Is A Hedge Fund An Investment Company?

HFA Padded
Predrag Shipov
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Is A Hedge Fund An Investment Company

Financial markets are divided among different financial investment companies with their unique set of characteristics. Hedge funds were always viewed as a mysterious way to invest mostly due to their limited access to new investors. When something is out of the view of the majority it becomes interesting. That is why one of the most common questions that we ran up to was “Is a hedge fund an investment company”.

Hedge funds are investment companies like other types of funds. The difference between them is in the approach and structure of the hedge funds. They pool money from wealthy accredited investors and their managers employ often aggressive strategies to generate a gain. These funds are not as tightly overseen and regulated as other investment funds, which leaves them more space to use different means to maximize their returns.

Among different investment vehicles, hedge funds are often criticized for their lack of transparency and conflict of interest. On several occasions in the past hedge fund managers were convicted on different charges, including trading in influence and insider trading.

Today, they are facing tough competition from passive investors, and tech-based solutions like Robo Advisors and Blockchain-based investment. Stay with us while we cover this essential topic for every finance aficionado.

Key Takeaways

  • Hedge funds are just one of the investment vehicles in a highly diversified investment market.
  • What sets them apart from others is a diverse array of investment strategies, allowing the creation of a unique portfolio of holdings.
  • Only accredited investors can invest in hedge funds due to the often risky strategies that these funds employ.

Definition And History Of Hedge Funds

Hedge funds are investment vehicles that pool money from investors. What sets them apart from other financial structures like ETFs, Pension Funds, and Funds of Funds, is that to invest you need to be an accredited investor.

To become an accredited investor, an individual must earn at least $200,000 per year ($300,000 if they are married), or have a net worth of at least $1 million.

Structures resembling hedge funds started to develop in the late 1940s. Hedge fund pioneer was Alfred Winslow Jones. He was thinking about two common risks involved with stock trading, market risk, and company-specific risk.

Stock traders often coped with fluctuations in overall stock prices. That combined with a risk regarding individual companies' performance made stock trading a difficult process.

His first idea was to utilize a long/short equity strategy. He bought stocks going long which he believed were undervalued. Simultaneously he was borrowing and selling stocks that he believed were overvalued.

This way he could earn a profit regardless of the market direction. He could profit from selling overvalued stocks in the short term. In the long term, he would earn from stocks that will gain value.

In 1952 he registered a first hedge fund which he named A.W. Jones & Co. By employing a long/short equity strategy he developed the most popular and effective way to invest with hedge funds.

He was so ahead of his time that it took fifteen years for the trend to catch on. Most investors didn’t understand the concept of short selling, which they considered to be too complex.

Due to increased market volatility in the 1980s, hedge funds gained new popularity. That period also brought new strategies that hedge fund managers used. Some of the most popular were event-driven investing, distressed debt investing, and global macro investing.

Since then hedge funds cemented their place in the financial markets. Their rise was uninterrupted until the economic crisis of 2008 when several major funds were seen as an amplifying factor.

In the last couple of years, due to stricter regulations, hedge funds restored some of their former glory. However, the rise of passive investing through ETFs saw a decline in the industry.

Structure of the Hedge Fund

Regarding hedge fund structure, they can be internally organized as limited partnerships (LPs) or limited liability companies (LLCs).

Limited Liability Companies

Hedge funds are primarily organized like LLCs, for several reasons. LLCs as a business structure offer limited liability protection to the members of the business. In reality, it means that in the case of a downfall of the fund, their personal assets are shielded from liabilities.

There are two ways to manage an LLC. One is to appoint a manager who will run it, or members of the LLC can decide to run it directly. Also, the structure of the LLC allows a larger number of investors to participate in the investing process.

Limited Partnership

In Limited Partnership hedge fund organizations, there are two types of partners. The General Partner (GP) has an unlimited liability for the debt of the fund. Also, he is responsible for the implementation of a hedge fund strategy.

On the other hand, Limited Partners (LP) are usually smaller contributors of capital. With this comes a limited liability for the debt of the fund, which is maxed out at the level of investor capital.

Since the General Partner makes all the daily and strategic decisions, in most cases LPs do not have much influx on the strategy. However, this approach differentiates between individual funds.

Who Can Invest In A Hedge Fund

Unlike other investment vehicles like ETFs, pension funds, Mutual Funds, and Funds of Funds, not everyone can invest in a hedge fund. To invest in a hedge fund an investor needs to be accredited. Gaining that title requires either a $200,000 annual income ($300,000 in the case that the investor is married) or at least $1 million net worth.

Ironically the reason behind limitation is an actual care for the investor's financial standing. Due to a diverse spectrum of strategies that are often risky, allowing everyone to enter the hedge fund market could lead to potential losses for masses of people.

Another reason for the high income and net worth cap is the luxury of sustaining losses. Wealthy investors can absorb a couple of hits in the market, without going broke. On the other hand, risky hedge fund strategies can leave ordinary-earning people without savings in the very short term.

The hedge fund industry is filled with unique risks that demand solid financial strength to compete and win. That combined with extensive knowledge that follows this type of investing, would be too challenging for an average person to jump into that ring.

Key Positions In A Hedge Fund

Hedge funds in comparison to other financial institutions are typically smaller in number of employees. However, to be able to utilize different strategies, and to analyze key factors in companies and markets, they need several teams. They are internally organized between them, with a strong connection with the rest of the organization.

What all hedge funds strive to have in-house is an investment team, a trading team, a fund administration team, and a risk management team. Besides these essential functions, hedge funds can also employ a compliance officer and a prime broker.

An Investment Team

An investment team is the core of most hedge funds. These teams consist of research analysts, portfolio managers, and sector directors.

Analysts are doing all the grunt work that later leads to definitive investment decisions. Some of their duties include analyzing target companies, expanding knowledge about a specific industrial sector, and creating investment models.

Portfolio managers work together with analysts in search of the best investment targets. Once the analysts conduct their research, they, together with managers, go through the data. While managers make a final decision regarding investment strategies, analysts are also involved in investment decisions.

The most common starting point at the beginning of the hedge fund career is an analyst. After a couple of years of learning the basics of the work, they are moved to a more responsible position of a manager.

Trade Team

The trade team consists of traders who execute trades based on decisions made by portfolio managers. Their main goal is to get the best possible prices for the securities both bought and sold by the fund.

A good trader has a solid understanding of timing the trade, which requires understanding the dynamics of the market. The market is a volatile playground, and timing the sale can have a major impact on the fund and its revenue. Traders use advanced tech trading platforms to analyze the market, and conduct trades.

Risk Management Team

Due to the combination of factors, hedge fund investing tends to be highly risky. To counter those risks hedge funds employ risk management teams. Risk managers are aware of all crucial risks, including market risk, liquidity risk, operational, credit, and model risks.

Stress testing is one of the prime functions of the risk management team. Managers conduct stress tests to observe how the fund's portfolio will behave in specific market conditions.

Risk managers use quantitative tools to measure the potential impact of different risks. Once the investments are made they utilize different techniques including hedging techniques, position sizing and diversification, and stop-loss orders. All these techniques offer different risk-mitigating features to the portfolio.

Variable Structure

Depending on the internal structure, priorities, and financial situation, hedge funds may choose to offset some of these functions to a third-party company. Sometimes traders are offset to outsourced trading companies. Other hedge funds may opt to avoid organizing in-house administration and research teams.

Hedge Fund Investment Strategies

What sets hedge funds apart from other investment companies is the diversity of investment strategies. Hedge funds have strong competition in actively managed mutual funds, but still offer a bit of exclusivity to their investors.

Although all hedge funds are nominally just hedge funds, depending on their core strategy there are major differences between them. Over time that resulted in forming different types of hedge funds.

In the beginning, the only hedge fund strategy employed was a long/short equity strategy. Later, strategies were developed that allowed hedge funds to diversify their portfolios. Currently, several strategies on the market allow every investor to find something suitable to his philosophy and goals.

Long/Short Equity

While this was the first hedge fund strategy, many funds still use this strategy as their primary. It offers diversification, risk mitigation, and potentially high returns. On the flip side, it demands high dedication and management teams with a lot of experience and knowledge.

Long/short equity strategy encompasses parallel trading on both short and long positions. Funds identify stocks that will potentially lose value in the short term, borrow them, and sell them. At the same time, they are finding undervalued stocks that based on their fundamentals have a chance for high gains in the long-term.

This way the fund wants to make gains without regard to the current market condition. They can earn from both long and short positions if the portfolio is constructed to reflect market neutrality.

Global Macro Strategy

Many hedge funds resort to global macro strategy to gain from large-scale economic or geopolitical trends. Managers who focus on global macro are analyzing the big picture, staying on top of major developments all around the world.

If they notice a sudden change in interest rates, they are looking at how to profit from them. Change in currency rates? The same thing. Geopolitical events, like wars, and changes in government can result in major shifts in local and global market conditions. Hedge funds aim to benefit from all these situations by positioning on the winning side.

This strategy also comes with a potential for constructing highly diversified portfolios. Considerable events can push funds into different markets, like currencies, bonds, stocks, commodities, or real estate. The goal is to identify the market that could generate the highest benefits.

On the downside of this strategy are potential risks. Analyzing large amounts of data and making bets based on them is always a lottery. Another important factor is the data that are used. Are they dependable and accurate? If not, everything can go in the wrong direction. And finally, when you decide to invest in the middle of a global shift, the market tends to be highly volatile. That can leave hedge funds with empty pockets instead of a new bounty.

Value Investing Strategy

Focusing on finding securities on a discount is not a new approach. It was defined by Benjamin Graham, and today’s most influential investor, Warren Buffett uses it.

The core principle of the value investing approach is to find companies that are traded below their intrinsic value. Besides finding relatively cheap companies, it is also important to identify companies that can come back from the gutter they fell into.

So, the first step is that through the fundamental analysis, analysts identify the intrinsic value of the company. Then they check the economic characteristics, like cash flow, level of debt, etc. Also, they investigate the landscape of the company, including the competition, and overall industry potential.

The goal is to find a company with a competitive advantage that operates in a potentially high-yield sector. Then the fund tracks that company and waits for their value to drop below the intrinsic value. Once it does, they move in.

Most value-investing hedge funds buy large stakes in the company. As the price continues to rise they trim the holding. Patience is one of the crucial elements of this strategy. Disregarding the short-term volatility is the second. Value investors must have confidence in the fundamentals of the company, and that it will over time deliver solid gains.

Event-Driven Strategy

Unlike global macro that aims to capitalize on global events, event-driven strategy is focused on gaining from corporate or market events. Investors who prefer this strategy are looking to capitalize from short-term market inefficiencies resulting in low stock prices.

The reasons for these situations to take place are company restructurings, mergers, bankruptcies, spin-offs, or changes in regulatory practices.

A good example of event-driven investment is the case of an acquisition. A manager gets information that the company will be acquired by the other company. As a result of that event, the stock price of the target company may rise. Before that deal is officialized, the manager buys stocks at their old, lower price. They can later keep it but usually sell it once it rises.

Another example of an event-driven strategy is investing in distressed companies or their debt. Hedge funds aim to capitalize on a potential turnaround of the company, or in a case of bankruptcy, asset sales. This is a highly risky strategy, then only managers with experience and knowledge dare to participate in it.

Trend-Following Strategy

The core principle of a trend-following strategy is to capitalize on market trends. They can exhibit an upward or downward trend, but hedge funds have tools to generate gains from both directions of the market.

To identify future trends they focus on technical analysis. With it, they analyze past trends, and price movements, and based on those place bets on future trends.

Once the trend is identified the fund enters the market on either side, buying or selling. Once a trend shows a sign of weakening it is essential to time the exit to minimize losses. Position sizing also plays a crucial role in minimizing risk.

Trend-following strategy is risky and challenging to implement. This can come as a result of false signals presented in the technical analysis resulting in bad-timed investments. Funds that use trend-following have to frequently enter and exit from positions. This practice can result in higher transaction fees, reducing gains.

Activist Strategy

Activist strategy revolves around acquiring a significant stake in the company. Usually, the size of the stake differs but rarely becomes a controlling stake. Placing people on the board of the company is the primary goal.

Through the board members, the fund can adjust the direction in which the company will move. The end goal is to generate gain for the stakeholders. Impacting a company can mean making a sharp operational twist, implementing new technologies, or some other major change in how a company functions.

Activist investors are often criticized for an array of different reasons. One of the common complaints is that activists will focus on the company in the short term. Once the company gains value, they exit from the holding, with its profit.

Also, activists are disruptive by nature. Sometimes they will cause more problems to the company. Their meddling in the company's business can end up in a decision-making process resulting in overall bad implications for the company.

How Are Hedge Funds Regulated

Hedge funds are registered as exempt offerings under Regulation D. This means that they do not need to go through the whole registration process with the Securities and Exchange Commission (SEC).

Also, they operate with less oversight when compared to other investment vehicles like ETFs and Mutual funds.

Their exempt offering status allows hedge funds to pool money only from registered investors. We already mentioned registered investors, and the high net worth and income threshold demanded to become one.

What can be of greater value to potential investors is that hedge funds are not required to provide the same level of disclosure in comparison to other types of funds. In reality that can leave an investor with little to no information regarding future investment strategies, or potential movements in the portfolio.

What is even worse, less experienced investors are usually not aware of all the risks. Every hedge fund strategy brings a different set of risks, and if managers are not willing to go into detail, that can leave investors in the dark.

After recent developments especially after the 2008 economic crisis, regulatory implications for hedge funds are tightened. Standards in reporting increased, and the SEC got information regarding AUM, leverage, liquidity, performance, and specific risk exposure.

Reports presented to investors should include net asset value, performance reports, portfolio holdings, and risk measures.

Hedge Funds and Investment Accessibility

Hedge funds are usually not available to average investors due to a number of factors.

The first factor that puts off most potential investors is the required status of an accredited investor. This practice is in place for two reasons.

First, hedge funds prefer to work with a smaller pool of wealthy investors. It is easier in administration and every other way to deal with ten investors that pooled $10 million each than to deal with a thousand investors with a pool of a thousand dollars each.

The second reason is that less experienced and lower net worth investors could lose all their money through investing. This is not something that is so troubling hedge funds. However, dealing with massive numbers of bankrupt investors may draw too much attention from regulatory bodies. This way, they manage to stay in the shadows and generate gain both for themselves and the investors.

There are also cases of closed-end funds where the fund is not accepting new investors. They have their regular client base and are sticking with it. Another case is hedge funds where an investor can jump in only if he knows a partner or an existing investor.

The final reason for hedge fund exclusivity is the complexity of their investment strategy. In general, investors should understand at least the basics of the investment process. If he cannot comprehend how his money is handled, he should not participate in the process.

Pros and Cons Of Investing In The Hedge Fund

Pros Of Hedge Funds

For investors who are qualified to become hedge fund investors, there are several benefits of this type of investing:

  • Potentially high returns

The mission behind every hedge fund was to aim to generate high returns. The first thing on every hedge fund manager's mind is to beat the comparative index. The next is to beat the fund's performance last year. Managers are always looking for some record to beat and to be better than in the past.

When compared to traditional ETFs and mutual funds, they have a potential for higher gains, but at a cost of a higher risk.

  • Diversification of the portfolio

In the majority, hedge fund managers are looking to diversify their portfolios. This is a common risk mitigation strategy looking to minimize the risk of fallout of a specific company or industry sector. Also, investing in a specter of assets can result in unexpected gains.

  • Hedge funds are actively managed

In contrast to some passively managed investment vehicles, hedge fund managers are constantly looking for new opportunities to invest and generate higher returns. Investors who don't prefer conducting research and investment by themselves see this as a major benefit.

  • Active risk management strategies

Due to the high-risk nature of hedge fund investing, managers have risk strategies for every investment approach they use. Several techniques are regularly in use, including hedging of the portfolio, stop/loss orders, and position sizing.

  • The highly diverse investment universe

Most financial vehicles including ETFs, Mutual Funds, pension funds, and others have a straightforward approach to investing. It doesn’t deliver high returns but also has lower risks. Hedge funds offer a whole new approach to investing, with a focus on almost every asset available.

Depending on the strategy, hedge funds can invest from public and private equity, venture capital, commodities, and real estate, to complex derivatives. This way investors get exposure to the trading markets like with no other investment vehicle.

Cons Of Hedge Funds

  • High fees

Hedge funds are known for their compensation structure named 2 and 20. Hedge funds charge 2% of the entire AUM as their management fee. In case the performance of the fund is higher than before the agreed threshold, managers earn a 20% fee from the profits.

This practice was regular in the past, but due to several factors, including the rise of competition, some hedge funds abandoned this practice.

  • Limited liquidity

Unlike mutual funds and ETFs which are generally highly liquid, hedge funds are quite the contrary. Every hedge fund has its rules regarding investment redemption periods. Some have quarterly, some semiannually, others annually, or even rarer chances to pull investments from the fund.

  • High risk in comparison to other investment vehicles

In contrast to potential higher returns, hedge funds also come with higher risks. They often use leverage to amplify their investments which could go both ways. It can generate massive returns, but it can also lead to debt.

Focusing on short selling, derivatives, or on distressed debt, are all dangerous investments. Investors who are not up for it should avoid it, and stick with other ways to invest.

  • Low transparency

Investment strategies, future plans, and other crucial elements of the fund's activities executives do not need to share with the investors. If the investor is not experienced and does not have an economic or finance background, it can be difficult to follow through with what is happening with his investment.

  • Focus on generating absolute returns

This may seem like a winning strategy to some, but to others, it can look reckless. Aiming to capitalize in all market conditions is a difficult feat to achieve. If you are on top of it, leveraging your position can easily lead to a complete failure.

  • Lack of regulation

This factor is closely connected with low transparency. While mutual funds are under the watchful eye of the regulatory bodies, hedge funds have a more loose regulation structure. This can lead to risky behavior for hedge fund managers. This is further amplified by the compensation structure.

Since they are earning more with more AUM and higher gains, managers will look for ways to capitalize in every situation. This often results in making deals with higher risks than necessary.

Difference Between Hedge Funds And Other Investment Vehicles

Hedge Funds VS Mutual Funds

Mutual funds are open to all investors, with low minimum investment requirements. They are passively managed aiming to track a specific market index. Fees are also lower when dealing with mutual funds.

In contrast to limited liquidity in hedge funds, investors in mutual funds have options for daily redemption. This means that if you choose to invest with mutual funds, you can get your investment back in a day.

Mutual funds are also closely monitored and regulated by the SEC. This results in higher transparency and less potential for shady operations.

Regarding returns, mutual funds offer medium to low returns. This is in contrast to the high return potential of hedge funds. On the other hand, investments are also coming with a lower risk of loss.

Hedge Funds VS Exchange-Traded Funds (ETFs)

To invest with an ETF the investor only has to have a brokerage account. Minimum investment often is in line with the price of a single share in the fund.

Like Mutual Funds, ETFs are passively managed. They tend to track a specific index or a group of securities. Unlike hedge funds, they do not aim to outperform the indexes but rather replicate their performance. Also, there are actively managed ETFs that are gaining popularity due to the diversification they offer.

Similar to mutual funds, ETFs are highly liquid and can be traded throughout the day. They are regulated in detail providing higher transparency and security to the investors.

Fees in ETFs are also much lower, usually settling at a percentage of the fund’s assets to cover operational costs.

Final Thoughts

The investing marketplace has never been so diverse like today. An investor can choose from passively managed mutual funds, and ETFs, actively managed hedge funds, to new investment technologies like Robo-traders.

Hedge funds offer a unique blend of diversity with different levels of risk and investment strategies. Finding something that suits you demands a thorough search. When choosing an investment vehicle keep in mind the track record and reputation that come with the strategy that suits your needs and goals.