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.
At Henssler Financial we believe long-term investors with investment horizons of 10 years or more should stay invested in the stock market through high-quality stocks. We feel our philosophy of buying high-quality stocks is a time-tested and pure way to preserve long-term investment capital without incurring unnecessary risk. We do not actively recommend or select hedge funds. However, if you would like additional information on hedge funds you may contact Henssler Financial at 770-429-9166 or [email protected].