The Hedge Fund: Understanding a 5.1 Trillion US Dollar Industry
Alfred Winslow Jones — If you are keen on finance and the financial markets and do not know his name, you should. He is the grandfather of the modern-day financial titans known as hedge funds. The European-American sociologist/philanthropist from the mid-nineteenth century spent his youthful years running secret missions for an anti-Nazi group and drinking whiskey with Ernest Hemingway (Mallaby, 2010). The person who paved the way for an industry that controls an estimated $5.13 trillion would have likely spent his formative years working under financial moguls at places such as JP Morgan Chase or Merrill Lynch (Statista, 2023). It is logical to think that lacking a typical finance background would be a limitation; however, Jones used his unique background to his advantage. His years spent fighting Nazism and working undercover taught him how to be creative and escape boundaries, leading him to create the structure for arguably the most powerful and successful investment vehicles known today.
You may be asking yourself, what is a hedge fund? Well, start by taking a look at one of the fundamental rules of finance: an increase in risk accompanies an increase in reward. Take corporate bonds, for example. Low-grade bonds typically have higher coupon rates –or returns– than investment-grade bonds. Why? Low-grade bonds often have higher credit risk, the risk that the firm will default on their obligation to pay back their debt, and investors must be compensated for that risk. Speculative stocks, which are highly sensitive to market movements, can yield higher returns than stable stocks but can also yield higher losses. Increased reward matched with an increase in risk.
Hedge Funds and the Notorious Short
Hedge Funds essentially break this rule. They are able to generate an increase in reward while at the same time minimizing risk. These funds generate alpha, which refers to excess returns not attributable to risk. This is possible through taking hedged positions. Hedge funds will hold both short and long positions in their portfolios, meaning that they profit when the market goes up and when the market goes down. Now, if you hold both of these positions, theoretically, all gains would be offset by equivalent losses. However, hedge funds use leverage to amplify their war chest, allowing them to create a more diversified long portfolio, minimizing exposure to stock volatility risk, and hedge their market risk with the short positions. A chart taken from Sebastian Mallaby’s More Money than God (2010) illustrates this:
In this example, the traditional investor had a $100,000 war chest, yet had to protect their capital by putting some of their cash into bonds. The hedged investor, who was able to leverage up and was protected by superior diversification and by their short positions, was able to profit in both a bull and bear market. Now, it is important to note that the hedged investor had to successfully pick stocks that would react in such a way to the market moments that it constitutes these returns. Done effectively, the hedge fund outperforms traditional funds.
Leverage and hedging are the primary factors contributing to the alpha generated by hedge funds. These elements dictate how the fund is invested, but there are other aspects that constitute hedge funds. One of the most important ones is their lack of regulation (Fung, et al. 2008). Other types of funds, such as mutual funds, have strict reporting requirements and are unable to short positions or use leverage, for example. This places constraints on their investment strategy, making it challenging to speculate and generate higher returns, and limits risk management. Hedge funds do this by being organized as a general partnership (Levy, 2023). In the eyes of the SEC, the fund is basically a bunch of friends with a lot of money who pool their money together and invest as they see fit. This allows them to avoid much of the regulatory red tape which limits other types of funds.
Manager Compensation
Hedge funds also have a fee structure different from most other funds. Mutual funds typically operate under an ad valorem fee structure, which is Latin for by the value, meaning that fund managers take a small percentage of the fund’s assets under management (AUM) (Levy 2023). Mutual fund managers are compensated based on the size of the fund, not directly from the performance. There is little incentive to rapidly grow the fund and drive great success. Although mutual fund managers can justify higher fees with better performance, that increase in incentive is negligible compared to the incentive present in hedge funds. Hedge funds have a performance-based fee structure in which they are compensated by taking a percentage of returns generated (Levy 2023). Remember how a hedge fund's success requires successful stock picking. Well, analyzing stocks and the markets to that extent entails an immense amount of work, which people are only willing to do if they are getting paid. It is important to note that this incentive can have potential downsides: managers who get compensated on returns are more likely to hold excessively risky positions in an attempt to maximize their earnings. This risk is mitigated by hedge fund managers being required to invest a substantial amount of their personal capital into the fund, so if the fund takes a hit, so do they.
Hedge funds are also what is known as a closed-ended fund. In an open-ended fund, investors have the ability to redeem their investments at any time, and the fund has to pay out. This results in the funds holding cash on hand to cover redemptions, which decreases efficiency as the asset is not being invested, limiting returns. In addition, if the fund does not have enough cash on hand, they will have to liquidate part of their portfolio. Hedge funds have lockouts and limitations on redemptions, enabling them to maximize returns (Levy, 2023). If investors cannot redeem their portion, then the fund is able to invest it all as they see fit.
These investment vehicles can be excellent ways to invest your money. While they might be riskier than, say, an index fund, they are usually exponentially more profitable and can be safer than other investment strategies due to their hedging, leverage, and expertise. Unfortunately, these funds are not available to the average Joe. Hedge funds have exorbitantly high minimum investments, usually over $1,000,000 (Levy 2023). That being said, if you have the ability, consider investing in a hedge fund. Understand that there may be an additional risk, but also keep in mind that they can generate an incredible amount of alpha.
Works Cited
Levy, A. (n.d.). Hedge Funds vs. Mutual Funds. The Motley Fool. https://www.fool.com/investing/how-to-invest/mutual-funds/hedge-fund-vs-mutual-fund/
FUNG, W., HSIEH, D. A., NAIK, N. Y., & RAMADORAI, T. (2008). Hedge Funds: Performance, Risk, and Capital Formation. The Journal of Finance (New York), 63(4), 1777–1803. https://doi.org/10.1111/j.1540-6261.2008.01374.x
Mallaby, S. (2011). More money than God : hedge funds and the making of a new elite. Penguin Books.
Assets managed by hedge funds globally 1997-2019. (n.d.). Statista. https://www.statista.com/statistics/271771/assets-of-the-hedge-funds-worldwide/
