As in case of the concept behind every investment, hedge funds idea is to maximise returns for the investors and trying to contain the risk associated with it. The investors pool their money in the fund which allows the fund to invest according the risk appetite and generate returns. There is a variety of strategies applied by hedge fund managers; they can investment in anything that is not prohibited under the law of the jurisdiction they operate in, for example they can invest in equity, futures, land, real estate, derivatives, currencies, and other alternative assets.
To achieve the desired returns Hedge funds strategies, including long and short investments to leverage risk. They can invest across different geographical locations as well as domestic market. Depending on the strategies and financial benefits, Hedge funds can create different types of structures to allow them to operate in the most efficient and cost-effective manner.
How does a Hedge Fund Operates:
The daily operations for the hedge fund is handle by the fund managers who has the responsibility to invest in equities, derivatives and other securities in accordance with the fund’s objective. They sell the strategy to the investors and get them interested to invest. The investors are institutions or high net worth individuals who can give the minimum amount of investment required generally around $100,000 to $200,000.
Hedge Fund Structures
Some of the most famous structures in the Hedge Fund World are:
This fund, as the names suggest, incorporates everything investors, investments, fees etc into a single legal entity with its own governing body. The fund operates everything on it own and has a specific strategy of investments for its investors.
ii) Master Feeder
This structure consists of two or more funds handling the investments separately to the investors (with very few exceptions). The Master and Feeder Funds are two separate entities but Governed generally by the same people. A simple master feeder fund will have a legal entity who does the investments on behalf of the investor which is called the Master Fund and the other legal entity will be feeder fund that takes care of the investor money as it comes in and passes on the amount to the Master Fund.
iii) Fund of Funds
This is where the hedge fund invests in the other establish Funds and buys shares/units in them and gains by benefiting from their investment strategies. Fund of Funds type structure has its own opportunities and perils. The management and incentives fees can be doubled for the investors on the other hand the investments made and money movements are taken care of by the invement manager of that particular fund,
Hedge Fund Strategies
To achieve the goal of maximising the profits for the investors, in certain cases the hedge fund manager may invests in high risk investment where there are high returns. There are several investment strategies that the hedge funds deploy to achieve its goal which is determined by its investments. Some of the most common strategies are listed below:
Equity (Long/Short) Hedge Funds
This is the hedge fund in its simplest. It attempts to hedge against declines in equity markets by investing in stocks or stock indices and shorting them in case of stock being overvalued. This type of fund is also called a vanilla fund as there are no major complexities in this strategy.
Macro Hedge Funds
The macro hedge funds invest in stocks, bonds, futures, options and currencies in hopes of benefiting from changes in macroeconomic variables. It looks into variables global trade, interest rates, policies and rifts to ensure the maximise the gains. The investments are usually highly leveraged and highly diversified which puts there funds in the high risk category of going bust pretty quick.
Relative Value Arbitrage Hedge Funds
These types of funds typically seek to exploit mis-pricings of related securities. The managers determine if an asset is undervalued or overvalued and accordingly buy or short them. It is a common strategy of relative value funds where a long and short position is initiated for a pair of assets that are highly correlated.
Distressed Hedge Funds
These funds are involved in loan pay-outs or restructurings. They may buy cheap bonds that are expected to appreciate or loans at a cheap rate, they can be risky given that the company’s stock or bonds are not assured to appreciate.
Hedge Fund Fees
There are two types of fees that investors pay in a hedge fund one is the management fee and the other is the incentive or performance fees. They typically charge a management fee of 1-2% of fund’s net asset value. This is paid irrespective of how the fund performs. The incentive fee is generally 20% of profits based on the benchmark or a hurdle rate (including high water mark).
High water mark is the concept that the hedge fund managers will receive the incentive fees only if the fund exceeds the pre-agreed threshold of the NAV. it has previously achieved. This is to ensure that the incentives are not paid on the profits that were just used to offset the losses of previous years. The calculation of profits for calculating incentive fees may differ between the funds and can follow different structures. This structure can be a bit hard to sell for some investors since the fund manager gets the asset management fee – which can be very high and it is paid by the investors regardless of how the fund performs. However, a point to note is that hedge fund managers tend to have their own money invested in the fund, which shows that their interests are aligned with the Fund’s performance.
Mutual Fund vs Hedge Fund:
Following are some differences between these two major categories of investment vehicles:
Mutual funds charge only a management fee, which is typically set at around 1–2%, and are heavily regulated around the amount and types of fees they can charge. They don’t take share from the profit
Mutual funds are open to general public and often have a low minimum investment threshold
Mutual funds are highly regulated and cannot make high-risk investments. As a result when compared to hedge funds the perform on the lower side.
On top of the management fees (around 1-2%), hedge funds also charge incentive fee or performance fee i.e. share from the profits which is normally 20%.
They target high-net-worth and sophisticated investors including institutions.
Comparatively less regulated hence can do high risk investment. Generally, tend to perform better than mutual fund due to it risk taking appetite.
Investing in the Hedge Funds…
Before thinking to invest in a hedge fund, a person should make sure they are prepared from a risk point of view and financially strong for the venture. There needs to be a due diligence done by the potential investor, to decide how aggressive and risky they wish to be and what are the goals that need to be achieve. A proper research of different funds and understanding the needs of their own, the investor should what fits best with the desires and capital availability.
Ali Boricha, Author has over 18 years of experience in Financial Reporting, Internal controls over reporting and Accounting with Global Organizations. Qualified in 2003 and he pursed some additional qualifications as gained more knowledge of different working environments and cultures. Most of my experience relates to Financial Services especially Private Equity, Real Estate, Hedge Funds and Mutual Funds but I have exposure to non-financial services client as well. He is based in Ireland with Multidimensional organisation world-wide.
Disclaimer: The content of this article is for information only and is not offered as an advice. Readers are encouraged to consult a suitably qualified professional adviser to obtain advice tailored to their specific requirement.