What Is a Hedge Fund?

If you’ve followed the news in 2021, you’ve likely heard a few fantastic things about the stock market. For instance, Bitcoin’s meteoric rise and fall was the talk of the nation for several weeks. And let’s not even start on Reddit forum WallStreetBets’ hand in the “meme stock” phenomenon that saw hedge funds lose $54 billionin January alone.

Or rather, let’s.

No, we aren’t going to dissect the WallStreetBets controversy. Instead, we’re going to focus on the so-called “bad guys” Reddit investors were one-upping: hedge funds.

TL;DR

  • Hedge funds are private, pooled investments set up by a professional manager or registered investment advisor to invest in other securities, assets, or funds
  • They are usually only available to accredited investors due to their high risk and complex investment strategies
  • These LLCs or limited partnerships are classified according to the underlying investment style, such as taking simultaneous long/short positions, investing based on events such as mergers or bankruptcies, or analyzing and investing in macroeconomic trends
  • A manager may take fees as high as 1-2% on all assets under management and 20% of all profits paid to investors above the hurdle rate

What is a Hedge Fund and How Does it Work?

A hedge fund is a private, pooled investment arrangement set up by a professional fund manager or registered investment advisor. Unlike stocks or bonds, a it isn’t a specific type of investment. Rather, it’s a set of funds contributed from pre-qualified investors used to invest in other securities.

Originally, when hedge funds were created in 1949, they were designed to hold both long and short stocks to hedge against risk – hence the name. This ensured that participating investors made money regardless of the market’s movements. Since 1949, the inner workings have changed quite a bit, but the name has stuck around.

Investments

Hedge funds are run by managers tasked with raising and investing funds according to their promised strategy. For instance, they may invest solely or in part in:

  • Long or short stocks
  • Currency
  • Derivatives
  • Junk bonds
  • Real estate
  • Art
  • Private businesses
  • Specialized assets such as music rights or patents
  • And even other hedge funds

Fees

Hedge fund managers receive compensation based on the arrangements of the funds’ operating agreements.

One standard compensation plan is known as the “2 and 20,” where fund managers receive 2% net assets per year regardless of performance, plus 20% of profits above a predetermined price. (In recent years, some funds have dropped these numbers closer to 1% and 17-18%, respectively.)

However, this fee structure has come under fire as hedge funds have faltered in recent years. As such, some use a compensation structure based on pure profits.

And regardless of which fee structure a hedge fund employs, the operating agreement often includes mechanisms to protect investors. For instance, high-water marks, prevent managers from getting paid twice on the same returns, while fee caps help mitigate excessive risk. Funds may also set a hurdle, or the minimum profit it must generate before managers can charge fees.

Tax Liabilities

Hedge funds operate as pass-through entities, which means that the fund itself incurs no taxes. Instead, when a hedge fund generates returns on its selected investments, the profits returned to investors are taxed based on where the fund is established.

For example, domestic U.S. hedge fund profits are subject to short-term or long-term capital gains taxes, the same as equity returns. However, offshore hedge funds that accept money from foreign investors and tax-exempt U.S. entities are taxed according to local regulations. Thus, investors don’t pay U.S. taxes on their profits.

Hedge funds structured as partnerships also take advantage of carried interest. In partnerships, the founders and managers are general partners, where the founders own the management company that runs the fund and managers earn a 20% performance fee. All other investors are limited partners.

Under this structure, managers are compensated with carried interest, as their income is taxed on a return on investments instead of salary or payment for services rendered. As such, their incentive fee is taxed at the 20% long-term capital gains rate instead of top income tax rates, imparting significant tax savings for funds and managers.

Hedge Funds vs Mutual Funds

Hedge funds are often placed in the same basket as mutual funds due to both being managed portfolios built from an investor-funded equity pool. But the reality is, hedge funds and mutual funds are more different than alike.

For instance, the bar to invest in a mutual fund is far lower than that to invest in a hedge fund. Typically, mutual funds set a minimum investment requirement between $100 to $2,500. On the other hand, hedge funds require investors to be accredited – and may set minimum starting investments over $1 million.

This is due in part to another difference between the two: hedge funds can invest in just about anything, so long as the manager informs investors of its strategy. This means that managers can take more aggressive positions in riskier assets, often using leverage to amplify returns – and losses. But mutual funds are more limited in their investment vehicles, such as to stocks, bonds, money market securities, and short-term debt. 

Additionally, hedge funds require higher fees – such as the “2 and 20” arrangement – compared to mutual funds, which usually charge an expense ratio between 0.25-1.5% of assets under management. At the same time, mutual funds are more liquid than hedge funds, which may impose “lockup periods” to restrict investor access to their money.

Hedge funds are also subject to reduced regulation and transparency compared to other investments. For instance, mutual funds, stocks, and ETFs must register with the SEC and follow applicable regulations. However, hedge funds don’t advertise publicly, which means they don’t have to follow the same regulations and disclosure requirements.

Who Can Invest in Hedge Funds?

Due to the risky nature and reduced regulatory oversight, hedge fund participants are limited to accredited investors. These are persons or entities who meet specific criterion according to the SEC.

  • Accredited persons must meet one of these criteria:
    • Annual personal income of $200,000 or more for two consecutive years before making the investment
    • Combined annual spousal joint income of $300,000 or more for two consecutive years before making the investment
    • Personal or spousal joint net worth of $1 million or more excluding primary residence
  • Accredited entities must meet one of these criteria:
    • A trust fund or benefit plan worth $5 million or more not formed specifically to make the investment and run by a “sophisticated” investor
    • Any entity in which all investors are individually accredited
  • Other qualified investors include:
    • An executive, partner, director, or other person tied to hedge fund
    • Investment advisors
    • Limited liability companies with more than $5 million in assets not formed specifically to make the investment
    • Rural business investment companies

(Note: a “sophisticated investor” is one with sufficient knowledge and experience to make informed decisions about potential investment risks.)

Types of Hedge Funds

Legally, hedge funds are typically set up as LLCs or limited partnerships. Oftentimes, they’re structured to take advantage of specific market opportunities. And as each uses its own strategy, they are classified according to investment style. This leads to significant risk and investment diversity.

For example, a hedge fund may employ strategies such as:

  • Long/Short Equity: The original hedge fund strategy. A fund takes long positions in suspected winners to finance short positions in suspected losers.
  • Market Neutral: This strategy targets zero net-market exposure, wherein long and short positions have equal value. It comes with lower risk and lower expected returns than a traditional long/short strategy.
  • Event-Driven: Event-driven funds attempt to exploit pricing inefficiencies that surround corporate events, such as mergers, acquisitions, bankruptcies, and earnings calls. Event-driven strategies come with additional risks derived from the underlying activities.
  • Credit: Credit hedge funds focus on credit instead of interest rates. These funds often prosper when credit spreads narrow during economic growth, though they present risk in slowing economies.
  • Arbitrage: Arbitrage strategies involve buying an asset in one market and selling it on another. In doing so, investors hope to profit on price discrepancies in the purchase and sale prices. Hedge funds may take one of several approaches:
    • Merger: Event-driven arbitrage on company mergers.
    • Convertible: Going long on convertible bonds (hybrid securities that combine straight bonds with equity options) and short on a proportion of shares into which they convert.
    • Fixed-Income: Wherein a fund seeks returns on risk-free government bonds, such as by making leveraged bets on how a yield curve will change.
  • Global Macro: This strategy involves analyzing how macroeconomic trends will affect currencies, commodities, equities, or interest rates, and then taking long or short positions according to their views.

Should You Invest in Hedge Funds?

For many investors, this question is moot thanks to accreditation requirements. But even for those who qualify, hedge funds require significant capital and take outsize risks compared to more tightly regulated funds such as mutual funds or exchange traded funds. (Not to mention the massive fees incurred on hedge fund profits.)

As such, most investors may fare better investing in more traditional and accessible vehicles such as mutual funds, bonds, stocks, and ETFs. While nothing’s guaranteed in investing, these securities have a robust track record for producing long-term gains – while hedge fund crashes have produced spectacular losses in the last few months alone. ­­­

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