What is a hedge fund and how does it work?

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What is a hedge fund

What is a hedge fund?

Hedge funds are alternative investment vehicle available only to sophisticated investors such as High Net Worth Individuals and institutions which are in possession of significant amount of wealth. These funds invest across diverse investment strategies using funds accumulated from the investors. Hedge funds are majorly organized as Limited Liability Corporations (LLC’s) or Limited Partnerships (LP’s) so as to take advantage of tax exemptions.

Before digging in the concept of hedge funds more, one needs to understand the difference between Mutual funds and Hedge funds. Both are investment products with some similarities and differences. They are similar in the way that both accumulate funds from investors and invest across a diverse portfolio of securities. Secondly, both are managed by professional managers. Thirdly, like in mutual fund, investors in hedge fund can withdraw their money subject to some minor conditions.

The differences between the two are enumerated in a tabular form as below:


               BASIS                                HEDGE FUNDS                                 MUTUAL FUNDS
 Investors/Participants These funds are available only to High Net Worth Individuals and sophisticated investors. These funds are available to general pubic/individual investors as these require small amount of investment from investors.
        Management These are managed aggressively and they take speculative position in derivative securities and possess the ability to short sell stocks. Mutual funds, on other hand cannot take highly leveraged positions. Investment in risky assets is strictly prohibited.
      Diversification They may/can rely on highly concentrated portfolios. Diversification is the key motive in order to protect the interests of the investor.
        Regulation These are largely not regulated and are not subject to regulations designed for investor protection. These are highly regulated and are subject to regulations because investor safety is of utmost importance.
          Return They offer absolute returns. They offer relative returns.


hedge fund working

Working of A Hedge Fund

Hedge funds are managed aggressively and tend to earn absolute returns. The pooling of money from investors allows a hedge fund manager to earn multiple times of this pooled money by leveraging other people’s money.

In order to understand the working of a hedge fund let us consider an example. Suppose Mr. X sets up a hedge fund called “XYZ Fund, LLC”. Operating Agreement- a legal document stating the working of the fund-states that Mr. X will receive 20% of any profits over 5% per year and that Mr. X can invest in anything-be it real estate, shares, startups, currencies, gold, art, etc.

Suppose 20 investors invest with an initial investment of $10 Million each. A total of $200 Million is collected and the fund administrator records the investment on the books after completing all the necessary formalities of investment agreement. The XYZ gets operational and Mr. X explores all possible attractive opportunities. After finding attractive opportunities, investment is done accordingly.

Also Read: What is Dividend Policy? Meaning, Definition and Affecting Factors

After a period of one year the fund goes up by 30% and is worth $260 Million now. As per the agreement, the first 5% of $260, i.e., 3 Million goes to the investors and the remaining being split as 20% to Mr. X and 80% to the investors. Hence, the capital gain of $60 Million gets reduced by $3 Million which goes to the investors. The remaining balance of $57 Million gets distributed in the ratio of 20:80. The 5% is known as the “hurdle rate” as this is the minimum rate that the fund manager has to earn for investors before earning any performance compensation. On the basis of performance of the fund earnings of Mr. X are $11.4 Million and of the investors is $48.6 Million ($3M for hurdle rate cut and $45.6 M for the 80% share).


Hedge Fund Fee Structure

Hedge Fund Fee Structure

Hedge fund manager’s compensation is comprised of two parts-Management fees and Performance based incentive fee. Fung and Hsieh (1999) determined a median management fee in range of 1-2% of AUM (Assets under Management) and performance fee also called incentive fee similar to the 20% of profit that Alfred Winslow Jones collected on the very first hedge fund.  The 2% management fee is paid irrespective of the performance of the fund. Hedge fund fee structure is generally referred to as “2/20” fee structure.

Some other aspects of hedge fund fee structure in relation to the above are also essential in order to determine the compensation pad to fund managers. These relate to the presence of High-Water Mark, hurdle rate and the crystallization frequency.

  • High Water Mark: This concept ensures that the fund manager will be compensated for management fees only if the fund exceeds highest NAV it has previously achieved. High water mark ensure that the incentives are not paid on profits earned to recover losses of past years.
  • Hurdle Rate: As discussed above it is the minimum return the fund manager should generate beyond which only he can charge a management fee

Compensation Criticism (2 and 20)

The most criticized component of the hedge fund industry is the compensation scheme which is called the “2 and 20”. This compensation scheme has become a standard in majority of the hedge funds operating currently. This phrase means that hedge fund managers charge a flat 2%-management fees- of total asset value irrespective of the fund performance and 20% of any profits earned by the fund. This “2 and 20” still prevails, however many funds are shifting to “1 and 20”. Investors fear the danger as some fund managers seek to increase the amount of money invested in the fund in order to collect more management fees which discourages them to take more risk.

Global Hedge Fund Investment

Global Hedge Fund Investment

The first hedge fund was introduced in 1949 by Alfred Winslow Jones’s company. The industry of hedge funds has grown multiple times and at present there are around 10,000 funds operating globally with assets totaling over $3 Trillion. Some of the top hedge funds include Bridgewater Associates LP, Bridgewater Associates LP, Och-Ziff Capital Management Group LLC, Brevan Howard Asset Management LLP, BlueCrest Capital Management, and many more. It is not always necessary that investment in hedge funds will be profitable. They always have significant failure rate. Some of the funds that have failed to generate returns even after accumulating huge amount of funds are Amaranth Advisors, Bailey Coates Cromwell Fund, Marin Capital, Long-Term Capital management (LTCM). Inspite of these failures hedge funds continue to attract investors in lieu of high returns even when markets are down. A careful study and research is required in order to invest in a hedge fund so that it meets your high return expectation.

Author: Anjali K. – Jr. Analyst


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