What Is A Hedge Fund?
A hedge fund is a private pool of money managed by professional managers whose main goal is to maximize returns for investors as quickly as possible in both up and down markets. Hedge funds are similar to mutual funds but have some very different characteristics.
For example, hedge funds are generally open only to large institutions or to "accredited" investors who must meet certain high asset and income size criteria, while most mutual funds are open to the general public and often have low minimum investment requirements.
Compared to mutual funds, hedge funds are lightly regulated, although they have become subject to more government oversight in recent years.
Greater Freedom In Investments
The biggest difference between the two is the types of assets each invests in. Most mutual funds concentrate on a specific type of assets, such as stocks or bonds, or a specific subset within those categories, such as short-term bonds or dividend stocks.
Hedge funds, by contrast, have much more leeway in what they invest in. Often, the fund invests in whatever the managers believe will generate the highest and quickest returns in both up and down markets. That could include stocks and bonds, commodities, options and futures, currencies and derivatives. They also employ various strategies, such as shorting assets and using leverage—i.e., borrowing money—to magnify returns.
Indeed, that's how they acquired their name, because they can "hedge" their bets by employing such strategies. In reality, hedge funds often take on very large risks. For example, they have the freedom to place outsize bets on assets they believe will outperform, even if that raises their risk. Mutual funds, by contrast, are largely prohibited from doing those things, unless their offering documents explicitly say they can.
Differences From Private Equity Funds
Hedge funds also have similarities with private equity funds, although there are sharp differences between them as well.
Both hedge funds and PE funds are mainly open only to large and accredited investors. Both also charge very high fees to their investors—generally 2% annually plus 20% of any profit they generate. By contrast, mutual funds generally charge 1% or less, sometimes much less.
The main differences between hedge funds and PE funds are in their respective investment time horizons and the way they put their money to work.
While PE funds invest for the long run—10 years or longer in some cases—hedge funds look to make quick returns. Likewise, PE funds take a very active role in the companies they invest in, usually installing their own management team and deciding the company's business strategy. Hedge funds, by contrast, usually invest in very liquid assets, such as publicly traded stocks, bonds, currencies and commodities and move in and out of them as they see fit.
Hedge funds and PE funds both require their investors to lock up their money for long periods, although the requirements for PE firms are much more stringent, often several years. Investors in hedge funds, by comparison, can usually take their money out every quarter, although some funds require longer lock-up periods. However, that differs sharply from mutual funds and exchange-traded funds, where investors can usually sell their shares the same day.
Hedge Fund Criticisms And Scandals
Hedge funds are less-tightly regulated than other financial institutions like banks and brokerage firms, so their risks to the overall financial system can be hidden, often until it's too late to do anything about it. That was the case in one of the most publicised hedge fund blowups in history that nearly precipitated an international financial crisis.
Long-Term Capital Management
Long-Term Capital Management, which had US$126 billion in assets and returned more than 40% in 1995 and 1996, lost 50% of its value in 1998 after Russia devalued its currency and defaulted on its debt, which also caused a sharp drop in international stock prices. LTCM, it turned out, owed a lot of money to several large banks and Wall Street investment firms, which demanded their money back and LTCM couldn't pay.
Eventually the U.S. Federal Reserve needed to bail the company out, because its failure to repay the banks threatened the safety of those banks. Under orders from the Federal Reserve Bank of New York, 15 banks spent US$3.5 billion to rescue the company in return for a 90% ownership stake in the fund.
Some hedge funds have also been exposed as using questionable—if not outright illegal—techniques to generate their returns.
For example, in 2009, Galleon Group was forced to close after its founder Raj Rajaratnam and several of its employees were charged with multiple counts of fraud and insider trading. He and others were convicted and sentenced to long prison terms.
Rajaratnam got his information from Rajat Gupta, a member of Goldman Sachs' board of directors and the former head of McKinsey & Co., who was also convicted and served time in prison. For example, Gupta told Rajaratnam that Warren Buffett was planning to invest in Goldman Sachs in September 2008 during the financial crisis.
Prominent Hedge Funds
Here are some of the largest hedge funds in the world, according to Pensions & Investments, as of 2017:
- Bridgewater Associates
- AQR Capital Management
- Man Group
- Renaissance Technologies
- Two Sigma Inv./Two Sigma Advisers
- Millennium Management
- Elliott Management
- Marshall Wace
- Davidson Kempner Capital Management
- Baupost Group
Hedge funds are lightly regulated, professionally managed private investment pools that are generally open only to large, accredited investors. The goal of hedge funds is to maximize returns as quickly as possible in both up and down markets by investing in a wide variety of assets and strategies, basically at the discretion of the managers. As a result, hedge funds, despite their name, often take risky bets. Hedge funds usually charge high fees and require investors to hold their money in the fund for long periods, in contrast to publicly traded mutual funds.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…