Most of you are aware of Seed Fund, Angel Investors, and Venture Capital Funds but little confused about what a Hedge fund is and why on earth they make so much money. In short, a hedge fund is essentially a structure that lets you invest your own money as well as others’ money into any kind of investment that you want without really too many regulations, typically these investments can be into startups, markets, instruments, real estate, strategies and anything and everything that sounds legal.
Let me simplify this by breaking it into 5 parts for easy understanding.
There are two main sides to this, on the one hand, there’s a General Partner which is basically a person who actually manages the money and typically tends to put a portion of his own money as well and on the other side sits Limited Partners who bring in the majority of the money, limited partners might include pension funds, sovereign funds, endowments and some high network individuals. These funds don’t actually accept money from normal people, they have a sort of a minimum requirement so essentially a minimum amount of money that you need to put in would typically be above the $1million mark and in addition to that they have a lock-up period where you can’t take the money out for a set number of periods usually something like five years, so even if you need the money they don’t let you take it out and that’s why it’s mainly only open to sophisticated investors.
2. Fee Structure
There are typically two types of fees in which the first one is Management Fees which is typically a fixed percentage on a yearly basis say around the 2% mark, so it’s 2% of the Assets Under Management (AUM) which is basically the amount of money that the fund manages, the second type of fees has to do with performance fees which are typically a percentage of the profits so these are non guaranteed and they’re not fixed if the fund does well and has a positive return they’ll typically take a 20% of it. Let’s look at an example suppose a hedge fund manager manages 100 million funds every year he gets a management fee of 2% so that’s basically 2 million to pay for salaries etc, now the beauty of this is regardless of whether he wins or loses the money he gets a guaranteed 2 million so essentially he guarantees that he’ll be able to pay everyone and all of that stresses is gone.
When it comes to performance fees, let’s say he’s up 30 million this year typically the performance fee is around 20% so he gets 6 million and that’s how they get so rich. The common term they use in finance is called the 2 + 20 and by that, they essentially mean 2% management fee and 20% of profits.
3. Investment Strategies
There are so many types of hedge funds, but for now, we’ll just focus on three of the most popular strategies.
i. Global Macro Strategy
This strategy bases its investment decisions on global economic and political trends instead of focusing on individual companies, they take a top-down approach, they base their decisions on things like interest rates, economic models, currencies or politics and their investment cycle is typically medium to long term where they might stay into something for even a couple of years, among the most famous global macro hedge funds are Bridgewater Associates and Moore capital.
ii. Quantitative Hedge Fund.
A Quant hedge fund doesn’t rely on humans for their trades instead they rely on algorithms that base their investment decisions, so essentially they employ a big army of physicists, mathematicians and computer scientists to create an algorithm that will predict the investment opportunities and executes them automatically. They mainly focus on the short term sometimes even less than a second to enter and exit a trade that’s why they use computers for that and nowadays quant hedge funds are probably the most popular especially given their really good returns compared to some other hedge funds and among the most famous ones there are Two Sigma and DE Shaw&Co.
iii. Event-Driven Hedge Funds
This basically targets mispricing because of major events like an acquisition, an earnings call or bankruptcy, their research mainly involves getting deep into the financial statements of companies, reading all their public documents and trying to get as much information as possible. An example of their strategy could be a healthcare company waiting to see if a new game-changing drug that they invented is going to get approved by the regulators, the hedge fund would take a positive or negative position depending on that and try to predict it, so these are typically short and medium-term investments and among the most famous hedge funds are Davidson Kempner and DuPont capital. These investment strategies I mentioned are typically quite generic and sometimes they’re a lot more narrow and specific.
4. Risk and Regulations
With a normal fund like a pension fund where you or I might put money in they’re actually very regulated essentially they’re not allowed to use certain financial instruments, for example, they’re not allowed to incur debt sometimes they’re limited to specific countries and various other things like that, essentially as a normal consumer you don’t want them to lose your money so basically they’re very risk-averse and highly regulated, but for a hedge fund, the risk levels are actually very different it’s a completely different story mainly because they only deal with sophisticated investors and they’re not regulated at all and so they basically can do anything they want as long as they make money.
There are two main metrics to measure the fund performance, the first is obviously returns and the second is diversification, returns are typically measured against the benchmark, for instance, it might be measured against the S&P 500, Nifty 50 or so on so forth, so anything above that is positive and anything below is negative, it’s that simple. Another big performance metric is diversification because what they do is so different to your average investor that basically means that they’re not correlated to the market, though the market might be in a recession the hedge funds might actually be doing well and making money and that’s something very attractive to investors obviously the opposite also applies.