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Why do Hedge Funds Exist?

.Why do Hedge Funds Exist?

Like many investors, I sometimes find myself overwhelmed by the many different types of investment opportunities available. This article will answer some common questions about one such investment type – the hedge fund. What is a hedge fund? And why do hedge funds exist?

Just like all other investment vehicles, hedge funds exist to return profit to investors. Unlike mutual funds or exchange-traded funds, hedge funds engage in key investment strategies that are not available to other registered asset management services. While hedge funds have fallen under increased scrutiny due to their high fees, performance incentives, and risk potential, many people rely on hedge funds as crucial holdings in their portfolios.

How do Hedge Funds Make Money?

All hedge funds have two main goals. The first is to make enough money to pay operating costs and the salaries of their employees. The second is to make money for investors.

Hedge fund companies profit on a mechanism that is often called the 2 and 20. The 2 and 20 is a fee and incentive structure where a holding corporation will charge their investors around 2% (or more generally, anywhere between 1% and 4%) of assets under management over the course of the year. This fee is intended to cover operating expenses for a company including some staff salary and administrative costs. The 2% expense fee is more expensive than some other investment vehicles. The Vanguard ETF VOO, for example, has an expense fee of 0.03%.

The counterpart of the 2% fee is the 20% performance fee (or performance incentive). The 20% fee is a much larger expense for investors who participate in these types of funds, but the performance incentive is only charged when a fund meets certain profitability thresholds. The performance fee is called an incentive because it incentivizes asset managers to increase a fund’s overall profitability. Similar to how the 2% fee can vary between funds, the performance fee will vary. Some management services take anywhere from as low as 10% to as high as 50% in fees.

Why are Hedge Funds Not More Popular?

The high price to invest in hedge funds is a common sticking point for investors. According to a Bloomberg article from July, many hedge funds have failed to achieve the same kind of results that they once did in the 1990s and earlier. The high returns of large hedge fund managers in the 1990s and earlier years helped to normalize the 20% performance fees. With many funds failing to reach the same large figures in the years since the 2008 financial crisis, many investors find that performance incentives cut into their overall profits and make hedge funds less lucrative than other investment vehicles.

While hedge funds seek to return profits to investors, the 2 and 20 fees mean that funds that would have outperformed average market returns will instead generate less profit for their investors. Even if hedge funds were returning the kinds of figures that we say before 2008, many investors have wondered if these figures were acceptable and sustainable.

Are Hedge Funds Bad?

 

The high entry price and excessive fees are some of the major concerns that people have with hedge funds. Other actively managed funds can have expense ratios under 1%, but this is often not the case with hedge funds.

Another concern that investors should acknowledge is that hedge funds are less regulated than other actively and passively managed index funds. The lack of regulation allows hedge funds to engage in riskier investment strategies. One such risky investment strategy is that hedge funds are able to trade in assets that aren’t registered with the Securities and Exchange Commission.

Unregistered investments can have major issues, and so investors should be aware and cautious when dealing with them. Investing in unregistered assets has led to several scams involving the fraudulent listing and selling of “Private Offerings.”

While private offerings may be listings for real companies that are not publicly available, they may not be. The SEC warns against this kind of scam in an article from 2014. While hedge funds should be able to avoid some of these scams, the risk of purchasing a fraudulent company still exists when purchasing unregistered investments.

More Difficulties / Concerns with Hedge Funds

Another issue with unregistered investments is that individual stockholders have less ability to verify whether a hedge fund is telling them the truth about their investments. The information that investors receive about unregistered investments normally comes directly from the hedge fund company, and because the asset is unregistered, the information that the hedge fund provides cannot be verified against public earnings reports or other information that the SEC requires from publicly traded assets.

Another problem with hedge funds is that they are able to take on more risk than many other actively managed funds. While it may be a good idea to invest in a hedge fund to increase diversification and avoid risk, indeed, this is where the “hedge” in hedge fund comes from (i.e., hedging with long and short positions), hedge funds are able to lose large amounts of money and even entire investment portfolios with a turn of the market.

Another concern to be aware of when dealing with hedge funds is how liquid your investment is. Many hedge funds have different rules and regulations around resale and leaving the investment. This could mean that, unlike holding other kinds of securities, you are locked into an investment for longer than you would like. You would want to be aware of the company’s policy regarding the resale of holdings or exiting a position before investing in a hedge fund

Who Can Invest in Hedge Funds?

Hedge funds are only open to what the U.S. Securities and Exchange Commission defines as “accredited investors.” These are people that have a net worth of over $1,000,000 or meet other financial thresholds. The SEC notes that accredited investors should be more sophisticated, and less needing of some of the protections that registered equities have to offer.

This means that hedge funds are more restricted than index funds or ETFs, which can be purchased by a much broader range of investors. The lack of registration with the SEC sometimes equates to a larger risk for these offerings. Accredited investors can potentially sustain greater losses.

Even though hedge funds are restricted to a portion of investors, they still manage incredibly large assets. As of June 30, 2020, one of the largest portfolios in the world was Bridgewater Associates with close to $100 billion under management. Comparatively, Fidelity’s S&P 500 tracking, large-blend mutual fund manages $274 billion.

How were Hedge Funds Created?

Many people will credit Alfred Winslow Jones, a man who coined the phrase “hedge fund” and ran one in the 1940s, as creating the first hedge fund. However, it is likely that the first hedge fund was likely created in the bull market of the 1920s by the Graham-Newman partnership.

The partnership included the famous 20th-century investor and writer Benjamin Graham and had many key aspects of a hedge fund that we acknowledge today. One of these characteristics is the type of compensation model that provides the managers with a percentage of the profits the firm produces.

The fund was also tiered in a similar way as we tier hedge funds today, with a central partner, or set of partners, and other limited partners with a stake in the company. The Graham-Newman company also held long and short-term positions to reduce risk, this is something that we still see in hedge funds. Like today, in the 1920s many different investment vehicles were available to wealthy investors. The hedge fund that the Graham-Newman partnership created is most similar to what we would recognize as a hedge fund.

Have Hedge Funds Consistently Performed Well?

While hedge funds may have existed for nearly 100 years, they have not stayed in the market consistently. Many hedge funds that existed historically had to close due to heavy sustained losses during periods of economic downturn. Two such times were during financial crashes in the late 60s and early 70s, and the mid-70s. While some hedge funds have struggled to sustain long term returns, other funds recovered. These were seen giving strong returns through the late 80s and 90s, only stopping when another similar economic downturn hit the US in 2008. In the early part of the 21st-century hedge funds held nearly $2 trillion in assets under management.

What Makes Hedge Funds Special?

As we have discussed in this article, hedge funds have a lot of similarities with other types of investment vehicles. The ultimate goal of a hedge fund, or any investment, is to return profits to the shareholder in proportion to their stake.

However, the types of activities that hedge funds are able to engage in make them distinct and different. While the high expense ratio, performance incentives, and the requirement to be an accredited investor keep some people from investing, the hedge fund remains one of the largest asset management structures in the US.

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Sources:

Vanguard S&P 500 ETF 

2 and 20 (Hedge fund fees) 

Investor Alert: 10 Red Flags That an Unregistered Offering May Be a Scam

Hedge Fund Fees in Free Fall Is the New Reality For a Humbled Industry

Updated Investor Bulletin: Accredited Investors

The Largest Hedge Fund Managers 2020 

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