How do Hedge Funds work?
Hedge funds originated from the investors who were long-duration investors and short-duration investors. They both created it to make sure they make money despite market fluctuations. The general premise of hedge funds is that they can make money regardless of the stock market direction. The fact they can not only take long positions gives them the opportunity to respond to market fluctuation.
Hedge funds have traditionally been thought of as arbitrage players, meaning they seek to earn a return while hedging against risk. The hedge fund is an aggressively managed portfolio of investment across asset classes. Some regions which are leveraged, take a long and short position or uses derivatives. It has the aim of generating high returns, either in absolute terms or over some specified benchmark. Also, it has some investment restrictions. It is set up as a private investment partnership open to limited investors willing and able to make large investments.
Investment in Hedge Fund
The investors who invest in hedge funds are termed as LP (limited partners) and the persons who manage the fund are called GP (general partners). The ticket size of investment in the hedge fund is large. Here a fund manager invests in different securities as per the mandate. Their strategy can involve especially being long or short or the hedge fund that specializes in certain specific investments ranging from common stocks to patents. The managers of the hedge fund have more flexibility than traditional investment managers.
Some of the hedge funds impose restrictions on the redemptions. Investors might need to keep their money in a hedge fund for a lockup period before they are not allowed for withdrawals.
Investors’ wish to invest in hedge funds, despite the restrictions on redemption is large because of reported returns of some hedge funds. They also have a low correlation with traditional investment, which makes investors more inclined. The common management fee structure in the hedge fund is 2% and 20%, which means 2% is a management fee and 20% is incentive fee. LP investor pays both the fee.
Popular Hedge Fund strategies can be categorized as:
- Event-driven strategies
This strategy seeks to achieve profit from short term corporate events. It can be a merger arbitrage, restructuring, special situation, etc.
- Macro strategies
This strategy emphasizes a top-down approach to identify economic trends and take decisions based on that.
- Equity hedge strategies
This can be thought of as the original hedge fund category. They are generally focused on the public equity market.
- Relative value strategies
This fund seeks to profit from pricing discrepancy between related securities. It can include fixed income, multi-strategy, etc.
Conclusion
Mutual funds and hedge funds differ in many segments. The hedge fund is attractive to many investors because it can generate a significant amount if the particular strategies go well. Some hedge fund charges different rates to different classes of investor. They may be willing to negotiate terms including fee, notice, lockup period, etc with their potential investor. In other words, the longer investors agree to keep their money in the hedge fund, the lower the fees.
