The new century saw the
term "hedge fund" become a household name. Depending on
the investor you are talking to, the recently popularized world of
hedge funds can be heard ringing with praises or be chastised into
infamy. Even with its recognizable name, most people still have a
hard time understanding what a hedge fund is.
Hedge funds are simply
investment funds that are free to invest in almost any investment
opportunity, utilizing a broad array of investment strategies with
limited rules that govern their existence. Currently, hedge funds
are undergoing a regulatory overhaul because they have become so large
and invest in complex securities. Hedge funds tend to be suitable
and limited to investments from individuals with a net worth greater
than $1 million and institutional investors. Hedge funds can take
on a number of different legal structures, but most hedge funds are
established as a limited partnership. The investors are the limited
partners and the investment manager is the general partner.
Hedge funds have been around
since the 1940s, so these are not totally new investment vehicles.
They received their colloquial name as their initial investment strategy
was designed to hedge against market risk. Market risk is the risk
that your investments will decrease in value simply because of the
direction and sentiment of the market. The ultimate goal of any investment
strategy is to increase the rate of return without increasing risk.
Since hedge funds can short stocks, they originally offered investors
the ability to hedge against the downside, thus attempting to create
a less volatile investment portfolio. Many hedge funds still employ
this initial strategy, but the world of hedge funds has expanded since
the 1940s and now includes managers that do not attempt to hedge against
downside risk—they do the opposite and take on excess risk in
the hopes of outsized gains.
Most hedge fund managers invest in equities,
fixed income, commodities and currencies. Some hedge fund managers
may invest a portion in non-liquid investments like private companies.
Hedge funds have a large toolbox of strategies to choose from, in
that they can short sell stocks, and own futures, options and swap
contracts. They can also employ the use of leverage. Like a mutual
fund, you need to fully understand the investment manager's strategy
and the tools that they plan to use to implement that strategy before
investing. Some hedge funds are quite conservative while others are
purely speculative.
Hedge funds also have a unique fee structure.
Most hedge funds charge a management fee like a mutual fund or separately
managed account. This fee is to cover general management fees and
the investment manager's cost of doing business (e.g. trading, salaries,
administrative cost, etc). Traditionally, hedge fund management fees
have averaged around 2%. Where hedge funds differ is they usually
charge a performance fee in addition to the management fee. This performance
fee is usually about 20% of the realized and unrealized gains in a
given year, although this fee can be higher.
Some hedge funds follow a high watermark
or hurdle rate strategy to assess performance fees. A high watermark
strategy means that investment managers must continue to hit new highs
before they can assess a performance fee. For example, if the hedge
fund started with a net asset value (NAV) of $100 and over the course
of the next 12 months rose to $120, the performance fee would be 20%
of $20 or $4. If the fund declined to $110 during the following year,
there would not be a performance fee assessed again until the NAV
climbed above $120.
The hurdle rate strategy pegs the performance
fee to a target return or benchmark. For example if the fund chose
to use the S&P 500 as the hurdle rate, a performance fee would
only be paid on the percentage the fund bested the S&P 500. Most
hedge funds have historically used low hurdle rates for self-serving
reasons.
Hedge funds should not be viewed as
a separate asset class. Instead they should be viewed as an alternative
way to access existing asset classes. Hedge funds have pros and cons
like all investments, so be sure you understand the investment manager's
strategy and the associated costs and risks that accompany the strategy
before you invest.
