Hedge Funds Definition - What is a hedge fund?

"Hedge Funds" or "Hedged Funds" or "Hedge Fonds" are funds that use different strategies to compensate against losses. For example, in equity market, hedge funds use short-selling (borrowed stocks) trading strategy to compensate against market downturn.

There is no proper definition for a hedge fund but these funds can be easily identified by some key characteristics like investment style, investment size, investment fees, leverage options etc.

Hedge funds are for highly sophisticated investors and not for general public.

In reality hedge funds are loosely regulated private pool of money which invests in all kinds of "legal investments" to maximize the returns. It can be equities, futures, currencies, commodities, bonds, real estate and even they invest in "Weather Derivatives" (betting on weather conditions) or even seed capital start-up companies like private equity / venture capital funds. Unlike mutual funds, hedge funds have no restrictions on "where" they could invest or "in what" they could invest in.

Number of hedge funds has grown rapidly in the past few years to more than 10,000 funds all around the world and total assets of more than a trillion dollars. Closedown / failure rates of hedge funds are very low compared to the start-up of new hedge funds. With startup / seed capital from their own pocket and with a Bloomberg terminal, more people are starting hedge funds. Most of them are former brokers, asset managers or traders in big investment banks / brokerages who had already managed money for high-net-worth clients. But to become a successful hedge fund, they need to raise capital of at least 40 million, follow a disciplined investment process with a high focus on risk management controls and make a decent return of 8% or more in the first year of operation.

The boom in hedge fund launches has benefited the service providers the most. Companies providing start-up and compliance services, prime brokers, administrators, auditors, legal service provider's, third-party marketers, IT and technology consultancies, risk management and research consultants are making a fortune out of it. The minimum startup / launching cost could come around $300-500K and the service providers benefits the majority of it.

The equity long-short strategy with a long-bias is the most common hedge fund strategy used, other strategies like CTA / managed futures, global macro, distressed debt securities, fixed income are also common. Whatever the strategy, most funds profits from the price difference in stocks, futures, options, bonds, commodities, currencies / forex and other forms of derivatives. Other hedge funds uses event-driven / special-situations style which exploit the financial situations of companies during mergers, acquisitions, takeovers, bankruptcies or political changes in some countries.

When the market become crowded, some fund managers uses very different strategy approach like giving bank loans, funding research in healthcare, pharmaceuticals and biotech companies, aircraft leasing, investing in retail business, invest in alternative fuel production like ethanol biodiesel, etc. The basics is that, hedge funds invest in areas where they see the opportunity of making money and successful hedge funds are the one who identify and utilize these opportunities in early-stage and cash-in before it becomes overcrowded.

Aggressive hedge funds will give high returns in a short time but high risk is also involved. Most common hedge fund statistics to measure / calculate risk/return are sharpe ratio, sortino ratio, calmer ratio, sterling ratio and treynor ratio. Other common statistics are annualized return, standard deviation, downside deviation, alpha, beta etc.

Most of the United States hedge fund companies are based (head office location) in tri-state area (New York, New Jersey and Greenwich - Connecticut) but list of hedge funds in other cities like California, Chicago, San Francisco, Dallas and Boston are also growing. Major centers in Europe are London, Italy, France, Russia and Switzerland and leading the pack in Asia-pacific and other emerging markets are Japan, Hong Kong, Singapore, Australia and Brazil.

Investments in hedge funds are highly risky; you could even loose your whole investment if the fund manager's bet goes wrong. Few examples, In September 2006 two top ranking energy hedge funds betting on energy futures on oil and natural gas lost around 5 billion US dollars, one of the fund even lost the whole investment. In 2005 one of the Singapore's biggest global macro hedge fund betting on derivatives in Korean market lost around 20 million in a single trade. In 2005 a commodities / futures brokerage hid millions in losses leading to near collapse of the firm. And the list is continually growing.

Hedge fund frauds are also common in the industry; lack of not doing proper due-dilligence process is the main reason. Managers who claim guaranteed capital protection with high returns within a short period of time or promising very high returns with a new strategy, etc are the ones you should lookout for.

SEC (Securities and Exchange Commission) in US and FSA (Financial Services Authority) in UK and other regulatory authorities in Asian, European and Latin American countries has come up with a restriction that only wealthy / high net worth investors like accredited investors and family offices and institutional investors like private banks, pension funds, endowments, insurances etc can invest in hedge funds so as to protect the ordinary / small investors from loosing money investing in hedge fudns.

Hedge funds also have a restriction on minimum investment amount an investor can invest, generally small-cap and mid-cap hedge funds will have a minimum deposit size of 100,000 US$ to 250,000 US$ and large funds with billions of dollars in assets under management (AUM) have anywhere from 500,000 USD to 5 Million USD and some have a lock-up period also, which lock the investment for 1-2 years.

Hedge funds have two kinds of fees, management fee that you have to pay as long as the hedge funds are managing your money, it's usually 1%-2% of the asset, paid annually. Performance fee which will be 20% of the return the manager make from your asset, most managers also maintain a "high-water-mark", which means you don't have to pay incentive fee if the return falls below the previous highest return and a "hurdle rate", a minimum return the hedge fund manager must make before charging performance fee.

Hedge funds are prohibited from soliciting or advertising to a general audience through websites / internet, cold calling or other advertising media. So, hedge fund conferences, forums and seminars are popular as it provides networking opportunity for the managers and the investors and the event management companies are organizing more conferences every year due to the increasing demand. Prime brokerage firms hosting capital introduction meetings / road shows are also gaining popularity.

As hedge funds cannot advertise itself, their websites should be password protected and allow only qualified clients who fill up proper questionnaire. All the incoming and outgoing emails and all other electronic communications between the hedge fund firm's employees and the investors must be stored in secured servers and are subjected to regulatory verifications if needed.

Offshore hedge funds are funds which are domicile / registered in offshore / international financial centers like Cayman Islands, British Virgin Islands, Mauritius and Hong Kong in Asia. These funds are not subjected to SEC, FSA or other financial regulatory authority regulations and provide a lot of tax advantages.

Hedge fund managers and hedge fund analyst gets one of the best salary in the financial industry. Top managers are paid in millions and you can see few managers in the forbes list of richest Americans. Because the salaries in hedge fund industry are the highest, even entry-level jobs are very popular and have lot of competition among the employment seekers. Hunting for best talents is also a difficult task for the hedge fund recruiters.

Success of a hedge fund is depended on the quality of the manager, so an investor should do a proper due-diligence process and investigate track records of the manager before investing in a hedge fund. Also you must read carefully the offer documents, marketing and reporting materials provided by the manager like the private placement memorandum (PPM), DDQ's, presentations, prospectus, subscription agreements, etc which contains the fund's strategy, specific market risk involved and other practices which the advisors follow, frequency of fund performance (NAV, RoR) reporting, whether market research is done internally or outsourced, contact details of hedge fund managers and service providers, investor and personal references etc.

Usually hedge funds are managed by a single manager so it is also called "Single manager funds".

"Fund of funds" or "Fund of Hedge Funds" or "Multi-Manager Hedge Funds".

These funds invest in to many hedge funds and usually take a multi-strategy approach. Some may argue that, with a hedge fund software for fund of funds portfolio construction and optimization techniques and a subscription to the data-feed from a hedge fund database provider, they can easily create a fund of funds, but in reality that is only a part of the whole process. If you are not able to allocate assets in to the top performing hedge funds because the fund is closed to new investors then these software analysis become pointless.

Advantages of fund of funds:

Reduce the risk of putting all your money in one basket.
The minimum investment size is much less than hedge funds (10 000 USD to 100 000 USD), so with less money you will have the benefit of investing into top hedge funds where minimum investment runs into millions.
You have the opportunity to invest in best hedge funds that are closed for new investors.
You don't have to go through a pain taking due-diligence process like checking on fund manager's and traders background, credentials and reputation, evaluating the risk management controls which the hedgefund follow, check on whether the fund uses third-party administrator and auditor on accounting and auditing processes, verifying the trade execution volumes and leverage options from the prime broker, etc.

Disadvantage:

You are paying double layer of fees, one to fund of funds advisors and the other to the hedgefunds that these fund of funds invest in.
You will get only a moderate return on your asset when compared to directly investing in hedge funds.

Disclaimer : The contents of this site are for information purposes only and does not constitute investment advice or counsel or solicitation for investment in any security. We will not be liable for any direct, indirect, incidental or consequential loss or damage that may arise out of using the information in this site or relating to a linked third party website. Investments in hedge funds involve a high degree of risk and you could lose all your investment. You should carefully read a fund's offering materials, fund manager's track record and related information for specific risk and other important information regarding an investment in that fund before investing. Hedge funds are available solely to accredited investors and institutional investors and not to general public. The information in this website is based on data gathered from publicly available websites and other information mediums therefore do not guarantee its accuracy, nor completeness. We do not represent any hedge funds or investment/financial advisors nor give any investment recommendations.