In today’s technology-driven world, investing has become much more accessible to everyone, and the availability of investment options is nearly limitless. It is even more so with institutional investors, who may focus more of their investible assets on hedge funds. So, what are the different types of hedge funds?
There are several types of hedge funds, the following are some of the primary ones. Commingled Funds, Managed Accounts, Fund of One, Listed Fund, Alternative Mutual Fund, and Undertakings for Collective Investment in Transferable Securities (UCITS).
- What Is a Hedge Fund?
- Type of Hedge Funds
- Hedge Fund Strategies
- Related Articles
What Is a Hedge Fund?
Hedge funds are investment pools that are actively managed by a hedge fund manager. These funds utilize various different investment strategies, which may include buying with borrowed money and trading in esoteric assets, in an effort to beat the average investment returns for their clients. These are usually considered to be risky investment options.
These hedge funds also require an extremely high minimum deposit and charge higher fees compared to the conventional investment funds. In the past, hedge funds were lauded for their stellar performance during the 1990s and 2000s, but many have underperformed since the financial crisis of 2007-2008, especially when the management fees and taxes have been factored in.
Type of Hedge Funds
A commingled fund is the most traditional fund type. It is like the private capital fund, commingled hedge funds pool capital from multiple external investors into one account managed by the fund manager, with all the assets shared by all the investors in the fund.
This type of fund is sub-managed by a hedge fund manager, limiting the investment decisions on behalf of one investor, rather than assets of multiple external investors. Through this managed account the investor owns the actual assets being invested in, rather than in a limited partnership as normal in a pool of interests.
The benefits of such a fund are:
- Lower risk associated with an unbalanced portfolio as in a commingled fund due to high redemption frequency of investors.
- The investor has full transparency on assets being managed and may customize the portfolio to their individual needs.
- An investor can nominate their own service providers as a way of lowering counterparty risk.
However, managed accounts will usually require an incredibly significant capital commitment from the investor, as there are operational and logistical difficulties for the manager in setting this type of fund. Therefore, the managed account is usually only available to the largest investors.
Fund of One
The fund of one has elements of both a commingled fund and a managed account. This is a fund that is usually structured as a limited partnership for only one investor. The primary difference between a fund of one and a managed account is in the ownership of the assets, in this case the fund manager will carry the ultimate liability.
The fund of one provides investors some of the benefits of the customization options of a managed account, with some loss of governance, since the manager retains full control over the fund strategy and the assets invested in.
A listed fund, by its name, is listed and traded on a stock exchange. Hedge funds are often listed on smaller market exchanges, such as the Irish Stock Exchange, so to provide some minimal level of oversight as demanded by investors. A fund listed on an exchange means it will be subject to a greater degree of scrutiny since performance and aggregate asset values must be disclosed in annual reports; however, the portfolio of assets invested in does not need to be disclosed.
Undertaking for Collective Investment in Transferrable Securities (UCITS)
UCITS are investment funds that fall within the European regulatory framework. This type of fund promotes elevated levels of investor protection through greater transparency of investment activity and therefore can be marketed to investors across Europe, unlike the typical hedge fund.
These funds must provide greater liquidity options and more regular transparency documentation that outlines the fund’s strategy and investments. Since there are more restrictions on these funds, the returns are usually lower as compared to the hedge funds, but it may be mitigated somewhat since they also have lower fees.
Alternative Mutual Fund
The alternative mutual funds, also known as “40 Act Funds”, are registered as mutual funds under the United States Investment Company Act of 1940. It is similar to the UCITS, in that it is regulated to some extent, and must provide greater transparency to the investors.
Hedge Fund Strategies
The concept of a long/short strategy is simple, research will usually provide data on both winners and losers, so why not bet on both. Taking a long position in the winners as collateral to finance the short positions in the losers. This type of portfolio combination creates greater opportunities for specific stock gains that would reduce market risk with the shorts offsetting the long market exposure.
It is basically going long and short on two competing companies in the same industry based on their relative valuations. It is a fairly low-risk leveraged bet based on the fund manager’s skill on picking a stock.
As the name implies, this strategy favors a zero net market exposure. Therefore, the fund manager relies solely on their stock selection skills to provide returns. It obviously carries a lower risk, but it also provides a lower return.
This is a riskier version of market neutral, as merger arbitrage derives its returns from takeover activity, and is often referred to as one type of an event-driven strategy. Once the share-exchange transaction is announced after a potential merger, the fund manager may buy shares in the target company and short sell the buying company’s shares.
This is a high-risk option; therefore, all participants must be very knowledgeable of what is involved. A merger could fall apart and thus all investments are lost.
Convertible arbitrage are hybrids in that it combines a straight bond with an equity option. This type of hedge fund will usually be long on convertible bonds and short on a proportion of the shares into which they convert.
The fund managers will try to maintain a delta neutral position, in which the bond and stock positions offset each other as the market fluctuates. To maintain the delta neutral strategy, the fund managers must increase their hedge, or sell more short shares if the price goes up and buy shares back to reduce the hedge if the price goes down.
Convertible arbitrage funds thrive on volatility. The more volatile the market, the more opportunities become available to adjust the delta-neutral hedge and take in trading profits.
Sort of in-between equity and fixed income lie event-driven strategies. This type of strategy is great during times of economic strength when corporate activity is high. In this situation, hedge funds buy the debt of companies that are financially distressed or have already filed for bankruptcy.
Most credit strategies utilize capital structure arbitrage, similar to event-driven strategies. Hedge fund managers will look for any relative value between the senior and junior securities of the same corporate issuer. They may also trade securities of equal credit quality from different corporate issuers. The credit strategy focuses more on credit rather than interest rates.
This strategy primarily focuses on risk-free government bonds, which eliminates credit risk. Fund managers will make leveraged bets on how the yield curve will change. If they expect long rates to rise relative to short rates, they will sell short long-dated bonds or bond futures and buy short-dated securities or interest rate futures. These types of funds will also typically utilize large amount of leverage to increase the potential returns.
This strategy analyzes how macroeconomic trends will affect interest rates, currencies, commodities, or equities around the world, and then take long or short positions in whichever asset class that aligns with their particular views. Although these funds can trade almost anything, fund managers usually will prefer more liquid instruments such as futures.
In this strategy, the fund manager will look for overvalued stocks in which they will take short positions. This involves extensive research to uncover any signs of financial trouble that may have been missed by investors.
A quantitative strategy uses quantitative analysis (QA) to make investment decisions. Quantitative analysis is a technique that uses mathematical and statistical modeling, measurement, and research that relies on large data sets, to better understand and predict patterns.
It will use technology to analyze and review the numbers and make trading decisions automatically based on mathematical models or machine learning techniques.
Regardless of the strategy used or the type of fund, the fee structures are primarily the same across the board for these hedge funds. Most funds will use the 2/20 fee structure, which is comprised of two key elements:
- Management fee of 2% annually is charged to cover the operating costs of the fund.
- Performance fee of 20% is charged as a reward for the positive returns and is set at 20% of the fund’s profits.
This has been the typical fee structure for some time, but in recent years there has been some pressure on hedge fund managers to lower their fees.