Can someone explain "hedge funds" (for Dummies) please.?

Question

My learning style is visual (artist) or if you could use metaphors it might make sense to me. Also, is this an effective way to invest these days? Thanks for making the effort.

Answer 1

A hedge fund is a private, largely unregulated pool of capital whose managers can buy or sell any assets, bet on falling as well as rising assets and participate substantially in profits from money invested. It charges both a performance fee and a management fee. Typically open only to qualified investors, hedge fund activity in the public securities markets has grown substantially, accounting for approximately 10% of all U.S. fixed-income security transactions, 35% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, and 30% of equity trades. Hedge Funds dominate certain specialty markets such as trading within derivatives with high-yield ratings, and distressed debt.

Alfred W. Jones is credited with inventing hedge funds in 1949.

In the United States, for an investment fund to be exempt from direct regulation, it must be open to a limited number of accredited investors only. While there is no legal definition for "hedge fund" under U.S. securities laws and regulations, typically they include any investment fund that, because of an exemption from the types of regulation that otherwise apply to mutual funds, brokerage firms or investment advisors, can invest in more complex and riskier investments than a public fund might. Hedge funds managed from other countries have similar relationships with their national regulators. As a hedge fund's investment activities are therefore limited only by the contracts governing the particular fund, it can make greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.

As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term "hedge fund" has come in modern parlance to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase risk, and therefore return, rather than reduce it.

Hedge funds have acquired a reputation for secrecy. Being outside the regulatory regime that applies to retail funds greatly reduces the information a hedge fund is legally required to make public. Additionally, divulging trading methods and positions would compromise the business interests of many types of hedge fund, tending to limit the information they want to release.

The assets under management of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Their sway over markets, whether they succeed or fail, is therefore potentially substantial and there is a continuing debate over whether they should be more thoroughly regulated.

Industry

In 2005, Absolute Return magazine found there were 196 hedge funds with $1 billion or more in assets, with a combined $743 billion under management - the vast majority of the industry's estimated $1 trillion in assets.[4] However, according to hedge fund advisory group Hennessee, total hedge fund industry assets increased by $215 billion in 2006 to $1.442 trillion, up 17.5% on a year earlier, an estimate for 2005 seemingly at odds with Absolute Return.

As large institutional investors have entered the hedge fund industry the total asset levels continue to rise. The 2008 Hedge Fund Asset Flows & Trends Report [6] published by HedgeFund.net and Institutional Investor News estimates total industry assets reached $2.68 trillion in Q3 2007. According to the BarclayHedge Monthly Asset Flow Report, hedge funds received only $15 billion in October, the second-lowest inflow in 2007. Year-to-date hedge funds attracted $278.5 billion, three times year-to-date inflow into equity mutual funds.

Fees

A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee). Performance fees are closely associated with hedge funds, and are intended to be an incentive for the investment manager to produce the largest returns he can. A typical manager will charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value (or "NAV") per annum and a performance fee of 20% of the fund's profit (being the increase in its NAV).

Fees are payable by the fund to the investment manager. They are therefore taken directly from the assets that the investor holds in the fund.

Management fees

As with other investment funds, the management fee is calculated as a percentage of the net asset value of the fund at the time when the fee becomes payable. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Therefore, if a fund has $1 billion of assets at the year end and charges a 2% management fee, the management fee will be $20 million. Management fees are usually calculated annually and paid monthly, but can also be paid weekly.

Performance fees

Performance fees, which give a share of positive returns to the manager, are one of the defining characteristics of hedge funds. The manager's performance fee is calculated as a percentage of the fund's profits, counting both unrealized profits and actual realized trading profits. Performance fees exist because investors are usually willing to pay managers more generously when the investors have themselves made money. For managers who perform well the performance fee is extremely lucrative.

Typically, hedge funds charge 20% of gross returns as a performance fee. However, the range is wide, with highly regarded managers charging higher fees. In particular, Steven Cohen's SAC Capital Partners charges a 3% management fee and a 35% performance fee,[7] while Jim Simons' Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its flagship Medallion Fund.

Performance fees are intended to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, performance fees have been criticized by many people, including notable investor Warren Buffett, for giving managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark and sometimes limited by a hurdle rate. Alternatively a "claw-back" provision may be included, whereby the investment manager might be required to return performance fees when the value of the fund drops.

High water marks

A high water mark (also known as a loss carryforward provision) is often applied to a performance fee calculation.[8] This means that the manager only receives performance fees on the value of the fund that exceeds the highest net asset value it has previously achieved. For example, if a fund were launched at an NAV per share of $100, which then rose to $130 in its first year, a performance fee would be payable on the $30 return for each share. If the next year it dropped to $120, no fee is payable. If in the third year the NAV per share rises to $143, a performance fee will be payable only on the $13 return from $130 to $143 rather than on the full return from $120 to $143.

This measure is intended to link the manager's interests more closely to those of investors and to reduce the incentive for managers to seek volatile trades. If a high water mark is not used, a fund that ends alternate years at $100 and $110 would generate performance fee every other year, enriching the manager but not the investors.

The mechanism does not provide complete protection to investors: a manager who has lost a significant percentage of the fund's value will often close the fund and start again with a clean slate, rather than continue working for no performance fee until the loss has been made good. This depends on the manager being able to persuade investors to trust it with their money in the new fund.

Hurdle rates

Some managers specify a hurdle rate, signifying that they will not charge a performance fee until the fund's annualized performance exceeds a benchmark rate, such as T-bill yield, LIBOR or a fixed percentage. This links performance fees to the ability of the manager to do better than the investor would have done if he had put the money elsewhere.

Managers who specify a "soft" hurdle rate charge a performance fee based on the entire annualized return once the hurdle rate has been achieved. Managers who use a "hard" hurdle rate only charge a performance fee on returns above the hurdle rate.

Because demand for hedge funds has outstripped supply, most managers do not now need hurdle rates in order to attract investors. For this reason, hurdle rates are now rare.[citations needed]

Withdrawal/Redemption fees

Some managers charge investors a withdrawal/redemption fee (also known as a surrender charge) if they withdraw money from the fund before a certain period of time has elapsed since the money was invested. The purpose is to encourage long-term investment in the fund: as a fund's investments need to be liquidated to raise cash for withdrawals, the fee allows the fund manager to reduce the turnover of its own investments and invest in more complex, longer-term strategies. The fee also dissuades investors from withdrawing funds after periods of poor performance.

The fee is typically known as a "withdrawal fee" where the fund is a limited partnership and a "redemption fee" where the fund is a corporate entity.

Answer 2

Think about an art gallery that takes $25,000 to open. You could get a loan - or you could ask 24 of your friends and acquaintances to put in $1,000 each (you're the 25th person) and everyone gets 4% (1/25) of the profits. If the business sinks, we're each out $1,000 - whereas if you alone put up the $25,000 you'd be out the entire amount.

Similarly, a financial fund (hedge, mutual, or pension) is where the 25 of you put in money and, instead of opening an art gallery, you invest and split the returns.  Same idea - you share the risk, share the profits. You also get to take advantage of scale buying. It is cheaper on a per-share basis to buy 10,000 shares than 100 shares. There are also investments (such as corporate bonds) that you often need a minimum of $10,000 to purchase. That's 10 grand sunk into one asset if you do it alone - but if 10 of us do it, it's $1,000 each. This means we get to invest in more places.

The difference between a hedge fund, mutual fund, and pension fund is basically who can invest in it, and what the fund can invest its investors' money in.

Pension funds are the most conservative - only high quality investments, usually strictly defined as being of a certain bond rating or above. This makes sense - pension returns are what are used to pay for retirees, so the money has got to be there.

Mutual funds have more leeway. Investors are expected to know what they're getting into, so there's more risk here. Through a mutual fund you can invest entirely in funeral home stocks, bonds for rural development in South America, or Russian export companies. You can also diversify - meaning you can invest in a lot of different companies in a lot of different industries. If you wanted to buy stock in 10 different companies on your own, that's 10 different transactions (and quite a bit of money, since you would probably buy a block of 100 shares each). Or you could put money into a mutual fund (usually $2,000 minimum) and you reap the benefits of all 10 companies' shares.

Now for the meat: hedge funds. Think of them as high-risk mutual funds for only wealthy people. Usually you need a net worth of $1 million and a net income of $250K annually in order to invest - and you may need to put in $100K up front.

The original meaning of hedge funds was from something called "hedging" which is a technical way to offset risk by taking advantage of derivatives in the markets. A derivative is basically an agreement between two investors to pay money to one or the other depending upon how an underlying asset (stock, commodity) performs. Using complex mathematical equations (financial engineering), a virtually assured rate of return can be found.... but it takes a ton of money to get it to be worth it. And if any of the assumptions of the models are wrong, the fund loses money big time.

Nowadays, hedge funds are allowed to invest in whatever their charters say they can, not just stocks and bonds (which mutual funds are limited to). Hedge funds often put money into buying up companies directly (or through venture capital firms), thus skipping the middle man of the financial markets and taking direct ownership of the profits. Hedge funds also have been known to invest in movies - extremely high risk - as well as other businesses.

You probably can't invest in a hedge fund at this point in time - if you can, the fees will be incredibly high. Every fund has a manager who is paid through the fund's income or returns (or both). Pension fund managers are often corporate employees with a fixed salary. Mutual fund managers are often employees of the fund provider, and their earnings are based on how much money the fund makes. Hedge fund managers get paid based on what they want to be paid - very lucrative work, very high fees.

If I were you, I'd consider mutual funds - especially the index funds, which track the markets and tend to be very low in terms of fees. You may also wish to purchase blocks of dividend-yielding stock (since dividends are taxed preferentially to interest income) since the market is low right now. But hedge funds aren't for the faint of heart - or even the middle-upper class.

Answer 3

A hedge fund is a way to invest some of your money to protect most of your money (as in, hedging your bets).

As an artist, think of it this way...  imagine a large new landmark building by a famous architect.  You look at the building and think it is sooo mundane, so uninspired.  You may be bored by or even hate almost everything about the building, but he or she included one, small, controversial architectural detail that so amazed and impressed you, that it outweighs all the failings in the rest of the project.

Meanwhile, the mainstream, unsophisticated person may love the rest of the building, and hate the little detail, but that detail is so small they probably don't even notice it.

A hedge fund is that little, controversial, risky detail among your investments.

You invest a little money in a high risk/high reward opportunity that goes in the opposite direction of your other investments.    Like, when oil prices go up, oil companies make money, but companies that sell gas-guzzling trucks lose money.  

So, if you have alot of your money invested in oil, you hedge by investing a little in truck companies.  That way, in case oil goes down, the truck stocks would go up, and you would be protected.  Except, to be protected enough, you would buy truck company OPTIONS instead of truck company stock.  Option prices move ALOT, while stock prices only move a little.  It is very risky, because options can lose all of their value quickly, but when an option goes up, it goes up, like, 10 or 100 times more than a stock would.  The idea is, the only way you could lose all of your money in the options is if you are making even more money in the oil stock.

That's a simple example; real hedge funds make sophisticated investments in foreign currencies and derivatives and other high risk investments that are known to move in the opposite direction of other investments.    A good example is gold; when the dollar loses value, gold moves up in value.    If you have alot of investment in U.S. dollars, you buy a small, high risk, high reward investment in gold, as a hedge.

Because of their high-risk nature, and their purpose, hedge funds are meant only to be used by very wealthy people, and usually require very large minimum investments, typically in the millions.

Hedge funds are controversial, because they make huge investments that go in the opposite direction of most other investors.  They will often make investments that bet a company will do poorly (aka 'short selling'), while most people are investing in companies that they think will do well.