- A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as short selling, leverage, and derivatives. Wikipedia
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- https://www.preqin.com/data/hedge-funds
- https://www.investopedia.com/terms/h/hedgefund.asp#:
""Hedge funds are free to use riskier strategies in riskier ways.
In short, they are free to choose esoteric investments that conservative investors won't touch.
Notably, hedge funds are not as strictly regulated by the Securities and Exchange Commission as mutual funds are.
As might be expected, the appeal of many hedge funds lies in the reputation of their managers, many of whom are seen as stars in the closed world of hedge fund investing.
These money managers don't come cheap. Hedge funds generally charge a fee of 1%-2% of assets, plus a "performance fee" of about 20% of the profits
. Notably, they frequently use leverage. That is, they use borrowed money to buy more of an asset in order to multiply their potential returns (or losses). They also invest in derivatives such as options and futures.""
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Legally, hedge funds are often set up as private investment limited partnerships that are open only to a limited number of accredited investors and require a large initial minimum investment.
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""Hedge funds are free to use riskier strategies in riskier ways.
In short, they are free to choose esoteric investments that conservative investors won't touch.
Notably, hedge funds are not as strictly regulated by the Securities and Exchange Commission as mutual funds are.
As might be expected, the appeal of many hedge funds lies in the reputation of their managers, many of whom are seen as stars in the closed world of hedge fund investing.
These money managers don't come cheap. Hedge funds generally charge a fee of 1%-2% of assets, plus a "performance fee" of about 20% of the profits
. Notably, they frequently use leverage. That is, they use borrowed money to buy more of an asset in order to multiply their potential returns (or losses). They also invest in derivatives such as options and futures.""
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Legally, hedge funds are often set up as private investment limited partnerships that are open only to a limited number of accredited investors and require a large initial minimum investment.
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Hedge Funds Exclude Small Investors
Hedge funds can accept money only from "qualified" investors—individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. Some set their minimums higher.
Those rules are imposed by the Securities and Exchange Commission because it otherwise does not strictly regulate hedge funds. It considers qualified investors to be suitable to handle the potential risks that hedge funds are permitted to take.
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Hedge funds can accept money only from "qualified" investors—individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. Some set their minimums higher.
Those rules are imposed by the Securities and Exchange Commission because it otherwise does not strictly regulate hedge funds. It considers qualified investors to be suitable to handle the potential risks that hedge funds are permitted to take.
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A hedge fund's investment universe is limited only by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies.
Mutual funds, by contrast, stick to stocks or bonds and invest for the long term.
A hedge fund's investment universe is limited only by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies.
Mutual funds, by contrast, stick to stocks or bonds and invest for the long term.
Hedge Funds Often Use Leverage
Hedge funds often use borrowed money to amplify their returns and allow them to take aggressive short positions.
As was seen during the financial crisis of 2008, leverage can wipe out hedge funds, along with other big chunks of the economy.
Hedge funds often use borrowed money to amplify their returns and allow them to take aggressive short positions.
As was seen during the financial crisis of 2008, leverage can wipe out hedge funds, along with other big chunks of the economy.
Hedge Funds Have a "2 and 20" Fee Structure
Mutual funds fees have fallen substantially in the last few years, hitting an average of 0.50% in 2020.15
Hedge funds, by contrast, use a fee structure that is called, in shorthand, "2-and 20." That's 2% of the assets under management plus a 20% cut of any profits generated.3
Mutual funds fees have fallen substantially in the last few years, hitting an average of 0.50% in 2020.15
Hedge funds, by contrast, use a fee structure that is called, in shorthand, "2-and 20." That's 2% of the assets under management plus a 20% cut of any profits generated.3
Special Considerations on Hedge Funds
All hedge funds are considered risky investments, but some are riskier than others. Here are some steps you should take if you are thinking about putting money into a hedge fund.
All hedge funds are considered risky investments, but some are riskier than others. Here are some steps you should take if you are thinking about putting money into a hedge fund.
First Step in Picking a Hedge Fund
When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each.
These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the largest hedge funds in terms of assets under management.
In any case, that's just the first step in your decision-making process.
When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each.
These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the largest hedge funds in terms of assets under management.
In any case, that's just the first step in your decision-making process.
Fund Absolute Performance Guidelines
Look at the annualized rate of return. Let's say that you want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that underperform the index over long time periods, and it could be adjusted based on the performance of the index over time.
This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and others.
But if these aren't the types of funds you are looking for, you must also establish a guideline for the standard deviation of the index over the previous five years. Let's assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can be eliminated from further consideration.
Unfortunately, past returns do not necessarily help to identify an attractive fund for the future. A hedge fund may have employed a strategy last year that won't work well next year.
Comparing Returns
Once certain funds have been identified as high-return performers, it is important to identify the fund's strategy and compare its returns to other funds in the same category.
An investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the 50th percentile as the guideline for filtering funds.
Now the investor has two guidelines that all funds need to meet for further consideration.
Applying these two guidelines still leaves too many funds to evaluate in a reasonable amount of time. Additional guidelines need to be established, but the additional guidelines will not necessarily apply across the remaining universe of funds. For example, the guidelines for a merger arbitrage fund will differ from those for a long-short market-neutral fund.
Look at the annualized rate of return. Let's say that you want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that underperform the index over long time periods, and it could be adjusted based on the performance of the index over time.
This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and others.
But if these aren't the types of funds you are looking for, you must also establish a guideline for the standard deviation of the index over the previous five years. Let's assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can be eliminated from further consideration.
Unfortunately, past returns do not necessarily help to identify an attractive fund for the future. A hedge fund may have employed a strategy last year that won't work well next year.
Comparing Returns
Once certain funds have been identified as high-return performers, it is important to identify the fund's strategy and compare its returns to other funds in the same category.
An investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the 50th percentile as the guideline for filtering funds.
Now the investor has two guidelines that all funds need to meet for further consideration.
Applying these two guidelines still leaves too many funds to evaluate in a reasonable amount of time. Additional guidelines need to be established, but the additional guidelines will not necessarily apply across the remaining universe of funds. For example, the guidelines for a merger arbitrage fund will differ from those for a long-short market-neutral fund.
Fund Relative Performance Guidelines
The next step is to establish a set of relative guidelines.
Relative performance metrics should always be based on specific categories or strategies. For example, it would not be reasonable to compare a leveraged global macro fund with a market-neutral, long/short equity fund.
To establish guidelines for a specific strategy, an investor can use an analytical software package such as Morningstar to identify a universe of funds using similar strategies. Then, a peer analysis will reveal many statistics, broken down into quartiles or deciles for that universe.
The threshold for each guideline may be the result for each metric that meets or exceeds the 50th percentile. An investor can loosen the guidelines by using the 60th percentile or tighten the guideline by using the 40th percentile.
Using the 50th percentile across all the metrics usually filters out all but a few hedge funds for additional consideration.
Establishing guidelines this way allows for flexibility to adjust the guidelines as the economic environment may impact the absolute returns for some strategies.
Factors to Consider
Factors used by some advocates of hedge funds include:
- Five-year annualized returns
- Standard deviation
- Rolling standard deviation
- Months to recovery/maximum drawdown
- Downside deviation
These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis.
The next step is to establish a set of relative guidelines.
Relative performance metrics should always be based on specific categories or strategies. For example, it would not be reasonable to compare a leveraged global macro fund with a market-neutral, long/short equity fund.
To establish guidelines for a specific strategy, an investor can use an analytical software package such as Morningstar to identify a universe of funds using similar strategies. Then, a peer analysis will reveal many statistics, broken down into quartiles or deciles for that universe.
The threshold for each guideline may be the result for each metric that meets or exceeds the 50th percentile. An investor can loosen the guidelines by using the 60th percentile or tighten the guideline by using the 40th percentile.
Using the 50th percentile across all the metrics usually filters out all but a few hedge funds for additional consideration.
Establishing guidelines this way allows for flexibility to adjust the guidelines as the economic environment may impact the absolute returns for some strategies.
Factors to Consider
Factors used by some advocates of hedge funds include:
- Five-year annualized returns
- Standard deviation
- Rolling standard deviation
- Months to recovery/maximum drawdown
- Downside deviation
These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis.
Other Fund Consideration Guidelines
An investor may also want to consider other guidelines that can either further reduce the number of funds to analyze or identify funds that meet additional criteria that may be relevant to the investor. Some examples:
- Fund Size/Firm Size: This may be a minimum or maximum depending on the investor's preference. Institutional investors often invest such large amounts that a fund or firm must have a minimum size to accommodate a large investment. For other investors, a fund that is too big may face challenges matching past successes.
- Track Record: If an investor wants a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate new funds. However, sometimes a fund manager will leave to start a new fund, so the manager's performance can be tracked for a longer time period.
- Minimum Investment: This is very important as many funds have minimums that can make it difficult for an individual investor to diversify properly. The fund's minimum investment can also give an indication of the types of investors in the fund. Larger minimums may indicate a higher proportion of institutional investors.
- Redemption Terms: These terms have implications for liquidity. Longer lock-up periods are difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges.
An investor may also want to consider other guidelines that can either further reduce the number of funds to analyze or identify funds that meet additional criteria that may be relevant to the investor. Some examples:
- Fund Size/Firm Size: This may be a minimum or maximum depending on the investor's preference. Institutional investors often invest such large amounts that a fund or firm must have a minimum size to accommodate a large investment. For other investors, a fund that is too big may face challenges matching past successes.
- Track Record: If an investor wants a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate new funds. However, sometimes a fund manager will leave to start a new fund, so the manager's performance can be tracked for a longer time period.
- Minimum Investment: This is very important as many funds have minimums that can make it difficult for an individual investor to diversify properly. The fund's minimum investment can also give an indication of the types of investors in the fund. Larger minimums may indicate a higher proportion of institutional investors.
- Redemption Terms: These terms have implications for liquidity. Longer lock-up periods are difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges.
Examples of Major Hedge Funds
Some of the largest hedge funds by total assets under management (AUM) as of 2018 included:
- Paul Singer's Elliott Management Corporation held $48 billion in AUM as of June 2021. Founded in 1977, the fund is occasionally described as a vulture fund, as significant assets are focused on distressed securities, including the debt of bankrupt countries.16 Regardless, the strategy has proven successful for multiple decades.
- Founded in 2001 by David Siegel and John Overdeck, New York's Two Sigma Investments is near the top of the list of hedge funds by AUM, with more than $66 billion in managed assets as of March 2021.17 The firm was designed to not rely on a single investment strategy, allowing it to be flexible along with shifts in the market.
- One of the most popular hedge funds is James H. Simon's Renaissance Technologies. The fund, with $130.7 billion in AUM, was launched in 1982, but it has revolutionized its strategy along with changes in technology in recent years.18 Now, Renaissance is known for systematic trading based on computer models and quantitative algorithms. Thanks to these approaches, Renaissance has been able to provide investors with consistently strong returns, in spite of recent turbulence in the hedge fund space more broadly.
- AQR Capital Investments oversees just under $164 billion in AUM as of August 2021.19 Based in Greenwich, Connecticut, it is known for using both traditional and alternative investment strategies.
- Ray Dalio's Bridgewater Associates remains one of the largest hedge funds in the world, with $140 billion in AUM as of May 2020.20 The Connecticut-based fund employed about 1,500 people as of August 2021 and focuses on a global macro investing strategy.21 Bridgewater counts foundations, endowments, and even foreign governments and central banks among its clientele.
Some of the largest hedge funds by total assets under management (AUM) as of 2018 included:
- Paul Singer's Elliott Management Corporation held $48 billion in AUM as of June 2021. Founded in 1977, the fund is occasionally described as a vulture fund, as significant assets are focused on distressed securities, including the debt of bankrupt countries.16 Regardless, the strategy has proven successful for multiple decades.
- Founded in 2001 by David Siegel and John Overdeck, New York's Two Sigma Investments is near the top of the list of hedge funds by AUM, with more than $66 billion in managed assets as of March 2021.17 The firm was designed to not rely on a single investment strategy, allowing it to be flexible along with shifts in the market.
- One of the most popular hedge funds is James H. Simon's Renaissance Technologies. The fund, with $130.7 billion in AUM, was launched in 1982, but it has revolutionized its strategy along with changes in technology in recent years.18 Now, Renaissance is known for systematic trading based on computer models and quantitative algorithms. Thanks to these approaches, Renaissance has been able to provide investors with consistently strong returns, in spite of recent turbulence in the hedge fund space more broadly.
- AQR Capital Investments oversees just under $164 billion in AUM as of August 2021.19 Based in Greenwich, Connecticut, it is known for using both traditional and alternative investment strategies.
- Ray Dalio's Bridgewater Associates remains one of the largest hedge funds in the world, with $140 billion in AUM as of May 2020.20 The Connecticut-based fund employed about 1,500 people as of August 2021 and focuses on a global macro investing strategy.21 Bridgewater counts foundations, endowments, and even foreign governments and central banks among its clientele.
What Is a Hedge Fund?
A hedge fund is an investment vehicle that caters to high-net-worth individuals, institutional investors, and other accredited investors. The term “hedge” is used because these funds historically focused on hedging risk by simultaneously buying and shorting assets in a long-short equity strategy.
Today's hedge funds offer a very wide range of strategies across practically all available asset classes, including real estate, derivatives, and non-traditional investments such as fine art and wine. Many use leverage strategies, meaning they borrow money in order to boost their potential returns.
Hedge funds are by definition lightly regulated and risky compared to mutual funds.
A hedge fund is an investment vehicle that caters to high-net-worth individuals, institutional investors, and other accredited investors. The term “hedge” is used because these funds historically focused on hedging risk by simultaneously buying and shorting assets in a long-short equity strategy.
Today's hedge funds offer a very wide range of strategies across practically all available asset classes, including real estate, derivatives, and non-traditional investments such as fine art and wine. Many use leverage strategies, meaning they borrow money in order to boost their potential returns.
Hedge funds are by definition lightly regulated and risky compared to mutual funds.
How Do Hedge Funds Compare to Other Investments?
Hedge funds, mutual funds, and exchange-traded funds (ETFs) all are pools of money contributed by many investors that aim to earn a profit for themselves and their clients.
Hedge funds, like some mutual funds but few ETFs, are actively managed by professional managers who buy and sell certain investments with the stated aim of exceeding the returns of the markets, or some sector or index of the markets.
Hedge funds aim for the greatest possible returns and take the greatest risks while trying to achieve them.
They are more loosely regulated than competing products, leaving them the flexibility to invest in just about every asset class available, including options and derivatives and esoteric investments that mutual funds can't touch.
Another difference is in costs. Hedge funds have much higher fees than other investment choices.
Hedge funds, mutual funds, and exchange-traded funds (ETFs) all are pools of money contributed by many investors that aim to earn a profit for themselves and their clients.
Hedge funds, like some mutual funds but few ETFs, are actively managed by professional managers who buy and sell certain investments with the stated aim of exceeding the returns of the markets, or some sector or index of the markets.
Hedge funds aim for the greatest possible returns and take the greatest risks while trying to achieve them.
They are more loosely regulated than competing products, leaving them the flexibility to invest in just about every asset class available, including options and derivatives and esoteric investments that mutual funds can't touch.
Another difference is in costs. Hedge funds have much higher fees than other investment choices.
Why Are Hedge Funds Considered Risky?
A conventional "hedge" in investing is a strategic move to cushion potential losses. This is done by betting a small amount of money on the opposite outcome from the one that the investor expects.
Today's hedge funds are searching for outsized returns. They may use any of a number of broad investment strategies for their funds but they are free to invest in any type of investment, including highly speculative instruments, in their search for returns.
Some of the unique risks of hedge funds:
- A concentrated investment strategy exposes hedge funds to potentially huge losses.
- These funds typically require investors to lock up money for a period of years.
- Use of leverage, or borrowed money, can turn a minor loss into a disastrous one.
A conventional "hedge" in investing is a strategic move to cushion potential losses. This is done by betting a small amount of money on the opposite outcome from the one that the investor expects.
Today's hedge funds are searching for outsized returns. They may use any of a number of broad investment strategies for their funds but they are free to invest in any type of investment, including highly speculative instruments, in their search for returns.
Some of the unique risks of hedge funds:
- A concentrated investment strategy exposes hedge funds to potentially huge losses.
- These funds typically require investors to lock up money for a period of years.
- Use of leverage, or borrowed money, can turn a minor loss into a disastrous one.
Why Do People Invest in Hedge Funds?
A wealthy individual who can afford to diversify into a hedge fund might be attracted to the reputation of its manager, the specific assets in which the fund is invested, or the unique strategy that it employs.
In some cases, the techniques used by hedge funds—such as combining leverage with complex derivative transactions—would not even be permitted by regulators if it were pursued by a mutual fund or another type of regulated investment vehicle.
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A wealthy individual who can afford to diversify into a hedge fund might be attracted to the reputation of its manager, the specific assets in which the fund is invested, or the unique strategy that it employs.
In some cases, the techniques used by hedge funds—such as combining leverage with complex derivative transactions—would not even be permitted by regulators if it were pursued by a mutual fund or another type of regulated investment vehicle.
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