What are Hedge Funds?
Hedge funds are private investment funds, meant for high net worth individuals and institutions. In many cases, hedge fund managers set up hedge funds as private investment partnerships. These partnerships are only open to a limited number of investors, who need to invest large sums of money upfront. This is why the general public cannot invest in hedge funds. Many hedge funds typically require investments worth millions of dollars. They often have long lock-in periods too, which means that you cannot withdraw your investments until a specified duration of time.
Hedge fund managers do not need to adhere to the regulations specified by the US Securities and Exchange Commission (SEC). Moreover, they do not need to be registered investment advisors either. Because they do not need to adhere to the regulations of the SEC, they frequently invest in riskier speculations by:
- Placing large bets on currencies and commodities
- Investing in short stocks, options and futures and,
- Buying on margins using borrowed money
Estimates suggest that hedge funds manage assets worth nearly $2 trillion globally.
Hedge funds do not usually disclose their trades and portfolios. They also trade in large volumes. As a result, they either make considerable capital gains or sustain significant capital losses. The key features of a hedge fund include:
- Being accessible (or open) only to certain qualified or accredited investors
- Having a wide range of investments, ranging from land to stocks and from real estate to currencies
- Employing leverage by using borrowed funds to maximize their returns
- Having a fee structure that comprises an expense ratio (about two percent) and a performance fee (about 20 percent of any gains)
How Do Hedge Funds Work?
A hedge fund manager sets up a hedge fund and invites some like-minded investors to invest in it. The fund manager prepares an operating agreement. This agreement documents the manner in which the fund works as well as the payment of profits. Typically, fund managers receive approximately 25 percent of any profits over five percent per year.
To illustrate the working of a hedge fund with an example, consider a situation where 10 investors sign up for a hedge fund. Each contributes $10 million, after filling the investment agreement. They send the funds to the fund administrator. The fund administrator documents the investment on the books and wires the funds to the broker. Thereafter, the fund manager informs the broker on how to invest the $100 million.
A year later, the fund generates a profit of 50 percent, making it worth $150 million. Based on the operating agreement, the first five percent of profits belong to the investors. So, the fund manager distributes five percent of the profits ($50 million) i.e. $2.5 million among the investors. In addition, the fund manager also needs to distribute any profit over the first five percent between the fund manager (25 percent) and the investors (75 percent). Therefore, the fund manager distributes 75 percent of the remaining $47.5 million among the investors i.e. $35,625,000. The fund manager pockets the remaining 25 percent, worth $11,875,000. This is the fund manager’s earning for managing the hedge fund for one year. This is why people consider the hedge fund business highly lucrative.
How Do Hedge Funds Make Money?
Similar to the way in which mutual funds or brokers make their money, hedge funds make their money via steep management fees. Each hedge fund levies a specific management fee. As hedge funds usually indulge in trading hundreds of millions of dollars, it is unsurprising that hedge fund managers earn phenomenal management bonuses.
Hedge fund managers also earn a percentage of the profits from the hedge fund trades each year. Typically, the standard percentage of profits ranges from 20 to 50 percent. These financial incentives motivate hedge fund managers to maximize their profits. At the same time, the hedge fund managers do not need to pay any percentage of the losses either.
Many hedge funds make their money by investing in options. Options entail betting on the future of a stock, so hedge fund managers place bets on whether the price of a stock could increase or decrease. For example, a hedge fund manager buys an option for $100 and speculates that the price of the stock would increase by a specific time the following day. If the price of the stock increases by the specified time the following day, the hedge fund manager gains an additional $100. This makes the investment worth $200. If the price of the stock remains constant or decreases with the specified time, the hedge fund manager loses the $100 invested in the option.
Hedge funds also make money by investing funds in the anticipation of big events. Therefore, they anticipate mergers and acquisitions, public offerings, new technology unveilings and other financial events and capitalize when these events occur.
The Top Hedge Funds You Must Know About
Recently, HSBC released a list of the top performers in hedge fund world. This list comprised the best hedge funds in terms of year to date performances in 2014. Given below are the top hedge funds, based on this list.
- Pershing Square: Up by nearly 24 percent for this year (as on July 15), this activist hedge fund topped HSBC’s list of best-performing hedge funds for 2014. Pershing Square Capital Management – a company run and founded by Bill Ackman in 2004 – manages this hedge fund. Pershing Square’s investment history also includes the launch of activist campaigns against Wendy’s and McDonald’s. As of 2013, this hedge fund manages assets worth $13.2 billion.
- Pharo Trading Fund: Founded in 2000 by Guillaume Fonkenell, this hedge fund comes a close second to Pershing Square on HSBC’s list. It yielded a return of 23.25 percent as of July 11. This hedge fund focuses on emerging market credit and currencies. It currently manages assets worth $4.7 billion.
- Cumulus Energy Fund Class A: This award-winning hedge fund comes third on the HSBC list, with a return of 23.15 percent as of July 18. Cumulus Energy is a hedge fund that trades in discretionary commodity futures. It places special emphasis on electricity and natural gas, especially in Europe. A winner of 10 awards between 2009 and 2014, this hedge fund manages assets worth $490 million.
- Trishield Special Situations Fund LLC: Jeff Buick formed Trishield Capital Management in 2008. This company manages the Trishield Special Situations Fund, which comes in at No. 4 on the HSBC list of top performing hedge funds for 2014. Its yield as of June 30 was 19.87 percent. This hedge fund specializes in investing in distressed, stressed, special situations and event-driven opportunities.
- Brookfield Global Reits Long Short Strategy: Ranked fifth in HSBC’s list, this hedge fund provided returns of 18.30 percent as of June 30. Brookfield Asset Management Inc, manages this fund with approximately $200 billion in assets. It focuses on domains like property, renewable energy, infrastructure and private equity.
- Chenavari Toro Capital: Managed by Chenavari Investment Managers, this fund provided returns of 18.24 percent as of June 30. This fund has a history of good performances behind it, with returns of 32 percent in 2012, 24.71 percent in 2011 and 90.56 percent in 2010. This fund has assets worth nearly $2 billion. This London-based hedge fund is one of Europe’s most successful hedge fund launches since 2008 as well.
What are the Benefits of Investing in Hedge Funds?
Investing in a hedge fund can be quite advantageous. People invest in hedge funds for long-term durations because these funds do not have the complicated entry or exit times.
Hedge fund managers usually secure their funds with sufficient options and derivatives. This is why hedge funds perform well even during a down market period. People include hedge funds in their investment portfolios for limiting their risk of loss, even as they seek to increase their gains.
Hedge fund managers give their funds a structure that makes them perform well regardless of the prevailing market conditions. By investing in hedge funds, investors can let their investments reap dividends. That too, without having to worry about the ebbs and flows of the stock market.
Despite having a reputation of being secretive and risky propositions, hedge funds represent a growth industry. In a down market environment, these funds can provide higher than average market returns. However, investors should exercise due diligence on the fund and its managers before investing. In the long run, the risk of losing an investment would have far greater repercussions than making a killing by investing in a hedge fund.
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You may also be interested in reading an in-depth article on Investments For Beginners, which opportunities you have to grow your income and get a better insight into how the system works.
