Hedge Fund

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. Financial regulators generally restrict hedge fund marketing to institutional investors, high net worth individuals, and accredited investors.

Hedge funds are considered alternative investments. Their ability to use leverage and more complex investment techniques distinguishes them from regulated investment funds available to the retail market, commonly known as mutual funds and ETFs. They are also considered distinct from private equity funds and other similar closed-end funds as hedge funds generally invest in relatively liquid assets and are usually open-ended. This means they typically allow investors to invest and withdraw capital periodically based on the fund’s net asset value, whereas private-equity funds generally invest in illiquid assets and only return capital after a number of years. However, other than a fund’s regulatory status, there are no formal or fixed definitions of fund types, and so there are different views of what can constitute a “hedge fund.”

Although hedge funds are not subject to the many restrictions applicable to regulated funds, regulations were passed in the United States and Europe following the financial crisis of 2007–2008 with the intention of increasing government oversight of hedge funds and eliminating certain regulatory gaps.

Although most modern hedge funds are able to employ a wide variety of financial instruments and risk management techniques, they can be very different from each other with respect to their strategies, risks, volatility and expected return profile. It is common for hedge fund investment strategies to aim to achieve a positive return on investment regardless of whether markets are rising or falling (“Absolute return”). Although hedge funds can be considered risky investments, the expected returns of some hedge fund strategies are less volatile than those of retail funds with high exposure to stock markets because of the use of hedging techniques.

A hedge fund usually pays its investment manager a management fee (typically, 2% per annum of the net asset value of the fund) and a performance fee (typically, 20% of the increase in the fund’s net asset value during a year).

Hedge funds have existed for many decades and have become increasingly popular. They have now grown to be a substantial portion of the asset management industry with assets totaling around $3.8 trillion as of 2021. Hedge fund managers can have several billion dollars of assets under management (AUM).

Strategies

Hedge fund strategies are generally classified among four major categories: global macro, directional, event-driven, and relative value (arbitrage). Strategies within these categories each entail characteristic risk and return profiles. A fund may employ a single strategy or multiple strategies for flexibility, risk management, or diversification. The hedge fund’s prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund’s investment strategy, investment type, and leverage limit.

The elements contributing to a hedge fund strategy include the hedge fund’s approach to the market, the particular instrument use, the market sector the fund specializes in (e.g., healthcare), the method used to select investments, and the amount of diversification within the fund.

There are a variety of market approaches to different asset classes, including equity, fixed income, commodity, and currency. Instruments used include equities, fixed income, futures, options, and swaps. Strategies can be divided into those in which investments can be selected by managers, known as “Discretionary/qualitative,” or those in which investments are selected using a computerized system, known as “Systematic/quantitative.” The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager, or a combination.

Sometimes hedge fund strategies are described as “absolute return” and are classified as either “market neutral” or “directional”. Market neutral funds have less correlation to overall market performance by “neutralizing” the effect of market swings whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market’s fluctuations.

The advocates of hedge funds paint a colourful picture of this type of investment. What you will hear less about the funds are its negative aspects.

Looking at the hedge funds, investors have to be concerned with some key aspects. These include:

• Alignment of interest
• Higher fees
• Less liquidity
• Less transparency
• Effective implementation

Benefits:

Unconstrained Toolkit

An unconstrained toolkit affords a skilled manager the ability to not only harvest alternative premiums but also customize individual positions and portfolio risk and reward.

The unconstrained toolkit may include short selling, active hedging, leverage, concentration, activism, and litigation. While the alternative sources of return may include event risk, complexity and liquidity premiums, arbitrage, distressed securities, futures, macro-trends, and more.

Diversification

Traditional portfolios are dominated by two systemic risks: equity beta and interest rate risk. Conversely, hedge funds can access both financial and nonfinancial (commodity) markets and are properly equipped to take positions in an expanded set of investment opportunities. These opportunities seek to provide diversification benefits to an existing portfolio.

Asymmetry

Hedge funds seek lower volatility of portfolio returns by achieving a certain level of positive asymmetry. Asymmetric investing means the probability for upside is greater than the downside. Managers who successfully reduce drawdown’s can allow for more consistent compounding, which is key to long-term portfolio growth.

The Risks and Limitations Associated with Investing in Hedge Funds

Like all investments, hedge funds come with their own set of associated risks. First and foremost, a hedge fund investor should be prepared to pay higher fees relative to a more traditional investing vehicle. Having said that, investors should focus on the net return delivered by the fund manager after all fees and not the absolute levels of fees themselves.

An investor should also be familiar with and be able to understand the memorandum documentation associated with the investment. This complex and sometimes lengthy document details the terms of the offering, and the risks of the investment, amongst other items.

Other issues include a lack of full underlying transparency/attribution & lagged reporting. This characteristic makes it more difficult for an investor to obtain and understand the underlying risk factors associated with the portfolio. This could lead an investor to be less familiar with how the allocation best fits within the context of a total portfolio.

Hedge funds also are less liquid due to potentially strict redemption terms. This attribute requires an investor to do extra diligence before deciding if it’s suitable to invest in this space.