The History of Hedge Funds
Although the term “hedge” normally refers to a practice where risks are offset, suggesting that hedge funds would consist of funds that are of below average risk compared to funds in general, this is not the case at all, and far from it actually.
The term hedge funds goes back to an experiment by writer Alfred Winslow Jones, who decided to start a fund back in 1949 that used short positions as a hedge against long positions. So the idea was that the fund would play both sides, something that wasn’t done in those days, and is still off limits today for the majority of funds.
Going both long and short is indeed a hedge though, and in the stock market, when the market is in a downward turn, if you only are going long, in the market to benefit from price increases in your stocks, you’re going to have to do something else to offset this risk, to hedge it in other words. So doing this is actually hedging, but it’s the positions that are being hedged, not risk being hedged in general.
Jones also used leverage, trading on margin, which is something that funds don’t generally do, or are even allowed to do. It is true that due to regulations, funds tend to be limited to basic investment strategies only, and this new hedge fund sought to do the opposite, to use strategies that are available to sharp individual investors, to look to maximize results.
Jones also added the innovation of bringing investors in the fund on board as limited partners, where all investors were partners with the fund management and one another, which involved a commitment of a significant amount of capital as well as for a specific duration, known as the lock in period.
He also charged much higher management fees then is typical, taking 20% of the fund’s profits for himself, and this scheme remains in place today, rewarding fund managers in line with the performance of the fund, which was another innovation of Jones.
The Rise, Fall, and Rise of Hedge Funds
This strategy dramatically outperformed other funds over the next two decades, although as the 1960’s unfolded, many hedge fund managers moved away from this recipe for success into a much more aggressive style in an effort to outdo one another and make even more money from the growth of their funds.
This led to a number of hedge funds going bust during the late 60’s to early 70’s, and the strategy fell out of favor for quite a while, until the late 1980’s saw the massive success of the Tiger Fund became well known. This led to a revival in hedge funds, as investors once again flocked to them, in spite of an even more risky approach than ever, trading heavily in things like currencies, futures, and options to further the potential rewards.
Even though the Tiger Fund and several other hedge funds ended up going belly up some years later, the hedge fund business has continued to grow, and today there are about 10,000 different hedge funds, controlling $3.2 trillion.
For those with a substantial amount of money to invest, and who find normal returns from mutual funds too tame, hedge funds allow investors to get involved in professionally managed funds that attract the very best minds, who are extremely well compensated to really put the pedal to the metal with the funds they manage and aspire to the big potential that these investors hope for.
How Today’s Hedge Funds Operate
Hedge funds are not anywhere near as tightly regulated as normal funds, and regulators understand that there is a big market for this, funds that aren’t restrained under the normal, very conservative requirements that funds in general are saddled with.
These regulations serve to protect investors from funds that are seen to use strategies that involve greater risk, like short selling, margin trading, investing in currencies, futures, options, credit swaps, arbitrage, distressed equities, and more, yet investors are free to do at least most of these things on their own if they wish.
So why not let funds do the same thing? Well hedge funds have been doing that for a long time now, and these strategies do indeed involve more risk, but this is risk that these investors wish to take on.
However, the SEC doesn’t want to let just anyone invest in these hedge funds, and you have to qualify as an “accredited” investor. To be deemed accredited, one must have an annual income exceeding $200,000, or joint income with a spouse over $300,000, over the last 2 years. One may also qualify by having a net worth exceeding $1 million, including home equity.
In addition, an investor who is a principal in the hedge fund company can also qualify, in addition to those who are investment brokers or advisors, on the basis of professional experience and knowledge.
The idea here is that one must show the means to withstand the additional risk that hedge funds represent, or have the knowledge to have a good understanding of what these added risks involve.
One of the requirements for investing in a hedge fund is that one must subject oneself to the lock up restraints of the particular hedge fund. This is required to allow the hedge fund manager to not have to keep too large amounts of the fund in cash to handle a lot of redemptions, which limits its growth.
So this is not for someone who is just looking to flip a position in a hedge fund and make a quick buck, although one can do that with a similar strategy on one’s own.
Constituents of a Hedge Fund
Nothing is off the table with hedge funds, provided they disclose what they are doing to their investors. Hedge funds will invest in just about everything, including long and short positions in stocks, bonds, futures, currencies, options, exotic derivatives, and even land and real estate.
Normal mutual funds typically only invest in stocks and bonds, and take long positions only, and don’t use borrowed funds as leverage. Hedge funds will often use leverage with their positions, controlling more to much more than they normally would, and this does definitely add risk to their positions, but if well managed, this can really accelerate returns, as it does with leveraged trades by individual investors.
Hedge funds typically charge both a 2% management fee and a 20% performance fee, and it’s actually the 2% that some investors have the most problem with, as this is on the high end. For those who seek the high returns that hedge funds shoot for, well you get what you pay for, and this allows hedge funds to attract the very best talent, and hedge fund managers can make enormous amounts of money, in the tens or even hundreds of millions per year.
The best hedge funds deliver double digit returns to investors, and this can range up to 30% per year or more. When the market underperforms, hedge funds are also better equipped to deal with these conditions, as they can take advantage of both bull and bear markets.
Getting Involved in Hedge Funds
Provided one has the means to qualify as an accredited investor, and one has a big enough risk appetite to want to invest money in a hedge funds, selecting one isn’t quite as easy as it is with normal mutual funds.
Since mutual funds just take long positions, you can readily compare them and decide which ones are doing better than others, and make your selection based upon their track record of keeping up with the market. You can also purchase index funds and be assured that your return will mirror a certain stock index less management fees, which tend to be very low for index funds since there’s no skill involved on the part of fund managers.
Hedge funds are a different breed, due to taking an number of other positions besides long the stock and bond market. One must pay attention to both returns over a period of time and risk exposure, both during this time and in other scenarios that may occur that affect the various investments the hedge fund holds.
Fortunately though, there are statistical models that look to assess all this. The most noteworthy way to assess the desirability of a fund is to look at their investment strategy, and hedge funds will fall into a number of classifications of strategy, to see if this strategy suits your preferences, objectives, and tolerance.
A fund whose strategy may be to hold long and short positions in equities may turn out to be more appealing than one that may hold a lot of derivatives, especially if they both are performing at the same pace. Since derivatives are riskier by nature, one should expect the performance to be higher to offset that.
Hedge funds can certainly be a more robust and exciting investment opportunity compared to run of the mill funds, as long as one is aware that with the potential of higher returns comes higher risks. However if these risks are well managed, the risk return ratio of hedge funds can be attractive indeed.