What Is A Hedge Fund?

A hedge fund is a pool of money from multiple sources or investors that is invested in various markets, using a number of different strategies. This is separate from more common funds such as mutual funds and exchange traded funds (ETFs), which are usually more restricted, typically focusing on one sector or type of stock. For example, a mutual fund may specialize in technology stocks or only small companies. They are limited in what kinds of trades they can make and must stick to the terms of their prospectus, a public document that lays out those restrictions.

Hedge funds, on the other hand, can buy any kind of stock and even sell them short. Selling short is betting on the failure of a company by borrowing stock to sell so that you make money if that stock goes down. They also trade in bonds, foreign exchange (also known as forex or the currency markets), commodities ... basically, any market that can be traded is fair game for a hedge fund. That answers the question of what a hedge fund is to some extent, but it doesn’t tell the whole story.

To break the phrase “hedge fund” down into its component parts, to hedge is to place a trade that is designed to reduce risk, or to offset or reduce losses in another trade. A fund is a pool of money, usually from multiple sources. That combination of “hedges” and multiple investors gives the impression that this type of fund is extremely safe, but that could not be further from the truth with regard to the modern funds.

They are, in fact, considered so risky as to be restricted by regulators, with only “accredited investors” (those with substantial trading experience, wealth and/or income - more on them later) and institutions allowed to invest in them.

A Brief History of Hedge Funds

Hedge funds weren’t always risky, though. In 1949, when Alfred Winslow Jones started the first hedge fund with his partners, the name was appropriate. What Jones worked out was that by combining two very risky strategies, borrowing money to invest many times the value of the fund (leverage) and short selling, as detailed above, it was possible to reduce risk while seeking good returns.

The leverage meant that the fund multiplied market returns when times were good, while the short component offset losses when the market fell. In other words, investors in the hedge fund could make a lot more money during good times and lose less when the market wasn't doing great.

Hedge Funds Today

These days, hedge funds have taken on different characteristics. In theory, the goal is still the same: to make money and limit losses. For example, a position in the currency market could be used to protect against potential losses in U.S. stocks. In reality, though, because of a focus on trading rather than investing, hedge funds are generally very risky investments for the public.

Losses can be huge, but when times are good, profits can be large. They have to be, to cover a controversial thing about hedge funds, their fee structure.

Hedge Fund Fees

Hedge fund fees are based on the old “2 and 20” system, where fund managers were paid 2 percent of the value of the fund, regardless of performance, and 20 percent of profits. Recently, some funds have reduced that to maybe a 1 percent standing fee and 10 or 15 percent of profits, but the result is still the same: the managers get paid no matter what, and only the investors bear the risk and get punished for bad performance.

As this opinion piece in the Financial Times points out, those types of fees can eat up around 80 percent of the returns in these funds. This situation is made worse by the fact that hedge funds typically have a “lock up” clause that severely restricts when and how investors can withdraw their money. You cannot just pull out of a fund that is underperforming: you have to give months, or sometimes years, of notice to withdraw money.

Who Actually Runs Hedge Funds

The biggest beneficiaries of those fees and restrictions are the fund managers, so it is reasonable to ask who these people are. Most are people who have had success in the past as traders or investors. The funds often bear the name of the manager, and in these days of intense media coverage of financial markets, many have become quite famous. You may, for example, have heard of Bill Ackman or Carl Icahn, two well-known fund managers who are often on the business TV channels pushing the benefits of their latest investment; a practice known as “talking your book.”

The “Carried Interest” Controversy

One of the biggest controversies surrounding hedge fund managers is that a large part of their compensation is, for tax purposes, treated as an interest in the fund, so-called “carried interest”, and is therefore taxed at a much lower rate than ordinary income.

Many people find the fact that people whose compensation is usually measured in millions get such a tax break puzzling, if not offensive. Cynics may point to the large political donations to both major parties that the industry is known for as reason that the carried interest rule is still in place.

Who Invests in Hedge Funds

There are, as mentioned above, two main types of investors in hedge funds, institutions, and accredited investors.

Institutional investors include pension funds from both state governments and trade unions, but could also be charitable foundations and trusts. They are not just based in the U.S., either. Institutional investors from overseas such as pension funds from China or sovereign wealth funds from Middle Eastern countries also invest in U.S. and other hedge funds.

Accredited investors are those that regulators deem suitable to invest in something as risky as a hedge fund. They must have a net worth of at least a million dollars and/or an annual income of over $200,000 for an individual. As of 2016, other ways to qualify are based on knowledge of markets. You can be an accredited investor if you are licensed in the financial industry or have significant job experience in the business.

Do Hedge Funds Actually Work?

There is growing evidence that, on average, hedge funds do not actually offer better returns than other investments. This Bloomberg article, for example, quotes a 2013 study that showed that in that year average hedge fund returns were ten percentage points below the return on the S&P 500. In five of the seven years preceding the article hedge funds performed worse than an average of global stocks.

It is hardly surprising then that, as this article details, many institutional investors are giving up on hedge funds.

So Why Do People Still Invest In Hedge Funds?

Given all of the controversy and problems, “why do people still bother?” is a reasonable question to ask. The answer seems to be for the same reason that millions of people play the lottery each year. The odds of winning may not be in your favor, but the rewards if you do are big enough to attract people.

In an era when traditional, interest paying investments return practically nothing and the recovery is slow and grinding, just the chance of spectacular returns can tempt even those who are normally quite cautious investors.

Despite those problems, the death of hedge funds has been predicted many times since their inception in 1949, yet they are still with us. Most people still believe that there is a magic formula of sorts to successful trading and investing. By giving their money to smart people with a track record they believe that they are closer to that formula.

As long as that feeling exists, and some funds offer market beating returns, hedge funds are here to stay and the question “What is a hedge fund?” will continue to be asked.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.