Hedge Fund – Definition

Cite this article as:"Hedge Fund – Definition," in The Business Professor, updated May 22, 2019, last accessed July 13, 2020, https://thebusinessprofessor.com/lesson/hedge-fund-definition/.

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Hedge Fund Definition

A hedge fund is a portfolio of investments that uses pooled funds from accredited investors or institutional investors in a bid to earn returns for investors. Hedge funds are regarded as aggressively managed funds because it employs the use of aggressive strategies like leveraged, long, short and derivative means to generate high returns for investors.

The strategies used in domestic and international markets by hedge funds are solely to realize high returns. Hedge funds are not heavily regulated unlike other funds such as mutual funds that are regulated by the SEC. However, only accredited investors can access the funds.

A Little More on What is a Hedge Fund

Typically, hedge funds make use of market opportunities that are seemingly unidentifiable such as leverage and derivatives to earn higher returns which are often more than the specified return or market benchmark.

Hedge funds are invested in a variety of assets and diverse strategies are used in a bid to make huge profit. The classification of hedge funds is based on the investment strategy used and the risks attributable to each strategy.

In a legal sense, limited and accredited investors have access to hedge funds, they are formed as private limited partnerships. Hedge funds require a lock-up period of at least one year, during which illiquid funds are reserved and used for strategic investment purposes.

The first Hedge fund was launched in 1949 by Alfred Winslow Jones’s company. It was launched after Jones successfully raised, invested and managed $100,000, using the classic short selling model and using leverage to earn higher returns. Jones was the first investor or manager to use a combination of short selling model, leverage and limited partnership summing up to the renowned hedge fund.

With the outstanding success achieved by Jones using hedge funds, mutual funds started losing their place and hedge funds gained an overwhelming popularity in the 1960s. Hegde funds outperformed all forms of mutual funds.

Interestingly, as hedge funds continued to trend, the popularity of Jones’s strategy began to wane as riskier strategies were devised which resulted in unaccountable losses between 1969 and 1970. Due to the losses, hedge funds became less popular until 1986 when an article on Julian Robertson’s Tiger Fund was released. Again, money managers drifted away from mutual funds and embrace hedge funds in early 1990s until they encountered losses in late 1990s and early 2000s.

In recent times, hedge funds have grown substantially and massively.

Characteristics of Hedge Funds

The major characteristics of hedge funds are as follow;

  • A hedge fund is established as a private investment limited partnership, it is limited to certain types of investors.
  • Only accredited or qualified investors with an annual income of over $200,000 (for more than two years) or a net worth exceeding $1 million can be part of hedge fund.
  • Hedge funds invest beyond stocks or bonds, real estate, currencies, land, derivatives, among others can be invested.
  • Hedge funds charge 2% asset management fee or evidence ratio. 20% is also charged as performance fees on any gains generated.
  • Hedge funds use leverage to enhance higher returns on investment. The returns usually exceed the market benchmark.

Hedging as used by Jones, the father of Hedge funds, is an approach of reducing risk but maximizing huge returns on investment. For instance, the first hedge funds used the short selling technique to lessen the risks of the bear market. However, as a result of investment roles performed by fund managers, hedge funds attract higher risks when compared to the overall market.

Huge losses are attributable to hedge funds and this is one of the risks. Also, investors are required to lock up funds, usually illiquid funds for at least one year, this is regarded as a risk of hedge funds. The use of leverage by hedge funds can also result in major losses.

Pay Structure for Managers of a Hedge Fund

In hedge funds arrangements, managers charge at expense ratio and a performance fee. They operate a “Two and Twenty” structure. This means hedge funds managers are entitled to 2% asset management fees and 20% of returns in investment annually. Managers are however often criticized for the 2% assets management fee because even if losses occur in hedge funds, managers still get 2%of the assets.

Also, it is possible that a hedge fund manager gets double payment on the same returns. However, high-water marks prevent this from happening and to protect investors. Another measure that controls the pay structure of hedge funds managers, especially when they assume excess risk is fee capitalizations.

Selecting a Hedge Fund

Picking a Hedge fund is one major question that qualified investors ask, especially those that are new to hedge funds, this is because of the numerous hedge funds that exist. However, selecting a hedge fund is what an investor must strategically decide on after weighing all options in terms of risks and benefits.

Since there are many hedge funds, first, the investor must be able to follow a due process and streamline hedge funds in order to select the most suitable one. Investors must identify appropriate metrics needed to select high-quality hedge funds or highest-performing funds.

While deciding which hedge fund to select, the absolute performance metric can be used by investors. For instance, the rate of returns of a hedge fund for the past five-years, is one of the factors an investor should consider before choosing a hedge fund.

A hedge fund with over 20% annual return is said to have a good performance. However, investors need to be careful when using this as a guideline because high returns might not necessarily mean a fund is performing well. Hence, aside from returns, investors need to consider the fund’s strategy and compare its returns to other funds in the same category to be sure whether it is attractive or not.

Aside from the absolute performs guidelines, there are certain relative performance guidelines that can be used when considering which hedge fund is most suitable. Metrics used in this category includes the comparison of hedge funds operating on the same terrain and not funds operating at distinct levels. For example, an investor can decide to filter out hedging funds that do not meet a 50th percentile guideline. The metric can however be loosened or adjusted due to certain environmental factors that tend to affect the relative performance of hedge funds.

In summary, when picking a hedge fund, guidelines for filtering or picking hedge funds are set using the following metrics;

  • Downside deviation
  • Standard deviation
  • Rolling standard deviation
  • Five-year annualized returns
  • Maximum drawdown

Other metrics not mentioned under the absolute performance and relative performance guidelines include; Fund size, Firm size, Minimum investment, Track record and Redemption terms of the hedge funds. These criteria however depends on the investors choice or preference and not just on the performance of the hedge fund.

Hedge Fund Taxation

Generally, the high returns that managers realize from hedge funds are given to investors (after a 20% on return must have been deducted by the manager).

In the United States, profits that investors realize from hedge funds and traced using capital gains tax. In cases of investments held for not more than one year, short – term capital gains rate is applicable. But for investments over one year, the tax rate is usually not more than 15% except in situations of high tax brackets.

However, hedge funds situated outside the United States do not attract any tax liability from the US on the realized profits.

There are specific hedge funds arrangements that are designed to reduce tax payments on returns. Hedge funds that take advantage of carried interest fall in this category, in this arrangement, a hedge fund is regarded as a limited partnership in which managers and founders are general partners while investors are limited partners.

In this arrangement, the performance fee that the manager collects is the 20% of the carried fund, this means that their income is taxed at a long-term capital gains rate of 20% as against income tax rates which can be as high as 39.6%. Hedge funds avoid paying tax using this method.

Another way hedge fund aid taxes is by using reinsurance businesses in Bermuda, since Bermuda does not charge corporate tax.

Hedge Fund Example Scenarios

Quite a number of internal scandals have been recorded in hedge funds in recent years, especially in 2008. One of the groups involved in this is the Galleon Group, managed by Raj Rajaratnam

which had over $7 billion of funds it was managing before its forceful eviction from hedge fund industries in 2009.

In 2009, fraud allegations, inside trading alongside other charges were levied against Raj Rajaratnam, of which he was convicted of and sentence to a 11-year prison term. Galleon Group was also closed down upon the conviction and legal punishment of its manager  at this period.

Regulation of Hedge Funds

Initially, hedge funds were less regulated by SEC, since it is a limited partnership fund that can only be undertaken by qualified investors, the regulations of hedge funds was a bit lose. However, with the prominence of hedge funds and certain scandals and irregularities emanating from managerial decisions, SEC began to pay more attention to its regulation.

The  the Jumpstart Our Business Startups Act (JOBS Act) that was signed into law in 2012 had a significant impact on hedge funds. Also, as against the initial notion of ‘accredited investors’, SEC approved a motion to allow hedge funds and other firms advertise and make offerings to whoever they choose to, although they can still choose to offer it to qualified investors. Hedge funds must however file a “Form D” with the SEC at least 15 days before advertising commences.

The insider trading scandals and fraudulent dealings within hedge funds in 2008 adversely impacted hedge funds. Not only has their returns diminished, their returns are no match for the returns of S&P 500. Investors began chasing after S&P 500 which is a mutual fund that provides equivalent of more returns than hedge funds (which are riskier).

Hedge funds have struggled in recent years but with the presence of funds with lesser risks and equal or greater returns, hedge funds have lost their reputation. Despite this downsize, the size of the hedge fund industry has not diminished. In the midst of pressure, some new hedge funds have begun to sprout.

Examples of Hedge Funds

There is a hierarchy containing the lists of hedge funds with high AUM, the following are top hedge funds appearing on the list as of mid-2018;

  • Ray Dalio’s Bridgewater Associates is the largest hedge fund in the world, with $125 billion in AUM as of mid-2018.
  • AQR Capital Investments is the second – largest hedge fund, overseeing just under $90 billion in AUM.
  • James H. Simon’s Renaissance Technologies, a company launched  in 1982 held $57 billion in AUM as at 2018.
  • Paul Singer’s Elliott Management Corporation which was founded in 1977 held a sum of $35 billion in AUM.
  • The New York’s Two Sigma Investments which was founded in 2001 held over $37 billion in managed assets.

References for Hedge Fund

Research articles for Hedge Fund

[PDF] Hedge fund benchmarks: A risk-based approach, Fung, W., & Hsieh, D. A. (2004). Financial Analysts Journal, 60(5), 65-80.

Hedge fund activism, corporate governance, and firm performance, Brav, A., Jiang, W., Partnoy, F., & Thomas, R. (2008). The Journal of Finance, 63(4), 1729-1775.

 

The risk in hedge fund strategies: Theory and evidence from trend followers, Fung, W., & Hsieh, D. A. (2001). The review of financial studies, 14(2), 313-341.

High‐water marks and hedge fund management contracts, Goetzmann, W. N., Ingersoll Jr, J. E., & Ross, S. A. (2003). The Journal of Finance, 58(4), 1685-1718.

An econometric model of serial correlation and illiquidity in hedge fund returns, Getmansky, M., Lo, A. W., & Makarov, I. (2004). Journal of Financial Economics, 74(3), 529-609.

Hedge fund performance and manager skill, Edwards, F. R., & Caglayan, M. O. (2001). Journal of Futures Markets: Futures, Options, and Other Derivative Products, 21(11), 1003-1028.

Role of managerial incentives and discretion in hedge fund performance, Agarwal, V., Daniel, N. D., & Naik, N. Y. (2009). The Journal of Finance, 64(5), 2221-2256.

Analysis of hedge fund performance, Capocci, D., & Hübner, G. (2004). Journal of Empirical Finance, 11(1), 55-89.

The statistical properties of hedge fund index returns and their implications for investors, Kat, H. M., & Brooks, C. (2001).

Share restrictions and asset pricing: Evidence from the hedge fund industry, Aragon, G. O. (2007). Journal of Financial Economics, 83(1), 33-58.

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