What is a Hedge Fund and what are some of the key characteristics that make them such a unique investment tool?
What is a Hedge Fund?
Founded by Alfred Winslow Jones, and a concept that only became widely known by 1966, a Hedge Fund (HF) is an investment fund where accredited investors can invest their money for an absolute return on the market.
Ok, so let me digest that. An investment fund attracts capital (money) from investors who pay the owners of the fund a fee (usually around 1-2%) to, in turn, generate a positive return on their investment. Accredited investors are investors that earn over $200,000 a year and have a net value exceeding $1 million. Absolute return is the attempt to seek a positive return whether the market is rising or falling.
Key characteristics that make Hedge Funds unique
- Private partnerships: HFs are created as partnerships, this is because a partnership structure has benefits regarding regulation. As a result of structuring themselves as a partnership HFs don’t need to register with the SEC and therefore avoid ‘restrictive’ legislation. A HF will have ‘managing/general’ partners, who are in control of the fund’s strategy and performance and also invest in the fund, which helps reduce conflicts of interest. The ‘limited’ partners in the HF refers to the accredited investors.
- Incentive fees: Whilst ordinary mutual funds only charge a management fee on their total funds under management, HFs pioneered the introduction of the incentive fee. Typically known as 2&20, the incentive fee is a payment that is made when a specific target, or exceptional performance, is met. 2&20 refers to a 2% management fee and a 20% incentive fee that is paid when performance targets are achieved. One example of a performance target is the ‘water mark’, where HFs can only charge an incentive fee if they reach a higher total amount of assets than their previous high. Incentive fees have also changed the philosophy of HF strategy, with some HF managers dubbing it ‘a strategy of picking the right stock analyst, as opposed to the right stock’, as it is believed the incentive fee will be enough to provide a suitable stock analyst with the right amount of desire to achieve exceptionally high returns for the fund.
- Leverage: Unlike mutual funds most HFs employ heavy leverage techniques, which is the process of borrowing money to magnify the amount you can invest. This means that HF’s transactional influence can be many times higher than the actual assets they have under management. For example a HF may have $500 million of assets from investors, but leveraging means they could place market positions of up to, or beyond, $750 million.
I thought it wouldn’t be right to complete a post on HFs and not mention some of the controversy they generate.
One of the main issues is with leveraging. Whilst it offers significant returns it is very risky, as it can also result in significant losses. An example of leverage famously going wrong is with the LTCM fund.
LTCM had a great start to its hedge fund career, it returned 21% in its first year, 41% in its second and 43% in its third. However following the Asian Financial Crisis (1997) and the Russian Financial Crisis (1998) it made a loss of $4.6 billion in just 4 months. LTCM collapsed following this loss and required a controversial and significant bailout lead by the Federal Reserve. It was deemed that LTCM had too much power over the market to be rescued and allowed to liquidate without government intervention. This brings back the favourite 2008 phrase of ‘too big to fail’.
Some critics have also argued over the role HFs played when it came to the acquisition of Cadbury by Kraft. Cadbury found that HFs developed large positions in their stock in the build up to the buyout, with many HFs looking to make a quick return by voting for the acquisition to take place. Cadbury had very unique values regarding its workforce and the first action Kraft took was to close a factory resulting in job losses, an action they had previously agreed not to go through with. This caused a great deal of controversy and led to a number of legislative talks in the UK about how to better protect our businesses from foreign takeover (source). It can be argued that HFs, in this case, caused harm to our society by aggressively seeking a quick return from the acquisition.
Let’s wrap this up
There’s no doubt Hedge Funds make money, and often a very significant amount. Their unique investment strategy of focusing in exotic financial instruments and seeking ‘alternative’ assets means that they tend to out-perform traditional investment funds.
But are they good for society and should they be more heavily regulated? What are your thoughts, are you a supporter or detractor?