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What are Hedge Funds?

Hedge Funds are pooled investments that invest using less conventional investment strategies and are associated with trading, leverage and complex risk management strategies.

As an asset class, they are referred to as Alternative Investments.  Hedge Funds are offered only to sophisticated investors, classified under regulatory terms such as “accredited”, “professional” or “qualified” investors.

 

Why are Hedge Funds different from Unit Trusts, Mutual Funds and Exchange-Traded Funds?

Fund Management is a highly regulated industry, providing not only professional investment management services but is also designed to protect investors’ interests.

This ensures investments are executed according to the pre-determined mandate agreed with the investors.  These are prevalent in Unit Trust, Mutual Funds and Exchange Traded Funds (ETFs).

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Although Hedge Funds are similar in the set-up and investment mandate to Unit Trusts, Mutual Funds and ETFs, they often do not disclose the details of their portfolio and investment strategies and process.

A typical Unit Trust will show the details of their investments and their process of selection such as the Top 10 holdings, portfolio allocation, disclosure of investment process and risk management process.

A Hedge Fund may only show their general strategies such as Equity Market Neutral, Long / Short and provide only a historical performance chart.

 

How do Hedge Funds actually work?

Hedge Funds provide little information on their investment process for obvious reasons such as not allowing competing investment managers to know their investment strategies and trades.

Hedge Fund Managers are highly skilled in trading, optimising risks & returns, financial modelling and analysis, knowledge and execution know-how of financial instruments.

These allow them to identify investment trends and opportunities, and using a variety of financial instruments, including derivatives, swaps, forwards and futures to manage the investments.

 

What are the typical fee structure?

Investment Committees

Hedge Funds typically charge an annual management fee and a performance fee.  They are quoted for example as: “2 and 20” which means 2% management fee and 20% of the funds’ profits.

Other terms includes hurdle rate and high water mark. Hurdle rate means the incentive or profit-sharing comes into effect when the fund’s annual rate of return exceeds the hurdle rate.

Example: If the hurdle rate is 7%, the performance sharing or profit sharing is only effective should the annual returns exceed 7%.

For high water mark, it is set using NAV (Net Asset Value) to determine if the Hedge Fund Manager is eligible for performance fee for the year or period.

In the example below, in Year 2, Year 3 and Year 5, the NAV is below the high water mark, thus the Hedge Fund Manager is not eligible for performance fee.

 Period High Water Mark NAV Performance Fee
Year 1 1 1.05 Yes
Year 2 1.1 1.09 No
Year 3 1.2 1.19 No
Year 4 1.3 1.31 Yes
Year 5 1.4 1.39 No

 

High water mark is a common feature in Hedge Funds alongside hurdle rate to ensure that the performance fee is paid without taking into account the losses or under-performance on the previous period / year.

 

Which are the biggest Hedge Funds?

In 2016, the biggest Hedge Fund is Bridgewater Associates with an AUM of $161 Billion.  Other big Hedge Funds include AQR Capital Management, Blackstone, Man Group and Renaissance Technologies.

Rank Hedge Funds HQ Founded in AUM
1 Bridgewater Associates United States 1975 $161 Billion
2 AQR Capital Management United States 1998 $84 Billion
3 Blackstone United States 1990 $70 Billion
4 Man Group United Kingdom 1983 $55 Billion
5 Renaissance Technologies United States 1982 $41 Billion

 

Source: Preqin

What are the different strategies in Hedge Funds?

There are many different strategies in Hedge Funds such as equity market neutral and long / short.

Example of Hedge Funds Strategies:

  • Equity Market Neutral
  • Long / Short
  • Arbitrage
  • Distressed Securities
  • Emerging Markets

Example of Hedge Funds Classifications:

  • Equity Strategies Funds
  • Macro Strategies Funds
  • Event Driven Strategies Funds
  • Credit Strategies Funds
  • Relative Value Strategies Funds
  • Multi-Strategy Funds
  • CTAs
  • Trading Styles
  • Funds of Hedge Funds
  • Liquid Alternatives

Source: Preqin

 

Where did Hedge Funds originate from?

The word “hedge” in financial term, is to manage the risks or protect the investment.  The earliest known Hedge Fund is in the 1920s in United States where private investment vehicles were available for wealth investors.

An early concept of Hedge Fund during the 1920s was the Graham-Newman Partnership, which is founded by Benjamin Graham and Jerry Newman.

In 1949, Alfred Winslow Jones’ company A.W. Jones & Co launched what is often recognised as the first Hedge Fund.

With a total capital of $100,000 ($40,000 of his own), Alfred W. Jones managed the risks of stocks by short selling other stocks – what is known as long / short today.  He also used leverage to increase return.

 



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