Understanding Hedge Funds (Key Points/Cheat Sheet)

Here are the key points from our video ‘Understanding Hedge Funds (A Brief Overview)’ that you can use as a reference guide or ‘cheat sheet’. The video is available on our YouTube channel and at the bottom of this article.

  • The birth of the hedge fund can be attributed to Alfred Winslow Jones who in 1949 took long positions of undervalued securities and short positions of overvalued securities as an insurance against the downturn in the market, thus creating a “Hedge Fund”, as he was hedging the position.
  • According to Warren Buffet, the roots of the concept dates back to the mid-1920s. Benjamin Graham who is widely known as the father of “value investing”, used the same strategy to hedge his investments and also to charge an incentive fee to investors. The strategy was to generate returns irrespective of the market’s direction. Hence, the name of the funds comes from the strategy itself.
  • The authorities have yet to assign the hedge fund a legal definition. Many regard hedge funds as an alternative investment vehicle, a pool of private funds managed by a sophisticated manager for the sophisticated and wealthy investors.
  • Due to their requirements and the structure, hedge funds are partially not regulated. Hedge funds cannot seek funds from the general public and they operate on a private investment partnership. Therefore, they have more operational freedom and can aim to generate returns in any kind of market regardless of the market condition.
  • In general, hedge funds and mutual funds fall under the same category of pooled investments. However, they are differentiated by the distinguishing attributes of the investors’ requirements. According to the SEC, an investor is considered accredited when they have earned an income of $200,000 in the last two years and expects the same in the current and the future year, or hold a net worth of more than a million dollars. This is required to ensure that the investor is able to take on the risk of investing in these unregulated securities. Therefore, the investor needs to be conscious of the uncertainties of taking such risk which in case of unexpected events could destroy their entire investment.
  • Unlike the traditional mutual fund managers, the managers of hedge funds are more diverse in nature and have the technical know-how to use exotic or complex instruments like derivatives to generate returns. The ability to go long or short in an asset, means they can also make use of more complex strategies such as equity hedging, tactical trading and arbitrage.
  • Because the managers have the skill to formulate their own trading strategies depending on the market conditions, they can charge an extra incentive fee on top of a management fee for their performance. The annual management fee ranges from 1% to 2%, independent of the performance of the fund. Additionally, the incentive fees typically range from 20% to 50%. This fee acts as an incentive for the manager to outperform and generate better returns in the market.
  • There has been a lot of pressure on hedge fund managers to reduce their fees. This year we have seen a lot of capital being withdrawn from hedge funds, particularly in Asia, due to the excessive fees they are charging and the availability of alternatives. This is also partly due to the relative underperformance of macro-related funds. This has led to a lot of money moving to private equity and real estate instead.
  • Overall there has been a big rise in the number of hedge funds, from 610 in 1990 to 15,000 in 2017. The funds that practice automation in their investment procedure have seen enormous growth in the hedge fund segment. Barclays claims that “Quants” are now responsible for around 17% of the total hedge fund assets.
  • This past decade has seen a sharp rise in the technological fields such as machine learning and Artificial Intelligence. A new kind of hedge fund is now combining machine intelligence to manage the investment of an American hedge fund. It is believed by some that the high usage of technology might prove to be helpful in preventing the market from large shocks in the future because AI will eventually exceed human abilities and perhaps get closer to solving the stability puzzle.
  • By nature, hedge fund managers tend to be secretive. Therefore, transparency remains a big issue when considering investing in hedge funds. The managers tend to be secret in their ways and the use of their strategies and may even keep the funds under a lock-up period whereby investors can only take out their funds during specific intervals that are set by the manager.
  • Hedge fund managers often use leverage to boost their returns and to make the fund more attractive. While leverage has got its benefits, it also has its downsides as it increases the volatility of the fund, thereby making it much more vulnerable to downside risk.

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