Hedge Funds Explained: Strategies, Risks & Investment

A hedge fund, an alternative investment vehicle, is a partnership where investors (accredited investors or institutional investors) pool money together, and a fund manager deploys the money in a variety of assets using sophisticated investment techniques. Hedge funds, as opposed to other funds, can use leverage, take short positions, and hold long/short positions in derivatives. They are less strictly regulated by the Securities and Exchange Commission (SEC)Securities and Exchange Commission (SEC)The US Securities and Exchange Commission, or SEC, is an independent agency of the US federal government that is responsible for implementing federal securities laws and proposing securities rules. It is also in charge of maintaining the securities industry and stock and options exchanges as opposed to other funds.

Summary

• A hedge fund, an alternative investment vehicle, is a fund that pools investors’ money together and utilizes sophisticated investment strategies to generate returns.
• Hedge funds are only accessible to accredited and/or institutional investors.
• The four main classifications of hedge fund strategies are event-driven, relative value, macro, and equity hedge.

Defining Accredited and Institutional Investors

Hedge funds are only accessible to accredited and/or institutional investors.

An accredited investorAccredited InvestorAn accredited investor refers to an individual or institutional investor who has met certain requirements set by the U.S. Securities and Exchange Commission (SEC). Accredited investors are allowed to purchase securities that are not available to other investors and that have not been registered with any regulatory authority. is an individual or business entity that is allowed to invest in securities that may not be registered with the financial authorities. In the United States, one must have a net worth of at least $1,000,000 (excluding the value of the primary residence) or an annual income of at least $200,000 for the past two years. Rule 501 of Regulation D of the U.S. Securities and Exchange Commission goes into further detail in defining “accredited investors.”

An institutional investor is a non-bank individual or company that trades securities on behalf of its members in large dollar or quantity amounts. Institutional investors include pension funds, mutual fund companies, insurance companies, commercial banks, mutual fundsMutual FundsA mutual fund is a pool of money collected from many investors for the purpose of investing in stocks, bonds, or other securities. Mutual funds are owned by a group of investors and managed by professionals. Learn about the various types of fund, how they work, and benefits and tradeoffs of investing in them, or hedge funds. Due to the deep pockets of institutional investors, they play a major role in the securities market.

Common Hedge Fund Strategies

Hedge Fund Research, Inc. identifies four main classifications of hedge fund strategies. Each strategy entails different risk and reward profiles:

1. Event-driven strategies

Strategies that seek to gain from inefficient price changes due to specific corporate events, corporate restructurings, mergers and takeovers, asset sales, spin-offs, bankruptcies, and other events.

2. Relative value (arbitrage) strategies

Strategies that seek to gain from price discrepancies between related securities whose price discrepancy is expected to be resolved over time.

3. Macro strategies

Strategies that seek to gain from global economic events and trends such as interest rate changes, currency changes, political changes, and others, by acquiring holdings with positive or negative exposure to such macro events. Macro strategies revolve around the prediction and projection of macro events.

4. Equity hedge strategies

Strategies that seek to gain from long and/or short positions in equities and derivatives.

Hedge Fund Fee Structure

A common hedge fund fee structure is called “2 and 202 and 20 (Hedge Fund Fees)The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents the management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates”. It means that the fund manager will charge a 2% management fee applied to the assets under management and a 20% incentive fee on returns greater than a specified hurdle rate. Incentive fees are only collected when the portfolio generates a higher return than the hurdle rate. Hurdle rates can be “hard” or “soft”:

1. Hard

A hard hurdle rate means that incentive fees are only collected on returns in excess of the benchmark. For example, if a hedge fund returned 25% with a 10% hurdle rate, incentive fees would be collected on the excess return of 15%.

2. Soft

A soft hurdle rate means that incentive fees are collected on the entire return of the portfolio so long that the return is greater than the hurdle rate. For example, if a hedge fund returned 25% with a 10% soft hurdle rate, incentive fees would be collected on the total portfolio return of 25%.

Example of a Hedge Fund Fee Structure

ABC Fund is a hedge fund with $100 million assets under management. The fund follows a “2 and 20” fee structure with a hard hurdle rate of 15%. Incentive fees are calculated on gross gains and not gains net of management fees. The performance of the hedge fund is provided below. Calculate the total fees paid to the fund managers.

Since the portfolio generated a return of 100%, which is above the 15% hard hurdle rate, the fund managers are entitled to an incentive fee.

1. First, we calculate the management fees as $1,000,000 x 2% = $20,000.
2. We then calculate dollar return above the hard hurdle rate as [$2,000,000 – $1,000,000 x (1+20%)] = $800,000. This is the dollar amount that the incentive fees will be charged against.
3. Lastly, we calculate the incentive fees as $800,000 x 20% = $160,000.

Total fees paid to the fund managers are $20,000 + $160,000 = $180,000.

Additional Resources

To get a better understanding of the hedge fund universe, check out CFI’s Introduction to Hedge Funds course. To keep learning and advancing your career, the following resources will be helpful:

• Alternative InvestmentAlternative InvestmentAn alternative investment is an investment in assets different from cash, stocks, and bonds. Alternative investments can be investments in tangible assets such as precious metals or wine. In addition, they can be investments in financial assets such as private equity, distressed securities, and hedge funds.
• Hurdle RateHurdle Rate DefinitionA hurdle rate, which is also known as minimum acceptable rate of return (MARR), is the minimum required rate of return or target rate that investors are expecting to receive on an investment. The rate is determined by assessing the cost of capital, risks involved, current opportunities in business expansion, rates of return for similar investments, and other factors
• Index FundsIndex FundsIndex funds are mutual funds or exchange-traded funds (ETFs) that are designed to track the performance of a market index. Currently available index funds track different market indices, including the S&P 500, Russell 2000, and FTSE 100.
• Hedge Fund Salary GuideHedge Fund Salary GuideThis hedge fund salary guide covers several jobs in the hedge funds sector and their corresponding midpoint salaries for 2018. A hedge fund