A hedge fund is an investment fund that pools capital from accredited individuals or institutional investors and invests in a variety of assets, often with complex portfolio-construction and risk-management techniques. It is administered by a professional investment management firm, and often structured as a limited partnership, limited liability company, or similar vehicle. Hedge funds are generally distinct from mutual funds, as their use of leverage is not capped by regulators, and distinct from private equity funds, as the majority of hedge funds invest in relatively liquid assets.
The term “hedge fund” originated from the paired long and short positions that the first of these funds used to hedge market risk. Over time, the types and nature of the hedging concepts expanded, as did the different types of investment vehicles. Today, hedge funds engage in a diverse range of markets and strategies and employ a wide variety of financial instruments and risk management techniques.
Hedge funds are made available only to certain sophisticated or accredited investors and cannot be offered or sold to the general public. As such, they generally avoid direct regulatory oversight, bypass licensing requirements applicable to investment companies, and operate with greater flexibility than mutual funds and other investment funds. However, following the financial crisis of 2007–2008, regulations were passed in the United States and Europe with intentions to increase government oversight of hedge funds and eliminate certain regulatory gaps.
Hedge funds have existed for many decades and have become increasingly popular. They have now grown to be a substantial fraction of asset management, with assets now totaling around $3 trillion.
Hedge funds are almost always open-ended and allow additions or withdrawals by their investors (generally on a monthly or quarterly basis). The value of an investor’s holding is directly related to the fund net asset value.
Many hedge fund investment strategies aim to achieve a positive return on investment regardless of whether markets are rising or falling (“absolute return”). Hedge fund managers often invest money of their own in the fund they manage. A hedge fund typically pays its investment manager an annual management fee (for example 2% of the assets of the fund), and a performance fee (for example 20% of the increase in the fund’s net asset value during the year). Both co-investment and performance fees serve to align the interests of managers with those of the investors in the fund. Some hedge funds have several billion dollars of assets under management (AUM)
Investors in hedge funds are, in most countries, required to be qualified investors who are assumed to be aware of the investment risks, and accept these risks because of the potential returns relative to those risks. Fund managers may employ extensive risk management strategies in order to protect the fund and investors. According to the Financial Times, “big hedge funds have some of the most sophisticated and exacting risk management practices anywhere in asset management.” Hedge fund managers that hold a large number of investment positions for short durations are likely to have a particularly comprehensive risk management system in place, and it has become usual for funds to have independent risk officers who assess and manage risks but are not otherwise involved in trading. A variety of different measurement techniques and models are used to estimate risk according to the fund’s leverage, liquidity and investment strategy.Non-normality of returns, volatility clustering and trends are not always accounted for by conventional risk measurement methodologies and so in addition to value at risk and similar measurements, funds may use integrated measures such as drawdowns .
In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence to assess the risk that error or fraud at a hedge fund might result in loss to the investor. Considerations will include the organization and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund’s ability to develop as a company.
Fees paid to hedge funds
Hedge fund management firms typically charge their funds both a management fee and a performance fee.
Management fees are calculated as a percentage of the fund’s net asset value and typically range from 1% to 4% per annum, with 2% being standard They are usually expressed as an annual percentage, but calculated and paid monthly or quarterly. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager’s profits. However, due to economies of scale the management fee from larger funds can generate a significant part of a manager’s profits, and as a result some fees have been criticized by some public pension funds, such as CalPERS, for being too high
The performance fee is typically 20% of the fund’s profits during any year, though they range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.Performance fees have been criticized by Warren Buffett, who believes that because hedge funds share only the profits and not the losses, such fees create an incentive for high-risk investment management. Performance fee rates have fallen since the start of the credit crunch.
Almost all hedge fund performance fees include a “high water mark” (or “loss carryforward provision”), which means that the performance fee only applies to net profits (i.e., profits after losses in previous years have been recovered). This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempting to recover the losses over a number of years without performance fee.
Some performance fees include a “hurdle”, so that a fee is only paid on the fund’s performance in excess of a benchmark rate (e.g. LIBOR) or a fixed percentage. A “soft” hurdle means the performance fee is calculated on all the fund’s returns if the hurdle rate is cleared. A “hard” hurdle is calculated only on returns above the hurdle rate. A hurdle is intended to ensure that a manager is only rewarded if the fund generates returns in excess of the returns that the investor would have received if they had invested their money elsewhere.
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year) or when withdrawals exceed a predetermined percentage of the original investment. The purpose of the fee is to discourage short-term investing, reduce turnover and deter withdrawals after periods of poor performance. Unlike management fees and performance fees, redemption fees are usually kept by the fund.