What is a Hedge Fund?

This is a visual representation of the trends of a hedge fund.

It all started in 1949 Alfred Winslow Jones, a former journalist, author, and sociologist started the first hedge fund under A.W. Jones & Co.

Jones was inspired to try his hand at money managing while writing an article about current investment trends for Fortune in 1948. He managed to raise $100,000 out of which he put in $40,000 from his own pocket and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks.

This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance returns. His fund was the first to invest in stocks with leverage while using short selling to remove market risk.

He looked at the performance of securities in broader markets and how to match short sales with long sales of stocks to manage a portfolio, thus literally hedging his investment. Structured as a limited partnership to avoid regulation this fund did well in the past. It received publicity in the Fortune Magazine and the concept of hedge funds was born.

The History of Hedge Funds

1950’s & ‘60’s

Hedge funds caught on significantly in the 1950s and ’60s. In 1952, Jones altered the structure of his investment module to convert it from a general partnership to a limited partnership, adding on a fat 20% incentive fee as compensation for the managing partner.

Jones earned his place in history as the father of the hedge fund by becoming the first money manager to combine short selling, the use of leverage, and shared risk through a partnership with other investors and a compensation system based on the performance of the investment.

In the 1960s hedge funds gained popularity when they dramatically outperformed most mutual funds. Fortune seems to have played a role in this when they highlighted an obscure investment that outperformed every mutual fund on the market in an article published in 1966.

The article caught on as it stated the hedge fund managed to do so by double-digit figures over the previous year and by high double-digits over the previous five years.

Early ‘70s

Eventually, the evolution of hedge funds led them away from Jones’ strategy in an effort to maximize returns the managers began choosing to invest in riskier strategies based on long term leverage rather than Jones’ original strategy of stockpiling combined with hedging. This experiment, however, resulted in heavy losses and numerous hedge fund closures between 1969 and 1970.

Once again an article heaved life into hedge funds when Institutional Investor touted a double-digit performance in the Tiger Fund which captivated investors.

1990’s & Beyond

Hedge funds in the 1990’s were powered on by high profile money managers who deserted mutual funds for the fame and glory of managing a hedge fund.

The industry has since expanded with total assets under management valued at more than $3.25 trillion according to the Preqin Global Hedge Fund Report.

The industry had transformed to offer a buffet of funds and an array of exotic strategies, including currency trading and derivatives such as futures and options.

The hedge fund has come to mean a private investment structure that charges a management and performance fee which is key to align the manager’s interest with the investors.

In essence, a hedge fund is akin to a marriage between a professional fund manager (who is known as the general partner) and the investors (sometimes known as limited partners) who together pool their money into this investment vehicle.

A Financial Partnership

A hedge fund is a financial partnership that pools funds to employ strategies to earn active returns for investors. Fund managers or hedge funds may use aggressive strategies for returns and make use of derivatives and leverage to generate higher returns.

Hedge fund strategies include long-short equity, market neutral volatility arbitrage, and merger arbitrage.

Hedge funds now include commodity investments, bonds, real estate, commercial financing, currency, foreign exchange, and almost anything that’s one of the reasons why they have grown to such a size to include such a broad spectrum of investments so the Hedge Fund industry today is enormous.

A group of people discussing the graphs and charts of the hedge fund.

What Is The Purpose of a Hedge Fund?

The purpose of a hedge fund is to maximize investor returns and eliminate risk. This structure and objective may sound oddly similar to that of mutual funds but that is where the similarity starts and ends. What really sets them apart from mutual funds is that they have a much higher minimum investment requirement.

The hedge fund industry is very lucrative for portfolio managers and analysts. For them, their knowledge is power and their greatest asset is the investment process, research, risk management, so, they are unlikely to reveal this unique knowledge to others who may easily copy it.

Rarely will you find someone like Jack Welch who, after leaving GE, spoke to many different companies and went on to write many books on the industry?

Some of the earliest hedge fund managers are Warren Edward Buffett, Gorge Soros, and Michael Steinhardt.

Just like any investment, Hedge Funds come with their share of positives and negatives.

Although a fund manager has plenty of knowledge in investments and finance, it is essential to have an unbiased evaluation of the pros and cons of this investment method.

Hedge Funds Pros & Cons

The Pros

As an investment, hedge funds seem quite attractive from afar, with its show of higher flexibility, aggressive growth, exotic strategies, and the lure of transparency due to mutual benefits.

Let’s take a look at some of the positive aspects of hedge fund investment.

Higher Flexibility

Since they are not traded publicly, they tend to have higher flexibility and there is no specific regulatory authority.

Aggressive Investments

To realize higher returns the strategies used involve short selling as well as leverage buying and derivatives.

Long or Short Selling

This is a strategy the fund manager utilizes to either purchase a stock that in their opinion is undervalued or vice versa.

Mutual Benefit

Since the hedge fund manager is personally invested in making the most of the hedge fund.

Expert Advice

Aside from being advanced in the field of investment, fund managers are usually well versed in financial matters.

Loss Reduction

In many cases, hedge funds provide loss reduction by increasing portfolio stability.

Increased Chance of Diversification

One of many reasons to include a hedge fund in portfolio investments is the ability to increase the chance of diversification and reduce risk. Using this to their advantage, managers are able to reduce risks.

So why do people invest in hedge funds? The attractive picture painted in news reports and the lucrative lust of financial benefit may seem alluring but these crystal waters are full of hidden dangers that aren’t so widely publicized.

Investors best concern themselves with the matters of less liquidity, higher fees, less transparency, and many more!

It would be wise for investors to address these issues before diving into hedge fund investments.

This is a visual representation of a businessman having problems with the hedge fund.

The Cons

High Fee

The fee is almost 1-2% of the asset under management due to the skill of managers plus 20% for excess performance.

A 2001 study on hedge funds called “Do the money machines really add value?” by Kat and Amin showed poor relations between stock returns and hedge fund returns do not attributable to manager skills but to the general type of strategy hedge funds follow.

Any fund manager following a log short type strategy can be expected to show low systemic exposure to the market.

High Risk

As the investment strategy tends to be such that it brings high risks in pursuit of larger returns.

So why do investors pay such a high fee? Credit Suisse Hedge Fund Index shows an annualized return of 7.71% from January 1994 to November 2017

Standard Deviation Hedge funds use this tool to anticipate the risk of investment however this tool does not indicate the overall risk of return.

So, not only do they have a high fee but also a low return as well as high risk. Neither do they offer the same liquidity as a mutual fund. Investing in a hedge fund involves a lockdown period where the fund is inaccessible after the lock-up and the investor’s ability to withdraw at their discretion can also be suspended.

Only when an investor can manage all these issues effectively will he benefit from a hedge fund investment. Unfortunately, most investors swim their way into sinking hedge funds.

The numbers are actually two out of five. These stem from many reasons including all of the above, topped off simply by a lack of understanding of what seems to be a sound investment risk.

Taking all the pros and cons into consideration, one can only assume the affluent and affording can choose to play with this exclusive investment option.

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