What is a Hedge Fund?
A hedge fund is an investment fund that pools money from multiple investors to invest the money in assets and deliver above-average returns to its investors.
A hedge fund aims to deliver a higher rate of return than an investor can receive from ordinary investment funds such as mutual funds, index funds, and exchange-traded funds. In order to achieve these higher returns, hedge funds tend to invest in riskier assets or use riskier investment strategies such as taking on high levels of debt to make their investments.
In addition, hedge funds tend to concentrate their investments in a few assets at a time. This lack of diversification increases the risk.
And hedge funds often require that investors lock up their money in the fund for a number of years and small withdrawals are only allowed at certain predefined quarterly intervals. This means that investors cannot quickly sell and exit the funds like investors in stocks can. This makes investments in hedge funds illiquid, which also increases the risk.
A hedge fund is usually set up as a private investment Limited Partnership. A General Partner manages the fund. The investors are the limited partners and they have no say in how their funds are invested. The general partner invests the funds at its full discretion.
As of January 2022, the global hedge fund industry consisted of about 27,255 hedge funds which had total assets under management of about $4 trillion. The U.S. was home to about 67.2% of total funds under management. In fact, New York City was home to 25% of the total funds.
Who is Allowed to Invest in Hedge Funds?
Because hedge funds invest in riskier assets or invest with riskier investment strategies, they are considered higher-risk investments that are only reserved for sophisticated investors called accredited investors.
An accredited investor is an individual or a legal entity including high-net-worth individuals, banks, insurance companies, brokers, trusts, and investment funds that is allowed to invest in sophisticated high-risk investments such as venture capital, hedge funds, and angel investments.
Securities regulators generally do not regulate hedge funds very strictly. Regulators deem that these accredited investors are sophisticated investors that understand the investment risk and can afford to take any losses.
UNITED STATES
Accredited Investor – Natural Person
In the U.S., under SEC Regulation D Rule 501, the Securities and Exchange Commission (SEC) defines an accredited investor as:
– An individual with gross income exceeding $200,000 in each of the two most recent years or joint income with a spouse or partner exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
– A person whose individual net worth, or joint net worth with that person’s spouse or partner, exceeds $1,000,000, excluding the person’s primary residence.
Accredited Investor – Legal Entity
In addition, the SEC defines a legal entity as an accredited investor as:
– any trust, with total assets in excess of $5 million, not formed specifically to purchase the subject securities, whose purchase is directed by a sophisticated person, OR
– certain entity with total investments in excess of $5 million, not formed to specifically purchase the subject securities, OR
– any entity in which all of the equity owners are accredited investors.
In most developed countries, the definition of an accredited investor tends to be similar to the SEC definition.
CANADA
In Canada, under National Instrument 45-106, the Securities Commissions in Ontario, British Columbia, and other provinces define an accredited investor as:
– an individual who, either alone or with a spouse, beneficially owns financial assets having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1,000,000; or
– an individual whose net income before taxes exceeded $200,000 in each of the two most recent calendar years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the two most recent calendar years and who, in either case, reasonably expects to exceed that net income level in the current calendar year.
The definition of a Canadian legal entity as an accredited investor is also similar to the SEC definition.
UNITED KINGDOM AND EUROPEAN UNION
In the UK and most of the Europe Union, accredited investors are referred to as Experienced Investors.
An experienced investor is defined as:
– a person who has carried out trade transactions, in significant size (at least €50,000), on the relevant market at an average frequency of 10 per quarter over the previous four quarters;
– a person whose financial instrument portfolio, defined as including cash deposits and financial instruments, exceeds €500,000;
– a person who works or has worked in the financial sector for at least one year in a professional position which requires knowledge of the transactions or services envisaged.
The definition of a legal entity as an experienced investor is similar to the SEC definition.
Hedge Fund Investor Requirements
Many hedge funds have even higher requirements for thresholds of income and net worth than the SEC does. These hedge funds set higher financial requirements of investors to determine whether the hedge fund will accept an investor’s money.
And all hedge funds have a minimum investment amount.
The smallest and least popular hedge funds generally require an investment of at least $100,000.
Larger hedge funds may require a minimum investment amount of a few million dollars. For example, Florida-based hedge fund Elliott Investment Management L.P., which was founded in 1977 and had over $51 billion in assets under management as of December 31, 2021, requires a minimum investment of $5 million per investor.
The Origin of the Hedge Fund
The first hedge fund A.W. Jones & Co. was set up by an Australian investor Alfred Winslow Jones in 1949.
A.W. Jones started out as a $100,000 fund which aimed to hedge its long investments in stocks by short-selling other stocks in its portfolio. In this way, the fund could minimize any losses in its long positions with its short positions.
A long investment in a stock is an investment in which the investor expects the stock price to increase in value. If the stock price goes up above the purchase price of the investor, the investor earns a profit.
A short investment in a stock is an investment in which the investor expects the stock price to decrease in value. If the stock price falls, the investor earns a profit.
Thus, the goal of a hedge fund was to always hedge its portfolio in order to minimize its losses. Hence the original name of this type of fund was hedge fund.
However, today, the portfolios of most hedge funds are not necessarily hedged.
A.W. Jones also introduced the compensation structure in which the general partner, that manages the investments for the limited partner investors, will receive a management fee and percentage of the fund’s investment profits as compensation.
Hedge Fund Fees
Because of the expectation that hedge funds can produce higher returns than your ordinary mutual fund or index fund, hedge funds charge high fees to their investor clients.
Generally, a hedge fund will charge a management fee of 1% to 2% of the total value of its assets under management. And it will charge a performance fee of about 20% of the profits it produces from its investments.
However, most hedge funds structure the agreement such that the performance fee can only be collected by the hedge fund manager if the fund delivers a return above a minimum return on investment called a hurdle rate. The hurdle rate is to prevent investors from having to pay performance fees for mediocre or average profits that the investor could have received from a lower-cost investment fund such as a mutual fund or exchange-traded fund.
For example, the hurdle rate could be set at a 6% return on investment, which is calculated as defined in the hedge fund agreement. The hedge fund manager will then only receive a performance fee if it delivers a return above 6%. This provides an incentive for the hedge fund manager to aim to deliver above-average returns.
The management fee is always paid to the hedge fund manager regardless of returns or profits. This fee is used for working capital to cover the operating expenses of the hedge fund.
Types of Hedge Funds
A hedge fund is generally categorized by the asset class or sector that the fund invests in or by the investment strategy that the fund focuses on. Some hedge funds may fit into multiple categories.
A few examples of hedge funds in different categories include:
Activist Hedge Funds
An activist hedge fund is a hedge fund that invests in a public company and seeks to push the company’s management to make changes in the business in order to increase the stock price of the company.
Pershing Square Capital Management
New York-based Pershing Square Capital Management is an activist hedge fund which was founded in 2004 by Bill Ackman and had over $13 billion in assets under management as of December 31, 2020.
In 2005, Pershing bought a 9.9% equity interest in fast food chain Wendy’s International, Inc. and pushed for Wendy’s to sell off its Canadian restaurant doughnut chain Tim Horton’s. In 2006, Wendy’s acquiesced and spun off Tim Horton’s in an IPO. Pershing sold its shares at a significant profit.
Pershing also makes short investments in stocks. In 2012, Pershing made a $1 billion short investment in the stock of vitamin supplements company Herbalife. Pershing claimed that Herbalife was an illegal pyramid scheme whose stock price would eventually go down to zero. However, multiple lawsuits against and investigations into Herbalife could not definitively prove that it was a pyramid scheme. As such, over a 5-year period in which Pershing held its short, the stock price increased by about 35%. In 2018, Pershing closed its short and exited its investment at a loss estimated at $760 million.
Distressed Debt Hedge Funds
A distressed debt hedge fund is a hedge fund that invests in the debt of a struggling company and swaps its debt for equity to acquire control of the company if the company cannot meet its debt obligations.
Note that a creditor (holder of debt) has a priority claim in a company’s assets ahead of a stockholder. Thus, the debt holder is first in line to receive debt payments that are owed to it by the company. The struggling company may be unable to service the debt and the debt holders might convert their debt to shares in the company.
This conversion will normally occur at a conversion rate that is much cheaper than if the hedge fund had invested directly in shares of the company.
The hedge fund that has now become a stockholder could then push the management team to make changes to improve the business and increase the value of the stock. Just like an activist investor would. In some cases, the hedge fund might call for the top managers of the company to resign and be replaced by new managers.
Elliott Investment Management L.P.
Florida-based hedge fund Elliott Investment Management L.P. is probably the most famous distressed debt hedge fund in the world. It was founded by Paul Singer in 1977 and had over $51 billion in assets under management as of December 31, 2021.
Elliott invests in the debt of companies and governments that are struggling financially.
Argentina Sovereign Bonds
Elliott invested in the distressed sovereign debt of Argentina by purchasing Argentina bonds with a face value of $630 million for about $117 million. In 2001, in a famous sovereign default, Argentina defaulted on $80 billion of this debt and offered to repay the debt at 30 cents on the dollar to investors. About 93 percent of the debt holders agreed to the deal but Elliott refused to accept the offer.
Instead Elliott sued the government of Argentina in multiple jurisdictions to collect on the full value of the bonds. Elliott won over $1.6 billion in judgments against Argentina in U.S. and U.K. courts but could not collect payment.
Elliott tried to lay claim to money deposited by the Central Bank of Argentina with banks in the U.S. and Europe but with no luck. The hedge fund also tried to seize Argentina’s presidential planes while they were in jurisdictions outside of Argentina but these attempts were also unsuccessful.
In 2012, Elliott successfully seized a naval vessel belonging to the government of Argentina while the ship was docked in Ghana. The ship was worth a tiny fraction of the $1.6 billion that Argentina owed Elliott but the media coverage about the incident provided Elliott with a powerful bargaining chip that it could use to wage a public relations war against the government of Argentina and collect on its debt.
Finally, in 2016, the bad press and poor credit rating of Argentina as a result of the default forced the government of Argentina to agree to pay $2.4 billion to Elliott to settle the dispute. Because Elliott had purchased the bonds at a discount of $117 million, the settlement delivered a profit of over $2 billion to the hedge fund.
AC Milan Football Club
To illustrate how diverse Elliott’s investments are, the hedge fund also made a loan to famed Italian football club AC Milan.
In 2016, a Chinese investor Li Yonghong agreed to buy AC Milan for €740m from its long-time owner and former Italian Prime Minister Silvio Berlusconi who had owned the club for 31 years.
Yonghong had trouble raising the capital needed to complete the deal. As such, in 2017, Yonghong turned to Elliott and the hedge fund provided a high-interest loan of €300m to Yonghong. The loan was secured by his stake in AC Milan. The loan enabled him to close the €740m transaction.
By July 2018, Yonghong had defaulted on the loan after Elliott refused to agree to offer a payment extension to him. Elliott then foreclosed on the security and assumed control of Yonghong’s 99.93% stake in the club.
Global Macro Hedge Funds
A global macro hedge fund is a hedge fund that invests in diverse assets such as stocks, bonds, commodities, and options to profit from global political or economic events.
A global macro hedge fund may study data such as monetary policy and its impact on interest rates which affect bond markets or currency exchange rates. Or the hedge fund may analyze the political stability in a specific country to forecast how its economy may perform.
Based on its assessment of the data, the hedge fund will make its investment decisions.
Citadel Advisors LLC
Chicago-based Citadel Advisors is a hedge fund that was founded by Ken Griffin in 1990 and had $33 billion in assets under management as of December 31, 2021.
It is a global macro hedge fund that has multiple funds that invest in assets including equities, commodities, global fixed income and macro, credit, and quantitative strategies to profit from macro political and economic events.
Citadel has delivered an average annual return of 20% to its clients since its inception. However, the hedge fund failed to anticipate the macro economic events in the subprime real estate market that led to the 2008 financial crisis. This error produced negative return years for Citadel and almost pushed the hedge fund into bankruptcy.
Griffin had to prohibit Citadel investors from withdrawing any money from the fund for almost a year. Eventually, it took Citadel almost 3 years to recover the losses it sustained in just 16 weeks in 2008.
Citadel is notoriously tight-lipped about its specific investments. But Griffin’s educational background in mathematics and his penchant for hiring mathematicians, actuaries, physicists, and engineers indicates that the hedge fund uses heavy quantitative analysis to make its investments.
We will discuss hedge funds that focus on quantitative analysis in the next section. These hedge funds are called quantitative hedge funds.
Bridgewater Associates, L.P.
Connecticut-based Bridgewater Associates, which was founded by Ray Dalio in 1975, is another large macro global hedge fund. Bridgewater had $140 billion in assets under management as of December 2021.
Quantitative Hedge Funds
A quantitative hedge fund is a hedge fund that uses mathematical algorithms to analyze market data in order to make its trading and investment decisions.
Quant hedge funds trade in all asset classes including equities, fixed income, commodities, currencies, and derivatives. The trading decisions are made automatically by computer algorithms rather than by human beings at the hedge fund as they may be prone to human error due to their emotions.
The programmers at the firm will develop software programs that enable the program to analyze market data such as information from the economy, a company’s financial data, demographics, and industry data in order for the software’s algorithm to make investment decisions.
Quant hedge funds develop complex mathematical models to try to forecast which assets and investment strategies will deliver high returns.
Quantitative hedge funds will generally not focus on any qualitative or subjective data that cannot be analyzed using numbers.
Renaissance Technologies LLC
New York-based hedge fund Renaissance Technologies LLC is a quantitative hedge fund that was founded by mathematician James Simons in 1982. As of December 2021, the hedge fund had $165 billion in assets under management.
Renaissance specializes in using quantitative mathematical models to deliver some of the best investment records in history. Their signature Medallion Fund is famed for delivering the best record in investing history.
In 1988, Renaissance set up the Medallion Fund, which manages the money of employees of Renaissance, and has delivered an average of 66% in annual returns from 1988 to 2018.
Renaissance stores decades of market data in its large digital warehouse and runs mathematical models to forecast the direction of the price of any securities in any market. The algorithms automatically analyze the data and execute trades.
Renaissance hires computer scientists, mathematicians, physicists, and statisticians.
Merger Arbitrage Hedge Funds
A merger arbitrage hedge fund is a hedge fund that earns investment profits when the fund correctly anticipates the successful outcome of a merger or acquisition.
The hedge fund seeks to profit from the spread – the difference between the current market price and the price at which the stock will be trading after the merger is completed.
A merger arbitrageur at a hedge fund will decide early on whether the transaction will close in the manner in which the arbitrageur predicted and the arbitrageur will make an early bet based on his analysis.
If the deal closes or a tentative deal is announced, the hedge fund can profit from a long position in the target company, whose stock price normally rises upon such an announcement.
If the deal does not close because it was a hostile deal that is rejected by the board or shareholders of the target company, or if the deal faces regulatory barriers such as antitrust issues, the hedge fund could lose any investment it made in the stock of the target company.
Paulson & Co. Inc.
New York-based Paulson & Co. is a hedge fund founded in 1994 by John Paulson. The hedge fund specializes in global merger, event arbitrage, and credit strategies. It has about $9 billion in assets under management.
The fund invests in merger arbitrage opportunities involving high-quality spreads, mergers announced that have the possibility of higher bids, and the hedge fund shorts merger deals that are unlikely to close.
Although Paulson has invested in merger arbitrage strategies since its inception, it was a relatively unknown firm. The firm only became famous when it made a fortune by betting against subprime mortgages, which collapsed in 2008 and led to the financial crisis.