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What are Hedge Funds?Hedge funds are a relatively recent phenomenon in the financial world. What is a hedge fund? They used to be known as investment pools or investment partnerships - basically wealthy investors pool their money together, and whoever runs the pool decides how and where to invest it. Most hedge funds still operate as limited partnerships or LLCs, with the fund manager being the general partner with controlling interest, and investors serving as limited partners. The word "hedge" refers to the various non-traditional investment strategies hedge funds can use to profit even when the market doesn't move or moves down, allowing investors to "hedge" their returns by betting against the house. In this guide, we will look at how hedge funds run, what kind of expenses they charge, how profits are shared, and what funds of funds are.
How do Hedge Funds Work?Hedge funds have come to control a huge amount of assets - over $1.3 TRILLION as of the end of 2006. Hedge funds are very lightly regulated by the SEC or government, allowing them to invest in many risky, non-traditional vehicles and derivatives that mutual funds cannot invest in. Because of this, only accredited investors are allowed to invest in them. What kind of things do hedge funds invest in? They can sell stocks and derivatives short, they can invest in futures, foreign currencies, arbitrage, they can use leverage or margin to increase their returns, invest in options, etc. Because of the intense competition and efficiency in capital markets, a lot of these hedge funds take large, risky positions, placing big bets on turns in the market. Sometimes this pays off with handsome gains, sometimes it pays off with painful losses. Payouts to the fund managers can be enormous - in 2004 and 2005, a few hedge fund managers pulled in performance bonuses of more than half a billion dollars (T. Boone Pickens, Steve Cohen - SAC Capital Advisors, James Simons - Renaissance Technologies Corp, Paul Tudor Jones - Tudor Investment Corp).Hedge funds are structured so that the managers running the fund get a fixed percent of the total assets each year as a management fee, usually around 2%. But on top of that, there are serious incentives to perform. Most hedge funds pay out 10-25% of the returns above a certain hurdle rate to the managers. So perhaps the hurdle rate of return is 8% -- any return above that, and the managers get to keep 10-25% of it. When you have tens of billions of dollars in assets invested, these kind of percents can add up to a lot of money fast. Unfortunately, there is no penalty for poor performance, other than missing out on the incentive bonus -- this can lead to managers making very risky, speculative investments, hoping for a big payoff, but also potentially big losses. Some famous hedge fund companies include:
Requirements for Investing in Hedge FundsAs mentioned above, since there is very little regulation of hedge funds and because of their risky investments, the government has restricted their access to only qualified investors than have specific levels of income and assets, and are supposedly more sophisticated and able to handle the risks associated with investing in hedge funds. The SEC recently voted to increase the minimum requirements to include $2.5M in assets (excluding real estate holdings) from the old level of $1M. The level had not changed since 1982. However, no one really checks up on investors to verify their assets or earnings, meaning just about anyone who has the money can invest in hedge funds. Investors can also qualify by having income in excess of $200K for the last 2 years. Many smaller investors can still get into hedge funds by investing in "funds of funds", which are investment funds that invest in shares of other hedge funds, essentially spreading risk across many funds instead of placing all your bets on a single fund and a single manager. Many of the US based funds of funds are registered with the SEC, allowing regular investors (not the specially accredited or qualified ones who have access to hedge funds) to invest. Some of the largest Fund of Fund companies include many of the large investment banking companies in the US:
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