16 Questions To Test What You Know About Hedge Funds

Ask anyone on the streets if they know what “hedge funds” are, and you will most likely be greeted with a blank look. And if not, thanks to bad press, a range of answers with often negative connotations. For example:

1. The name says it all. Well, they hedge.
2. It is a type of very risky investment. These guys are responsible for all, if not most, of the market crashes.
3. I have seen them on news. They charge ridiculously exorbitant fees but yet deliver mediocre results.

And the list goes on.

It might be instinctive, but as a professional in the industry, I see it as my duty to educate and correct any misconceptions that anyone might have about the work we do. Though I must admit that there are some facets of truth in these replies.

As an example, many hedge funds do hedge, but some don’t. It is a matter of what strategy they use. Depending on what type of risks you are looking at, hedge funds may not be any riskier than your typical passive index funds or buy-and-hold stock portfolio. In fact, some risks, such as market risks, can actually be lower. As for fees, I would not deny that it is higher than most traditional investments. There are many debates on this both for and against. But ultimately, investors determine what they are willing to pay depending on the value they perceived. What perhaps might be a surprise to some though, is that despite performance trailing the markets in recent years, hedge funds actually still outperform over the longer term (starting from the 90s).

I will leave these for now, each of which can be a lengthy topic by itself. For now, let’s answer some basic questions.

1. Who founded the first hedge fund?

Many people does not know the answer to this question, even for those who work in this industry. Most just never bother to ask themselves this question and I am one of those when I first started my job. It is not a requirement to know and neither is it something that ever pops up in the course of my work while talking to colleagues or clients. At least, not that I remember. People tend to talk more about the greats of their time — Paul Tudor Jones, George Soros, Ray Dalio, Kenneth Griffin, Steve Cohen, Jim Simons, etc. But, still, I believe it is good to know, especially for someone who works in this industry.

There are 2 persons who can claim credit to the founding of hedge funds. The more well-known is an Australian named Alfred Winslow Jones, and the other, an American called Karl G. Karsten. Interestingly, both of them were not finance professionals to start with.

Karl G. Karsten (1891–1968)

Karl G. Karsten was a statistician and economist. In the course of his research work, he developed certain “barometers” to forecast business conditions. These included measures on volume of trade, interest rates, wholesale price level, building activity etc. In the 1930s, he applied these “barometers” to the stock market by starting a private fund using his and his colleagues’ money. He set the foundation then, perhaps for the first statistical arbitrage fund, where he bought a group of stocks that are predicted to do best and shorted another that are predicted to do worst. According to records, his fund did very well. In less than 6 months, it was up 78%, and it displayed desirable characteristics such as the ability to make large gains while keeping losses low. It also exhibit a return profile that is independent of the market it trades. However, his sole objective is to test out his theory. There was no intention on his part to ever evolve this into a commercial for-profit fund.

Alfred Winslow Jones (1900–1989)

Alred Winslow Jones was born in Australian, but moved to the United States at the age of 4. He is also acknowledged as the “father of the hedge fund industry”. Prior to his involvement in hedge funds, he had worked as a diplomat and journalist. He also subsequently earned a doctorate in sociology. So why was he given this title? Because after that, he pioneered the first commercial for profit hedge fund in 1949 with a significant amount of his own money using a partnership structure. This partnership structure helped him circumvent the restrictive Securities and Exchange Commission (SEC) regulations, allowing him more flexibility in his choice of investment strategies. He also took a 20% cut of the profits on the fund and charged no fees if he did not make any money.

He based his strategy on 2 simple principles: (1) he believed he has superior stock picking skills, (2) but he is unable to predict broad market directions. So what he did is also similar to what Karl G. Karsten did, he bought stocks that he thinks will do well, and shorted those that he thinks will do badly, albeit using different proportions and means to select the stocks. The shorts are what constitute the concept of a hedge and hence the name “hedge funds”. The net result is a portfolio that was less sensitive to broad market movements and with profits that were highly dependent on his ability to pick the right stocks. In addition, he took on leverage to amplify his returns, by using the proceeds from his short sales to increase the positions of the stocks he bought. What he did then is still very much relevant today.

2. What are hedge funds?

This might disappoint you, but a simple definition does not exist. You can easily look up the websites like Investopedia or Wikipedia or read from books. Most of the answers will be along lines that hedge funds are alternative investments, pooled funds, lightly regulated, accessible only to accredited investors, pursue aggressive strategies (e.g. shorting, concentrated bets, use of derivatives, leverage etc), illiquid, and measured on absolute returns and so on. These are all correct but rather restrictive definitions.

You cannot rely on the literal meaning of “hedge” as well. Modern day hedge funds, even though they are still called “hedge funds”, have evolved to do all sorts of different things other than what Karl G. Karsten or Alfred Winslow Jones started. The concept of a hedge may not be as strong, or even just outright not applicable to some of these funds. Even the boundaries between hedge and mutual funds are blurring. For example, long-short strategies use to be associated only with hedge funds. Today, you can also find special long-short mutual funds such as the 130–30. On the regulation side, hedge funds, meeting certain criteria, can also be offered to retail instead of only accredited investors. So do not be too obsessed with finding a perfect definition.

3. How much assets are held by Hedge Funds?

As at 1stquarter of 2018, the Assets Under Management (AUM) for hedge funds stands close to USD 3 trillion. You can visit Barclayhedge.com to see the latest information. The AUM has steadily increased from year 2000, only to suffer a huge drop during the 2008 financial crisis. But as of today. it has broken the prior records.

4. What is the relationship between the Investment Management Company (IMC) & Hedge Fund?

People often use certain terms of a hedge fund structure loosely in a casual conversation. This can often lead to confusion later. For example, some refer to the hedge fund and its investment management company interchangeably. This is especially when their names bear close similarities, which is frequently the case. For example, you can have ABC Capital Pte Ltd which manage ABC long-short equity fund and ABC global macro fund.

The fund is a separate entity set up to hold money and make investments according to the fund’s offering documents. The investment management company (IMC) is a licensed entity that is appointed to manage the fund’s investments. It does the research, makes the investment calls, size up the positions, execute trades, monitor risks, does the marketing and handles investor relations etc. In majority of the cases, this company is also the one that sponsors and sets up the fund. The IMC, together with other service providers engaged by the fund, carry out most of the work. Other than a board of directors, the fund has no employees. Such an arrangement is not unique to hedge funds. You will find similarities within the more well-known mutual fund industry.

The portfolio manager is the person in the IMC that manages investments for the fund. This person can be an employee, but more often than not, he/she is also a stakeholder in the IMC and has a personal investment in the hedge fund itself.

5. Why do we need a separate fund entity? Why not just do everything within the IMC?

The segregation of the fund from the IMC benefits both the IMC and the investors. In such an arrangement, investors can participate in the fund’s profits without taking on business risks associated with the IMC. The fund pays a management fee to the IMC but is not liable for expenses incurred by the IMC such as office rental, computer infrastructure, utility, and manpower costs. If the IMC were to go bust for whatever reason, creditors will also have no claim over the investor’s assets in the fund, except for the IMC’s own investment in it, if any. The IMC in turn gets full discretion over the management of the fund and is able to fully concentrate on investment management to deliver on its returns. If there is any perceived downside, it would be that investors in the funds have no voting rights or say in the management of both the IMC and the funds. They can, however, exit the fund by way of redemption according to the terms stated in the offering documents.

6. What is a pooled investment and are there any implications?

The concept is simple. Let’s say you are good at investing and would like to help your family and close friends make some money. So you raise money from them and put it all into a single broker account under your name to trade or invest on their behalf. In this scenario, you might want to note that while the broker holds the money, it does not how much belongs to who. As far as they are concerned, it all belongs to you. Thus, the onus is going to fall on you, or someone else that the people who parked their money with you can trust, to maintain proper records of all the transactions and keep track of how much each person holds in the account.

Sounds like common sense? Yes, that is the gist of it. But in an institutional setting like hedge funds, you are not just going to be dealing with your family or close friends who have absolute trust in you. You will need to have proper legal structures and safeguards in place. For that purpose, most funds engage external service providers such as fund administrators to perform this function. This gives assurance that the IMC cannot freely manipulate the numbers.

There are benefits to such a set up. A pooled arrangement provide investors, even smaller ones, with economies of scale such as lower trade commissions, lower borrowing costs, better broker services, ability to diversify more widely across different assets, regions or strategies etc. It is also easier for the portfolio managers operationally, since they just have to focus on managing a single pool of money without concerns on conflicts of interests.

7. Are there other alternative besides a pooled fund?

Some IMCs do offer what is often called managed accounts as an alternative to a pooled structure. In that case, a separate hedge fund entity is not needed. What are managed accounts?

Let me use back the previous example. So instead of pooling all the money into an account under your name, you ask each one to open their own personal broker account and fund it. After that, both parties will agree on terms like performance targets, risks and compensation etc. Then your family and friends will authorize you to trade on their broker accounts. Basically, that is it.

Hedge fund managed accounts operate in a similar way. This type of arrangement is actually gaining favor among investors as there are various advantages. It is gives psychological security since the money remains with the investor. Investors have greater flexibility and control to tailor the investment solutions to their needs. They have full transparency on their account to know what is happening to their funds. On top of that, large investors can often negotiate better terms, e.g. lower fees, for themselves. However, managed accounts can be operationally taxing for the IMC since they would have to juggle conflicts of interests, trading and record keeping among multiple accounts. In addition, if the account is too small, it may not be feasible to implement certain strategies. Hence, hedge fund managers usually require managed accounts to be of a certain size before they think it is worth taking on.

8. Why is there an onshore and offshore version of the same fund?

If you have followed news or readings on hedge funds, you will most certainly come across funds that seem to have an onshore and offshore “version”. I was baffled too when I first encounter these terms while trying to compile performance data about a few hedge funds I was researching on. That was more than a decade ago.

Onshore funds are domiciled in the local jurisdiction and offshore funds are funds domiciled in other foreign jurisdictions. As it turns out, tax implications are the impetus behind the use of an offshore fund which is typically incorporated in a tax haven such as Cayman Islands. And do not be mistaken, this is not some shady tax evasion plan. It is entirely legitimate and sensible. These offshore fund caters to foreign investors and other tax-exempt entities so that they will not be subject to any inadvertent tax from the local jurisdiction of the onshore fund. For example, if you are a non-US investor and you invest in a US onshore fund, you might find yourself subject to certain US taxes such as income tax if the fund engage in specific activities, and estate tax upon death.

The solution to this is to park your money with the offshore fund instead. To cater to global investors, many US funds adopt a master-feeder structure, with an onshore US feeder fund for US investors, an offshore feeder fund for foreign or tax exempt investors, and an offshore master fund. The 2 feeder funds will invest everything into the offshore master fund. All investment activities are carried out in the master fund.

9. Who can invest in hedge funds?

Hedge funds in most jurisdictions are lightly regulated. This frees them to implement non-traditional strategies that would not have been possible, say, in a mutual fund. But this flexibility comes at a price. Most hedge funds are only allowed to be marketed and sold to accredited investors.

Someone who is accredited is assumed to be sophisticated enough to understand and undertake the risks involved. What does it take to be “Accredited”? For individuals, the yardstick to qualify as one is rather superficial. On most part, you just got to show that you are rich. How rich? That depends on the regulations governing where the fund is offered. In the United States, you would need a net worth of USD 1 million excluding the value of your primary residence or have an annual income of USD 200,000 or more in the last 2 years. In Singapore where I am, you will need to have a net personal assets of at least SGD 2 million or have an income not less than SGD 300,000 in the preceding 12 months.

For institutions, licensed and regulated entities such as banks, fund of funds, sovereign wealth funds, pensions or listed companies are all eligible as investors. You can look up a compiled list of what it takes to be accredited in different countries on Wikipedia.

10. What kind of strategies can hedge funds use?

Hedge funds can use non-traditional strategies to make money. This is in contrast from most mutual funds that are mostly long-only. Long-only funds can only pick and buy securities. Hedge funds can short-sell, trade on margin (leverage), use derivatives, take on concentrated bets, buy and trade physicals such as real estate/gold/oil and much more. This greatly widens their latitude to make money in different market conditions, thereby producing a different return profile from mutual funds. This is their major selling point as another asset class to own for diversification benefits.

There are a whole multitude of different hedge fund strategies today ranging from equity long-shorts, activists, sector specialist, distressed investing, event driven, convertible arbitrage, merger arbitrage, global macro, multi-strategy, volatility to fund of funds and more. A few can technically be classified under the umbrella of a broader strategy. But do not be too fixated on these strategies as I will not be touching on them here. It is good enough to have a flavour of how diverse the hedge fund strategy landscape looks.

11. What are hedge fund’s benchmark and how does it differ from mutual funds?

For mutual funds, it is more straightforward to see if the manager is adding any value through his active management. Since their scope revolves very much around their designated market, you can compare how the fund did against its benchmark (usually some market or composite index). You can call this the relative returns approach. A good active mutual fund will be able deliver stable and consistent excess return (after fees and expenses) above their benchmark. To achieve this, the mutual fund manager would have to be a star performer in picking both good stocks to overweight and bad stocks to underweight. The difficulty to outperform the benchmark is compounded by fees which over time can take a hefty chunk out of the returns. For the same reason, passive mutual funds or index funds, which are simply set up to replicate a market index, will always underperform its benchmark.

Hedge funds are measured based on absolute returns as opposed to relative returns used by mutual funds. Absolute return is like a fixed or range of target returns which the hedge fund will aim to deliver regardless of market conditions. Why adopt such a measure? First of all, a key motivation behind early and many modern hedge funds stems from being independent of the market. Secondly, it is difficult to set a meaningful benchmark for hedge funds. Even funds among the same class of strategy can be radically different. For example, both a long-volatility fund and a short volatility fund would be grouped as volatility funds and perhaps be compared against a volatility hedge fund index. But because most volatility hedge funds are short-volatility, the index will be heavily skewed towards short-volatility. It would not then make much sense to compare a long-volatility fund against it.

12. Do hedge funds really make money in all conditions since they pursue absolute returns?

Personally, I do not fully agree with the definition of hedge funds aiming to deliver regardless of market conditions. Modern day hedge funds are much more diverse and there are some with very specific focus. For example, there are long-only hedge funds and these funds are not immune when the bear hits. There are also dedicated short-bias funds and long volatility funds that specialize in being a hedge for tail events. These funds keep a slow-bleed on most of the time since market is usually on an uptrend and volatility keeps decaying over time.

You might be thinking who would want to run such a fund. Would anyone even invest in them? The answer is yes. Because when the big crash comes along and trounce most people out there, these guys jump through the roof and have their last laugh. So they fill an important gap in the portfolio of large institutional investors who allocate capital to these funds to get the protection they need during bad times.

Hence, we should not take the definition of absolute return as a one size fits all. All strategies have will their own strengths and weaknesses. What is more important is for the investor to do his/her own due diligence to understand and find out what each fund is made out to do before plunging in.

13. How transparent is a hedge fund?

Most hedge funds are shrouded in secrecy. In the first place, they are not allowed to market publicly so it is no wonder not much is known about them. Unlike mutual funds which published a lot more information on their reports such as country, sector, industry exposure and their largest holdings, hedge funds are not required to do so. There are no governing standards on the reporting format. What is reported will differ from fund to fund. But most hedge fund reports will display basic metrics such as month-to-date return, year-to-date return and a commentary. If investors require full transparency, they are better off opting for a managed account if it is available.

14. How liquid are hedge funds?

Liquidity is how readily you can buy or sell something. For example, actively traded large-cap stocks are highly liquid. You can buy or sell the stock in large quantities during trading hours without materially impacting the price of the stock. Mutual funds are also considered liquid investments since you can subscribe or redeem from it on a daily basis. Hedge funds, however, are a lot less liquid in comparison.

The liquidity terms among hedge funds can vary a great deal. It is really up to the fund’s sponsor, usually the IMC, to define the terms in the offering documents. To a large extent, it depends on the strategy of the fund. A short term trading fund with holding period of days to weeks may provide monthly liquidity or better, meaning you can subscribe or redeem every month. An equity long-short fund that invests over a long term horizon may provide quarterly or semi-annual liquidity, and quite often, also impose a lock-in period of a year or more. Lock-in is a stipulated period where the investor is unable to redeem (hard lock-in) or can redeem but with a penalty (soft lock-in). On the other end of the spectrum, funds that deal with private equity or hard to liquidate assets can lock your money in for as long as 5–10 years.

15. What are the fees and expenses associated with investing in a hedge fund?

Let’s look at the more well-known and debated one first — fees. Hedge funds generally charge what is known as 2 and 20 in the industry. This means an annual 2% management fee and 20% performance fee. These fees are paid to the IMC. The 2% management fee is calculated and deducted monthly (pro-rated). This is to pay the IMC for their investment management service. It goes to cover running costs and salaries of the employees in the IMC. The performance fee may follow a different schedule, say, quarterly, semi-annual or annual. At the end of each scheduled period, if the fund’s value rises above the previous high water mark (previous high made at the end of each scheduled period), it takes a 20% cut of the profits. If the AUM of the hedge fund is large, this payout can be substantial.

The fund also incur expenses which are deducted off directly from the fund. These are not included in the fees. For example, the initial set up costs of the fund is usually borne by the initial investors. The fund also pays a host of other things such as fees to the fund administrator, fund auditor, fund legal counsel, fund custodian, regulators, distributors as well as trading related costs such as market data, broker commissions, etc. While these expenses can be material for a starting hedge fund with little assets, it becomes a lot more manageable if the fund size grows huge and it is spread out over more assets.

Overall, hedge fund fees and expenses are higher than mutual funds whose expense ratio which can be as low as 0.25% (passive index funds) or more than 2% (active managed funds) and it covers pretty much everything. This glaring difference pressured many hedge funds into lowering their fees especially with increasing competition and lackluster performance in recent years.

16. Can I use hedge fund type strategies on my personal trading account?

The answer is both yes and no. You can have the expertise but that is not all there is to it. While some strategies like equity long/shorts can certainly be replicated on smaller accounts, there are others that are simply out of reach for the average person. As an example, a hedge fund that trades a diversified portfolio of futures contracts such as e-mini S&P 500, Nikkei 225, 10 Yr Treasuries Note require a certain size to implement (without taking ridiculously high leverage) as each contract is currently valued at more than USD 100,000 each notionally. High frequency trading strategies are also beyond the means of most people due to the high set up cost. Activists funds are also not for the typical Joe, as it requires you to buy huge stakes into the company to steer and influence management decisions.

_____________________________________________

That’s all for now. Hope this gives you a better idea of what hedge funds are, how and why they operate as they do, and some of their distinctive features.

Originally published at investmentcache.com on September 18, 2018.