. Hedge fund managers who are prepared to take on this extra risk and work are able to cash in for their shareholders.
• Merger arbitrage or “deal arbitrage” tries to make money by taking advantage of a price spread between current market prices of corporate securities and their anticipated value upon the successful completion of a takeover, merger or spin-off.
• Global macro strategies trade currencies, futures and option contracts that take advantage of global trends rather than individual securities.
• Emerging markets focus on emerging and less mature markets such as equities found in small stock markets. Because many emerging markets are too small to support short selling, futures or options, more of these funds tend to be long.
• Fund of funds is, as you might expect, a fund that invests in a number of underlying hedge funds. By spreading out over 10–30 that cover completely different segments and strategies, FOFs can be some of the most diversified investments available. This diversification comes at a cost as investors have to pay two layers of fees: to the hedge fund manager, and to the manager of the FOF. These funds are closer to a mutual fund and are typically more accessible to individual investors who are able to buy in and liquidate capital more readily.