What is a Hedge Fund?

Hedge funds and mutual funds have many similarities. A mutual fund is a pool of assets made up of investments from many different individuals and institutions. They invest in mutual funds because mutual funds provide diversification and there is a person or team of people that manage the investments of that mutual fund, usually under an investment mandate explicitly stated in the fund’s prospectus. (So what are the differences?)

A hedge fund is very similar in that it is a pool of assets from many individuals or institutions. In the case of hedge funds, however, they are limited in the number of investors they can have and the types of investors they can accept. The number of investors depends on whether the fund is a 3c1 (100) or 3c7 fund. For the most part, only accredited investors can invest in hedge funds. An accredited investor is one that has $1 million in investable assets and has made over $200,000 a year in two of the preceding three years. If a couple is being considered together, the requirement increases to $300K.

Both hedge funds and mutual funds can invest in the same securities. At least in most cases. The difference is that hedge funds can enter into combinations of investments not available to mutual funds and they can also apply leverage to their portfolios. There are probably as many unique hedge fund investment strategies as there are hedge funds so for simplification we try to categorize the different strategies to make comparisons. The process is similar to grouping large cap managers with large cap managers, or growth managers with growth managers.

Some of the hedge fund strategies include: long/short, convertible arbitrage, merger arbitrage, relative value arbitrage, global macro, commodity trading advisor, fixed income arbitrage, and several others. There are a handful of hedge fund indices that have their own set of indices and similar but distinct categories. For the time being, I’ll describe a very simple long/short strategy.

When a mutual fund manager thinks a stock will appreciate from $50 to $100, they will buy the stock. A hedge fund will do the same. However, if a mutual fund manager thinks a stock’s price will go from $100 to $50, there is nothing they can do. A hedge fund however, can borrow the stock from someone else, sell it in the market for $100, and hope they can buy it back in the future for $50. If they are right and the stock drops to $50, they can buy it in the market and return the borrowed stock plus interest. The net result to the hedge fund manager is a profit of $50 minus interest to borrow the share. This is called short-selling, and long/short hedge funds enter into a diversified set of transactions on both stocks expected to appreciate (long) and stocks expected to depreciate (short).

We should also consider that many hedge funds are managed by some of the most talented fund managers. Lured by the thought of 2% management fee and 20% incentive fees, many good managers may leave the larger mutual fund firms or brokerage houses to start their own hedge fund. There is a drawback, however, which is that the 2/20 fees also attract poor managers and now that there are close to 10,000 funds, by some estimates, it gets harder to uncover good managers.

Within a portfolio, hedge funds can provide good diversification and either enhance returns or reduce volatility. There are hedge funds that are designed to generate very high returns, sometimes reaching 30% or more. These hedge funds carry with them a great deal of risk, however. It’s the only way to generate such high returns and although risky, can enhance returns to a well diversified portfolio. There are other hedge funds that use very conservative strategies that can be used as substitutes to fixed income, particularly now that interest rates are so low. These funds provide stability to a well diversified portfolio and uncorrelated returns to both stock and bond markets.

Don’t believe all the hype that hedge funds are bad. The only ones that make the news are those that blow up. We never hear about the ones who quietly generate 12% per year with low volatility. That would be too boring for CNBC to cover. That’s OK, we’ll cover them here!!