An introduction to hedge funds

QuietGrowth - An introduction to hedge funds

Hedge funds are alternative investments that use various strategies attempting to generate potentially high returns. Unlike mutual funds and ETFs, hedge funds are less regulated and can pursue more aggressive and speculative investment strategies.

Hedge funds typically use various complex investment techniques, such as leveraging, short selling, derivatives, and algorithmic trading, to maximise returns. They often invest in stocks, bonds, currencies, commodities, and real estate.

Hedge funds are typically open to accredited investors, meaning individuals with high-net-worth, and institutions, and usually require a large minimum investment. They have a high-risk, high-return profile. They may not be suitable for all investors, and it is essential to carefully consider one’s investment goals, risk tolerance, and investment time horizon before deciding to invest.

Different strategies of hedge funds

There are many different strategies of hedge funds, including:

  • Long/Short Equity: This strategy involves taking both long positions in stocks that are expected to rise in value and short positions in stocks that are expected to fall in value. The goal is to profit from both the upward and downward movements in specific stock prices.
  • Arbitrage: This strategy seeks to profit from the price difference between two similar financial instruments, such as stocks or bonds. For example, a hedge fund might buy a stock that is underpriced in one market and sell it in another market where it is overpriced.
  • Macro: This strategy involves investing in various assets, including currencies, commodities, bonds, and stocks, to profit from broad economic trends and macroeconomic events. For example, a macro hedge fund might bet on a rise in the price of oil by purchasing oil futures.
  • Distressed Debt: This strategy involves investing in the debt of companies in financial distress to profit from a turnaround or restructuring. For example, a distressed debt hedge fund might buy the bonds of a company that is in bankruptcy proceedings.
  • Event Driven: This strategy focuses on special situations, such as mergers, acquisitions, bankruptcies, and restructurings, and invests in companies undergoing these events. For example, an event-driven hedge fund might purchase the stock of a company that is being acquired in a merger.
  • Statistical Arbitrage: This quantitative strategy involves using statistical models and algorithms to identify mispricings in the market and profit from them.
  • Trend Following: This systematic strategy involves investing in assets experiencing upward momentum and avoiding assets experiencing downward momentum.

These strategies can help generate returns uncorrelated with those of traditional investments, such as stocks and bonds. Additionally, hedge funds may employ leverage (borrowing money to increase investment returns) and derivatives (financial instruments that derive value from underlying assets) to enhance returns.

History of hedge funds

The history of hedge funds dates back to the 1940s. The first hedge fund was established by Alfred Winslow Jones in 1949. He created the fund intending to combine the benefits of both long-term investing and short-term trading. He used a strategy of taking both long positions in stocks that were expected to rise in value and short positions in stocks that were expected to fall in value. This strategy, known as “hedging,” was designed to reduce risk and generate returns in both bull and bear markets.

Jones’ hedge fund was successful, and others soon followed his lead. By the 1960s and 1970s, hedge funds had become popular among wealthy individuals and institutional investors. In the 1980s and 1990s, hedge funds continued to grow in popularity and attract more investment capital.

However, the popularity of hedge funds also brought increased scrutiny from regulators and the media. In the late 1990s and early 2000s, several high-profile hedge fund failures and scandals, such as the collapse of Long-Term Capital Management, raised concerns about the risks associated with hedge funds. In response, the U.S. government passed legislation, such as the Hedge Fund Regulation Act of 2004, to increase regulation and oversight of the hedge fund industry.

Today, hedge funds remain a significant part of the investment landscape, managing trillions of dollars in assets. While some hedge funds have struggled in recent years due to poor performance and increased competition, many remain successful and continue to generate returns for their investors. The hedge fund industry continues to evolve, with new strategies and investment opportunities emerging all the time.

Number of hedge funds

Providing an exact number of hedge funds worldwide is difficult, as new ones are constantly being established, and others are being closed down. Additionally, some hedge funds operate in countries that do not have a robust regulatory framework, making it difficult to track their number and activities.

Estimates suggest thousands of hedge funds operating worldwide, managing trillions of dollars in assets. The largest concentration of hedge funds is in the U.S., where the industry has a long history and is well-established. Estimates suggest approximately 10,000 hedge funds in the United States, managing trillions of dollars in assets. It’s worth noting that the number of hedge funds has been declining in recent years in the U.S. due to poor performance, increased competition, and higher regulatory requirements. As a result, the hedge fund industry has become more consolidated, with a smaller number of larger hedge funds dominating the market.

The U.K. and Switzerland are also home to many hedge funds.

Many Australian hedge funds specialise in local and regional investment opportunities, including the country’s robust real estate and commodities markets. Estimates suggest several hundred hedge funds operating in Australia, managing billions of dollars in assets. Despite its growth, the hedge fund industry in Australia remains relatively small compared to other financial centres, such as the U.S. and the U.K.

Investment performance of hedge funds

The success of hedge funds is a complex and controversial topic. Some hedge funds have generated impressive returns for their investors over the years and have established themselves as some of the most successful investment vehicles. However, the rest of the hedge funds have generated inconsistent performance, and many have struggled to deliver positive returns in recent years.

It’s worth noting that the hedge fund industry is highly competitive, and many hedge funds have shut down due to poor performance. Additionally, hedge funds are known for their high fees, which can eat into returns. This has led some investors to question the value of hedge funds and seek other alternative investment vehicles that might offer better returns for lower fees.

It’s difficult to determine the highest returns ever given by hedge funds, as performance data for many hedge funds is private. However, some hedge funds have generated impressive returns over the years and have established a reputation for delivering strong performance. For example, some well-known hedge funds, such as Renaissance Technologies, Bridgewater Associates, and AQR Capital Management, have generated returns above 20% annually over long periods.

It’s worth noting that these are exceptional cases, and the vast majority of hedge funds have not been able to deliver returns of this magnitude. Additionally, even the best-performing hedge funds have experienced periods of weak performance, and investment in hedge funds is not without risk. As with any investment, it’s essential to carefully consider the risks and potential rewards before investing in a hedge fund.

Size of hedge funds

The size of hedge funds can vary widely, with some managing only a few million dollars in assets while others manage billions of dollars.

It’s important to remember that the size of a hedge fund does not necessarily indicate its investment performance or potential. Some smaller hedge funds may perform better than larger ones, and vice versa.

Net worth of an individual to access hedge funds

The net worth required to access hedge funds varies depending on the specific hedge fund.

Some hedge funds cater to institutional investors and require a minimum investment of several million dollars. In contrast, others cater to high-net-worth individuals and may have lower minimum investment requirements of several hundred thousand dollars or more.

Hedge funds often have access to investment opportunities not available to retail investors. Generally, the higher the minimum investment requirement for a hedge fund, the more exclusive and less accessible the investment will likely be. High-net-worth individuals and institutional investors are typically the primary target market for hedge funds because they tend to have the financial resources and risk tolerance necessary to invest in these assets.

Proportion of portfolio in hedge funds

Some high-net-worth individuals allocate a portion of their portfolios to hedge investments to diversify their holdings and potentially generate higher returns.

Many financial advisers suggest that a well-diversified portfolio of a high-net-worth individual should have between 5% and 10% invested in hedge funds. However, this is just a rough estimate, and the exact portfolio mix will depend on an individual’s specific financial circumstances and investment goals.

Hedge fund investments and play money

Usually, hedge fund investments of an investor are considered part of her play money.

Hedge funds as part of the satellite portion of core-satellite investing

The satellite portion of a core-satellite portfolio can contain hedge funds.

Hedge funds and long-term investing approach

Hedge funds can employ a wide range of investment strategies, and the investment horizon of a hedge fund depends on the specific strategies it uses. Some hedge funds are designed to be long-term investments, while others are focused on generating short-term profits.

For example, some hedge funds employ a “buy-and-hold” investment strategy, holding onto investments for a prolonged period to achieve long-term gains. These hedge funds are typically focused on generating long-term returns and may invest in various assets, including stocks, bonds, and real estate.

On the other hand, some hedge funds employ a more active, short-term trading strategy, in which they buy and sell investments quickly to generate profits from short-term market movements. These hedge funds are typically focused on generating short-term returns and may employ various investment strategies, including short selling, leverage, and derivatives.

Investor preference between hedge funds and private equity

Both hedge funds and private equity have unique investment strategies and risk/return profiles, and investors may choose one over the other based on their individual investment goals and risk tolerance. For example, some investors may prefer the more active management style of hedge funds. In contrast, others may prefer longer-term investment horizons and greater control over portfolio companies offered by private equity firms.

In recent years, private equity has seen increasing popularity due to strong performance and the growth of the private equity industry. However, hedge funds also continue attracting significant investment, particularly in a volatile and uncertain investment environment.

Fee structure of hedge funds

The most common fee structure for hedge funds includes the following elements:

  • Management fee: This is a fee charged by the hedge fund to cover the costs of running the fund. It is typically a percentage of the assets under management (AUM), ranging from 1% to 2% per year.
  • Performance fee: This is a fee charged by the hedge fund based on the fund’s performance. It is typically a percentage of the fund’s gains, ranging from 10% to 20% of the profits generated.
  • Other fees: There may be additional fees associated with investing in a hedge fund, such as transaction fees, custodial fees, and auditing fees.

It should be noted that ‘carried interest’ can be a significant component of the remuneration of the hedge fund manager for her investment performance. It is typically a percentage of the profits generated by the fund and is often referred to as the ‘carry’.

The specific fee structure of a hedge fund can be complex and will depend on the investment strategies used by the fund and the agreements between the fund manager and the investors.

Our view at QuietGrowth

To know about our view at QuietGrowth regarding hedge funds, refer to the ‘Hedge funds‘ section in our Investment Methodology page.

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