A Simple Guide to Understanding Hedge Funds

Mary Clare Novak
Mary Clare Novak  |  September 16, 2019

When it comes to investing, the options are overwhelming and the returns aren’t always what you expect.

However, those that tend to be luckier with their investments and enjoy the high stakes process might want to take it a step further and become involved in something a little more exclusive and strategic, like a hedge fund.

And no, a hedge fund is not a piggy bank full of change to save up for a boundary of shrubs around your home.

When reading that definition above, it sounds as if hedge funds are just like any old investment. However, there is a lot that sets them apart. Let’s go over the basics of hedge funds to understand what makes them special and appealing to those looking for investment opportunities.

Hedge fund basics

Hedge funds are known as alternative investments, meaning the characteristics of the funds, strategy behind the investment, and regulations overseeing the process set these funds apart from other financial activities.

Characteristics of a hedge fund

There are a lot of ways to invest your money. While they might all appear to be the same, each process has its own special set of characteristics that set it apart. Here are the seven key characteristics that all hedge funds have, making it a unique investment opportunity. 

1. Limited to accredited investors

Hedge funds are exclusive. Only accredited investors and high-net-worth individuals can partake in a hedge fund. This means that anyone with an annual income greater than $200,000 for the past two years, or with a net worth that exceeds $1 million can invest their money in a hedge fund. Those individuals are then deemed qualified by the Securities and Exchange Commission (SEC), meaning they recognize that these people can afford the risks associated with hedge funds.

hedge fund statistic

2. Slightly regulated

Because the people involved with the pooled investment are recognized by the SEC on an individual level, the hedge fund itself is not required to register. Some funds will register just to give their investors peace of mind, but it is not necessary. No matter if they register or not, it is still illegal for hedge funds to violate laws concerning insider trading, fraud, and any other financial regulation.

3. Provide lots of options

Other pooled investments, like mutual funds, are limited to putting money towards stocks and bonds, Hedge funds, on the other hand, have more freedom. They can invest in anything, including stocks, real estate, and currencies.

4. Include leverage

A lot of times, hedge funds will use financial leverage, or borrowed money that is invested, to earn a greater return.

5. Illiquid

Another key feature of hedge funds is that they are illiquid. Most managers will limit how many times investors can withdraw their money. This means that if you invest your money in a hedge fund, you are in it for the long run. The money you invest can be held for years.

When your money is held for a long time, it can be easy to lose track of it. Check out some investment portfolio management software to keep track of where your money is.

See the Highest-Rated Investment Management Software →

6. Aggressive

High-risk high-return is put into action with hedge funds. However, if the techniques being implemented are working, the investors will continuously see a profit.

7. Fee structure

Hedge funds charge both an expense ratio and a performance fee. An expense ratio is simply the money put towards administrative, management, and advertising expenses. A performance fee is a payment made to the manager of the hedge fund for positive performance of the investment.

The fee structure for hedge funds is often called Two and Twenty. Investors are charged a 2% management fee, regardless of the performance of the hedge fund. Then, they are charged a 20% performance fee, only if the fund exceeds the hurdle rate. A hurdle rate is the minimum rate a hedge fund expects to earn on an investment.

TIP: Getting your finance terminology mixed up? Learn the basics of a sinking fund to see how it's different from a hedge fund.

Hedge fund structure

Most hedge funds are structured as limited partnerships, and there are a couple of key players to the group.

Investors: People investing in a hedge fund must be an accredited investor (yearly income of $200,000 or more) or a high-net-worth individual (net worth exceeds $1 million).

Investment manager: An investment manager makes a lot of the decisions for the hedge fund, like choosing where to allocate capital and managing the risk.

Prime broker: This special kind of broker that will help the fund complete large investment transactions.

Executing broker: The executing broker is responsible for the completion and processing of the hedge fund’s investments. They will ensure everything is compliant with the policies and procedures that apply to them.

hedge fund structure

Hedge fund managers

Hedge fund managers benefit from the Two and Twenty fee structure. While the 20% performance fee only helps them if they put the work in, the 2% management fee ensures they see a profit, no matter their amount of effort.

Let’s say a manager is working with a $100 million hedge fund. They could put their feet up and sip on a latte all day without working and still receive their 2%, which would be $2 million. That’s a pretty decent pay day.

However, just because these investors have a lot of money and feel like risking a little bit of it, doesn’t mean they accept an unorganized operation. Hedge fund managers will use financial services CRM software to make sure their investors feel taken care of.

See the Highest-Rated Financial Services CRM Software, Free →

Hedge fund performance guidelines

While the manager of the hedge fund will see a profit no matter what, they still want that 20% performance fee. Also, a happy investor. Let’s go over some of the important parts of evaluating the success of a hedge fund.

Rate of return: The rate of return is the gain or loss an investment sees over a set period of time.
Standard deviation: The standard deviation of an investment shows how often the rate of return deviates from the average.
Drawdown: The percentage difference between the peak and trough performance during a specific period of time for an investment. The investor should take into account the amount of time it took for the investment to recover.
Downside deviation: General negative movement of the economy or the price of a security.
Minimum investment: How much the fund requires to invest.
Redemption terms: The repayment of any fixed-income security.
Fund size: How many investors are allowed to contribute to the fund.

Hedge fund strategies

While all hedge funds share the characteristics listed above, they can approach earning money a little differently. There are two terms you need to know before we go over the strategies for hedge fund management.

Long trade: an asset that a trader hopes will go up in price.

Short trade: an asset a trader hopes will go down in price.

Long/short equity

A long/short equity hedge fund strategy is quite simple. Investors buy equities that are predicted to increase in value and sell those that are likely to decrease in value. One long trade and one short trade. It is common for investors to do this with two businesses in the same industry: invest in a predicted winner and loser. The profits of the money from the winner can be used to finance the losers. When done correctly, the fund will see a profit either way.

Market neutral

The market neutral strategy places equal value on the short and long trades in the market. Get it? They are neutral to the current conditions of the market. Investors match the positions they take on short and long stocks. So if one ends up doing better than the other, they win either way.

Merger arbitrage

Arbitrage strategies attempt to take advantage of price differences between investments that are closely related. The process often involves using financial leverage.

In a merger arbitrage, an investor will take opposing sides in two companies that are currently merging. The stock is bought before the merger occurs and the investor expects a return once it is over. However, they must take into account the fact that the merger might not close on time, or at all.

Convertible arbitrage

A convertible arbitrage hedge fund is long on convertible bonds, or bonds that can be converted into shares, and short on the shares that those convertible bonds can become. This strategy attempts to profit off the inefficiencies of a business’s convertible bonds.

Fixed-income arbitrage

The fixed-income arbitrage strategy is a strategy where the hedge fund invests in both sides of an opposition in the market to account for small price discrepancies. These hedge funds will keep an eye on fixed-income returns, like on government bonds. When they sense mispricing, they will take a long and short position, often with leverage, and then see a profit when the pricing is fixed in the market.

Event-driven

An event driven strategy includes hedge funds buying stock when prices inflate and deflate after a certain event, like a takeover or restructuring.These funds will sometimes purchase the debt of companies that are in financial distress or have gone bankrupt. They will first buy senior debt, because it is the money that bankrupt business must pay back first.

Credit

A credit hedge fund is another example of a fund that invests in the debt of other businesses. Investing in a credit focused hedge fund takes a great deal of knowledge in the debt side of the capital structure.

Global macro

Global macro hedge funds invest in stocks, bonds, and currencies in an attempt to profit from the effect of political or economic events on a particular market. This process involves deep evaluations of the rise and decline of a nation’s economy. They position themselves to profit off a particular outcome of an economic or political event.

Short only

The short only method is basically trying to uncover accounting fraud or any misrepresentation of the value of stock in a financial statement.

Taxing hedge funds

Hedge funds avoid certain regulations that other investment vehicles are required to pay attention to, meaning they can engage in certain financial activities that are off limits to others. Hedge funds can maneuver these rules so the managers and investors are barely taxed. This is why you must be an accredited investor or a high-net-worth individual to invest in a hedge fund.

A lot of hedge funds take advantage of carried interest, where the fund is treated and taxed as a partnership: the fund manager is the general partner and then investors are the limited partners.

The fund manager’s income is taxed as a return on investment, not a salary.

However, when a hedge fund returns money to its investors, that return is subject to capital gains tax, which is a tax on the positive difference between an asset’s sale price and the original price at which it was purchased. There is a short term capital gains tax that applies to profits on investments held for less than one year. For investments held longer than one year, the capital gains tax can go as high as 20%.

Hedge fund controversies

The hedge fund business structure has a lot of critics. The above explanation of carried interest, along with the fact that they dodge certain taxes, have caused people to see hedge funds as a loophole to being taxed and regulated properly.

The carried interest rule has been brought to Congress multiple times, as people are noticing that hedge fund managers are often rolling in cash because they aren’t paying the marginal income tax rate.

Certain hedge funds have also been found guilty of participating in insider trading.

Over the hedge

Big exhale. Hedge funds can get pretty complicated. With the different characteristics, strategies, tax regulations (or lack of), and controversies, understanding hedge funds is a lot to chew. However, if you are looking to make investment and you meet the requirements of the people that can invest, it can be a great source of income.

Want to learn more about the current state of investing in 2019? Check out our resources on investment statistics to get the scoop. 

Mary Clare Novak
Author

Mary Clare Novak

Mary Clare Novak is a Content Marketing Associate at G2 in Chicago. A recent graduate, she is happy to be back working in her favorite city. In her free time, you can find her doing a crossword puzzle, listening to cover bands, or eating fish tacos.