What Is a Hedge Fund?

“Hedge fund” is a term that many people have come across, but surprisingly few actually know what it means. So today we’re going to explain what a hedge fund is and how they work.

First things first, what’s a hedge fund?

The first thing to remember is that a hedge fund isn’t one type of investment. Rather, it’s a pooled investment structure, usually a partnership or a limited company, set up by a hedge fund manager. The words ‘hedge fund’ describe that structure and the investments that sit within it.

Okay, so a hedge fund is the structure surrounding the investments. But what does a hedge fund do?

Typically, when a manager decides to launch a new hedge fund, they raise capital. If they have a good track record, investors will allocate capital into the hedge fund structure.

Once the manager has enough capital for launch, typically between $5m and 25m, they will invest it into a range of securities. The idea is that the manager looks at the world and the market and buys investments that rise in value over time, hence making a profit for investors. All hedge funds seek “alpha,” which is a return over and above what the market is returning. Many of them also use trading strategies, such as leverage and risk management using derivatives.

The type of hedge fund dictates what sort of investments it makes. There are many different types. For example, a ‘long-only’ hedge fund invests in securities that it hopes will go up in value, whereas a ‘long/short’ hedge fund invests in some securities that it hopes will go up (going long) and some that it hopes will go down (going short).

So hedge fund investors want to generate profits on their investment. How do hedge fund managers make money?

Hedge fund managers can make a lot of money, but this tends to be the case only if they make a profit. That’s because fees for hedge funds are usually based on performance.

The standard structure for a hedge fund is called ‘2 and 20’. This means that the manager charges 2% of the total assets that they manage and 20% of the profits that they make.

So it can be lucrative for good managers, but lots of hedge funds go bust and lots of managers commit their own capital to their funds. So managers take a lot of personal risks too.

Can I invest in a hedge fund?

Most hedge funds take investment from high-net-worth individuals and corporations, such as pension funds, investment banks and asset managers. Investors into hedge funds must be either “accredited investors” and/or “sophisticated investors“. This is because hedge funds are risky, so only experienced investors are able to weigh up the pros and cons of investing.

Why are hedge funds in the news so much?

Hedge funds don’t have a good reputation. Some of this is warranted, and there have been scandals in the sector, but mainly it’s because managers have made so much money in recent decades. As with footballers or movie stars, there’s nothing wrong with fortunes legally earned, but the problem with hedge funds is that money is often made when lots of people lose money.

Because hedge funds can ‘go short’, they make money even if markets fall and economies falter. For example, in the crisis of 2008, some hedge funds made massive amounts of money. Hence, managers are seen as being disconnected from the fortunes of the everyday economy.

But that’s not a hedge fund manager’s fault. They are risking a lot too, with many hedge funds managers putting their ‘skin in the game’. It’s also true that many of the world’s highest paid hedge fund managers, such as Ray Dalio and George Soros, came from meagre backgrounds.

What are the alternatives to investing in a hedge fund?

As we’ve explained, most people can’t invest in hedge funds as they’re only for sophisticated and high net worth investors or institutions. In short, hedge funds aren’t for everyone.

So here are two alternatives to hedge funds that everybody can invest in:

Exchange Traded Funds (ETFs)

ETFs allow investors to put their money in a sector of the stock market without having to pick and choose every single stock. ETFs can give you exposure to a variety of asset classes, such as equities, by tracking the performance of an index, like the S&P 500. ETFs are very low cost and they don’t charge for buying and selling. In short, ETFs are the opposite of hedge funds, because they are flexible, liquid, low cost and accessible.

Robo-advisors

Automated investment services – robo-advisors – invest in the stock market for you. All you need to do is sign up with a robo-advisor and pick a strategy into which you will invest your money in a wide range of investments. The robo-advisor will then, over time, invest, with a human making sure that the robot stays on track. Robo-advisors typically have lower fees than hedge funds because there are lower costs in running the business. They don’t have to pay a hedge fund manager a bonus for a start!

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So is investing in a hedge fund the right option for you? The answer is almost certainly, no. Unfortunately, it’s unlikely that you have the necessary level of wealth of expertise to invest in these assets so you’ll probably be much better off going for lower cost assets, like ETFs.

It’s also worth remembering that hedge fund performance isn’t anything special. There’s a famous story about the legendary investor, Warren Buffett, who, a decade ago, took a $1 million bet that investing money in an index fund (like an ETF that tracks the index) would earn a higher return than with a hedge fund manager.

Well, Buffett won when his pick, the S&P 500 tracker fund he invested in, gained 126% over ten years, whereas the five hedge funds that he went up against added a mere 36% on average.

So, sorry to say, hedge fund managers, but hedge funds are not only expensive and hard to access… but they’re also not great when it comes to performance. All in all, at Sarwa, we think they’re best to be avoided.

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