Basically, a hedge fund is a fancy name for an investment partnership. Its members are the fund manager (general partner) and investors (limited partners). Limited partners invest their money in the fund, and the general manages them in accordance with the chosen strategy. The goal of the fund is to maximize profits and eliminate risks, which is why its name is derived from the word "hedge". Perhaps this is where the similarity with other funds, such as mutual funds, ends.
The name "hedge fund" has stuck with these structures, as they seek to capitalize on both rising and falling markets. Hedge fund managers simultaneously take long and short positions in other assets (short positions allow you to earn on falling prices).
Key Features of Hedge Funds
- Open only to "accredited" or qualified investors: Contributors must meet certain capital requirements of more than $1 million, excluding the value of their primary residence.
- A wide variety of strategies: The choice of instruments is limited only by the mandate of the hedge fund. In fact, he can invest in any assets - land, real estate, stocks, derivatives, . For mutual funds, in contrast, only stocks and bonds are available.
- Use financial leverage: Hedge funds are often leveraged to increase returns. The financial crisis of 2008 perfectly showed that great leverage can lead to disastrous consequences.
- Fee structure: Hedge funds charge investors not only a fixed commission, but also a so-called “performance bonus”. Usually the fees are 2% and 20% - 2% for asset management, 20% of profits.
There are other distinctive features of hedge funds. They are private investment partnerships designed exclusively for wealthy savers and can do whatever they want with their money within a predetermined framework. Such a wide expanse may seem risky - sometimes it is. Some of the most notorious scandals in the financial industry have involved hedge funds. On the other hand, high flexibility attracts the most talented money managers to hedge funds, demonstrating impressive long-term results.
Hedge fund activity - fictional example
To better understand how hedge funds work and why they are so popular with investors and managers, let's create a fictitious fund and follow its performance for one year. Let's call it, say, the Value Opportunities Fund. The operating agreement, the legal document governing the activities of the fund, states that the manager receives 25% of income in excess of 5% per year. In addition, you can invest in any assets.
10 investors became interested in the prospectus of the fund, each invested $10 million. Thus, the assets amount to 100 million dollars. All depositors signed an investment agreement, similar to an account opening form, and sent checks directly to the fund's broker or administrator. The administrator reflected their investments in the balance of the fund, and then redirected them to the broker. Usually an accounting firm acts as an administrator. Now our fund is open and ready to go. The manager finds an attractive opportunity, calls the broker and instructs him to put all 100 million dollars into it.
A year has passed, and the fund's assets have grown by 40%, to $140 million. Now, according to the current agreement, the first 5% belongs to investors, and all income in excess of this amount is distributed in the proportion of 25% to 75% between the manager and investors. Thus, 2 million (5%) will be deducted from the 40 million received at the end of the year, and the remaining amount of 38 million will be divided between the manager and investors. This 5% is called the "threshold return" because the manager, in order to make good money, must first exceed it.
Based on the results of the year and the agreement with investors, the manager received $9.5 million. Investors have earned a total of 30.5 million. As you can see, working with a hedge fund can be very profitable. If his assets were $1 billion, the manager would earn $95 million, the investors $305 million.
Of course, managers are often criticized for such high compensation. However, people who condemn them (often the media have a hand in this) forget that investors also got a decent jackpot. When did you hear a successful hedge fund investor complain about the manager's fee being too high?