Hedge funds are often mentioned in financial news. They’re debated when Congress or the administration is talking about changes to the tax code. Most of us have a sense that hedge funds are some sort of investment vehicle reserved for wealthy people.
But what are hedge funds, really? How do they work and who are they for? Are hedge funds something smaller investors should consider?
Although hedge funds won’t generally pop up in Facebook ads, they really aren’t that mysterious. They’ve been around for 70 years, there are more than 15,000 of them, and they manage a total of over $3 trillion in assets. Here’s how they work.
Hedging Your Bets
In the gambling world, hedging your bet generally means protecting your main bet against an unforeseen or unlikely outcome.
For example, say you bet $100 with the sportsbook in a casino that your hometown team, which is playing in the Superbowl, will win. Your team is the favorite, so the casino is giving 2:1 odds. If your team wins, you get $200. If your team loses, you lose your $100 bet.
You decide to hedge your bet against the possibility that your team could lose by placing a smaller wager on the other team as well. If the casino is giving 4:1 odds on the other team, betting $25 will protect your original $100 bet.
If your team wins, you get $200 (from your $100 bet) and lose your $25 bet on the other team. You walk away with $175.
If your team loses, you lose the $100 bet on your hometown team, but win $100 from your $25 bet on the other team. You break even.
By hedging your bet you’ve guaranteed you won’t lose. You can only win or break even.
That’s the thinking behind Hedge Funds: they use strategies to “hedge” and are supposed to behave differently than the market overall – they go up less and they go down less, in theory…Of course, that doesn’t guarantee that investors don’t lose money.
Does it always work that way? To answer that question, it helps to understand the history of hedge funds and how they’re managed.
The First Hedge Fund
Back in 1948 Alfred Winslow Jones, who’d written about investment trends, decided to use what he’d just learned about investing to manage money. (The regulations were a little looser back then.)
He raised $100,000, $40,000 of it out of his own pocket, and tried to minimize the risk of holding long-term stock positions by short selling other stocks. Short selling means you borrow the stock and sell it. But you have to replace it. If the stock goes down, you buy it at a lower price to replace it and you make money. If the stock goes up, you have to buy it back at a higher price so you lose money. A portfolio of stocks and a portfolio of shorts will in theory move in opposite directions.
Since this portfolio would theoretically be very stable, he thought adding on debt, or leverage would be a smart way to enhance returns. He then made it into a partnership, where he and the investors shared in the risk and return. For all this innovation, he made the change that hedge funds are most known for today – a very lucrative compensation structure. He received a 20% incentive fee meaning he was entitled to 20% of the gains he achieved for investors.
He was the first money manager to combine:
- Short selling
- The use of leverage shared risk through a partnership with other investors
- A compensation system based on investment performance
That combination, which is the underpinning of many hedge funds today, made him the father of the hedge fund.
The Growth of Hedge Funds
For wealthier investors, the idea of a fund designed to mitigate potential losses and make money regardless of what the market does quickly became popular. The fact that hedge funds resembled a private club only open to rich people undoubtedly had its appeal as well.
The growth of hedge funds really accelerated in the 1990s, when high-profile money managers moved from mutual funds to become hedge fund managers. Lured by the higher fees and reduced regulatory oversight, many of those managers saw greater opportunities, and the industry exploded: Barclays estimates that assets under management (AUM) of hedge funds grew by $2,350% from 1997 to 2019. In that same time period, the number of hedge funds more than quintupled.
Today, the largest hedge fund in the world is Bridgewater Associates, which was founded in 1975 in Westport, Connecticut. The fund ended 2019 with $160 billion in AUM, according to Pensions & Investments. No other hedge fund has over $100 billion in assets.
For comparison the largest mutual fund, Vanguard’s Index 500, has over $338 billion in assets.
How Hedge Funds Work
Although they employ different investment strategies, most hedge funds claim to offer approaches not found in mainstream mutual funds. The main thing all hedge funds have in common is the partnership and compensation structures that Mr. Jones invented.
Bridgewater Associates uses a global macro investing strategy based on economic trends. The second largest hedge fund, Renaissance Technologies, analyzes and executes trades using complex mathematical models. Several hedge funds say their “secret sauce” is artificial intelligence, machine learning, and other technology-driven strategies. But, there are also hedge funds that are not hedged at all and simply use the partnership and fee structures to house active management strategies.
Though strategies may differ, one thing that virtually all hedge funds have in common is high fees. Typically, hedge funds charge annual fees of approximately 2% or more, significantly higher than most mainstream mutual funds. They also take a portion of gains for themselves. While this is the most common pricing, known in the industry as “2 and 20”, there are some funds that do not hedge as aggressively that charge lower fees or only take incentive fees after beating a benchmark, and there are some, including Renaissance, that charge extraordinarily high fees – 5% and 50%!.
Who Can Invest
Hedge funds aren’t open to just anyone. The U.S. Securities and Exchange Commission (SEC) generally only allows accredited investors to invest in hedge funds. An accredited investor can be an institution, such as a bank or pension fund. Individuals who are accredited investors must have a net worth of at least $1 million, not including their primary residence, or an income of $200,000 a year ($300,000 a year if including their spouse’s income).
As a result, hedge funds tend to have high minimum investments, typically $100,000-$1 million. They’re also less liquid than mutual funds, and withdrawals may be limited or not possible during certain periods.
More practically, hedge fund investors should understand the investment philosophy, performance, risks, and fees associated with any specific hedge fund before investing.
Investors should also note that hedge funds generally aren’t registered with the SEC, so some of the protections and transparency mandated by SEC regulations don’t apply. Hedge funds are also limited in the number of clients allowed to invest and don’t advertise or market to the general public. That air of mystery tends to add to their mystique.
Hedge Fund Performance
Since hedge funds generally invest in the same stocks, bonds and other assets available to mutual fund money managers, do they outperform those managers? Do hedge funds outperform market indexes, such as the S&P 500?
In the aggregate, no. The Credit Suisse Hedge Fund Index, which measured hedge fund performance from January, 1994 to October, 2018, showed that the passive S&P 500 Index outperformed every major hedge fund strategy by about 2.28 percent in annualized return. The S&P 500 boasted an annualized return of 9.81 percent, while the hedge fund index averaged 7.53 percent. A similar study by Epsilon Asset Management, a quantitative investment firm, showed that even when a hedge fund outperformed the market over a shorter time period, that superior performance was negated by the fund’s high fees.
But some hedge fund strategies performed differently at specific times. For example, from 1994 to 2009, dedicated short strategies lagged the market, but market neutral strategies outperformed the S&P 500 on risk-adjusted terms (i.e. did worse in annualized return but incurred less than one-fourth the risk).
Having said that, some investors choose specific funds based on their predictions of the stock market’s future. If they perceive a bear (declining) market coming up, they may seek out a hedge fund designed to do well during bear markets.
So why choose a hedge fund? Some hedge funds have outperformed the market over shorter periods of time. Hedge funds also tend to offer investors more diversity, because many funds have a different asset mix than the holdings of mainstream mutual funds.
Should You Invest in a Hedge Fund?
As with any investment, the best approach is always based on two considerations:
- What is your overall financial plan based on your goals, risk tolerance, and timeline
- How does this investment fit into your plan?
A trusted financial advisor can help determine whether any hedge fund, as well as a specific hedge fund, should be part of an investment portfolio. Make sure you know what you’re investing in, why you’re choosing that investment, and how that investment matches the other investments in your portfolio.