Do you want to know what Hedge Funds are all about? If yes, make sure you read this article carefully to the end.
What is a hedge fund?
Hedge funds are alternative investment funds that pool money from professional investors and invest it into the public market. Their main goal is to outperform the S&P index and realize returns in any market environment.
Typically managed by institutional investors, hedge funds utilize a wide array of complex and nontraditional investment strategies – such as derivatives and short selling – to generate profits. While their strategies are often diversified to mitigate risk, hedge funds are generally considered a high-risk, high-reward investments with a steep barrier to entry.
Hedge Fund Industry at a Glance
The industry had $4.18 trillion in assets under management in 2022, according to the Preqin Global Hedge Fund Report for the year.1
There were more than 8,800 hedge fund managers at the end of 2022. In the final quarter of 2022, money flowed out of hedge funds for the third quarter in a row to the tune of $7.4 billion.
For the year, there was a total of $62.4 billion in net outflows.4 This is significant because it shows investors were interested in other investments in 2022.
How Do Hedge Funds Work? What Do They Do?
In general, the goal of a hedge fund is to employ trading strategies that allow it to generate positive returns regardless of market conditions.
In other words, hedge funds aim to profit whether equities and other assets are going up or down in value so that their wealthy clients can profit during bull markets and bear markets alike.
Most hedge funds buy (and/or short) publicly traded stocks, but they can also make use of alternative assets—like fine art, real estate, currencies, crypto, and even patents in their money-making strategies.
Different funds have different goals and employ different techniques, but all aim to produce standout returns for their clients while attempting to minimize risk. See Google Play Gift Card.
Hedge funds’ namesake comes from the way they minimize risk many hedge funds “hedge” their bets by taking offsetting positions in assets they are long on.
This could mean buying put options, selling stocks short, or even investing in assets that tend to outperform at different times in the economic cycle than their primary holdings.
In doing so, they can minimize their losses to some degree should the assets they are long on fall in value.
4 Common Types of Hedge Funds
There are many different types of hedge funds, and different funds have different goals and focuses. A few common types are described below.
1. Long-Short Equity Hedge Funds
Long-short equity funds are probably the most common type of hedge fund. These funds go long (i.e., buy) stocks they think will appreciate in value and short (borrow and sell) stocks they think will fall in price.
This strategy helps minimize exposure to market volatility by maintaining positions that can generate returns in both bull and bear climates.
Different funds go long and short in different proportions—some devote 60% of their funds to long positions and 40% to shorts. Others do the opposite. Many funds strategically employ a “market neutral” strategy by going long and short in equal proportions.
2. Global Macro Hedge Funds
Global macro hedge funds are those that aim to capitalize on changes in macroeconomic factors like market shifts that occur due to international economic and political events.
Macro funds rely on research and make trading decisions based on fluctuations in things like interest rates, national and international policies, indexes, and currency values.
Funds like these are usually highly diversified and tend to use a lot of leverage to maximize returns. For this reason, macro funds are considered risky, and many notable funds—like Long-Term Capital Management, which had to be bailed out in 1998 due to its dismal performance—have failed.
3. Relative Value Arbitrage Hedge Funds
Relative value funds aim to profit from the price differences of closely related securities. To do this, they attempt to determine which securities are undervalued compared to their peers and which are overvalued, then buy long and sell short accordingly. These sorts of funds often use leverage and buy on margin.
4. Distressed Hedge Funds
Distressed hedge funds invest in promising distressed securities—like junk bonds of companies that are in financial trouble but have a path to recovery.
Bonds like these are cheap for their yields due to the high level of risk they carry. Distressed funds also invest in things like loan payouts and restructurings.
What Sorts of Fees Do Hedge Fund Managers Charge Investors?
Traditionally, many hedge funds charged clients “2 and 20”—that is, a 2% management fee and a 20% performance fee.
The management fee is 2% of the fund’s net asset value annually and can be thought of as similar to the expense ratio of a mutual fund or ETF; it covers the expenses associated with the management of the fund (e.g., office space, employee salaries, etc.).
The much steeper 20% performance fee, however, only comes out of the fund’s profit—not its total assets. This is the fee clients pay the fund manager for (ideally) beating the market by a large margin via their careful research and trading decisions.
If the fund doesn’t make a profit, this fee isn’t charged, but 2% of each client’s investment is still paid to the fund’s manager annually regardless.
Note: While “2 and 20” are the traditional fee levels for hedge funds, actual fees tend to be lower in the modern day.
According to CNBC, the average hedge fund management fee was 1.37%, and the average performance fee was 16.4% as of 2020.
What Are Some of the Largest Hedge Funds?
- Renaissance Technologies
- Bridgewater Associates
- Man Group
- D.E. Shaw Co.
- AQR Capital Management
- Millenium Management
- Elliot Asset Management
- Two Sigma
Hedge Fund Regulation
Hedge funds face little regulation from the Securities and Exchange Commission (SEC) compared to other investment vehicles.
The SEC only requires hedge funds to register if they have more than $150 million in private funds and manage one or more funds.
However, hedge funds operate in many countries besides the U.S., and will follow the regulations of their home country.
Funds with assets under management of $500 million or more must file quarterly and report the details of their liabilities and assets.
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