Hedge fund facts for kids
A hedge fund is a special kind of investment fund. It collects money from many investors, like a big pool. This money is then used to buy and sell different types of investments. Hedge funds use clever and sometimes complex strategies to try and make money, no matter if the markets are going up or down. They also try to protect their investments from big market changes.
These funds often use advanced techniques like short selling (betting that a stock's price will go down) and leverage (using borrowed money to invest more). Because of these complex methods, in places like the United States, hedge funds are usually only for very wealthy people or large organizations, not for everyday investors.
Hedge funds are different from regular mutual funds or ETFs that most people can invest in. They have more freedom in how they invest and can take bigger risks. Unlike private equity funds, which invest in things that are hard to sell quickly, hedge funds usually invest in things that can be bought and sold easily. This means investors can often put money in or take it out more regularly.
After the financial crisis of 2007–2008, new rules were made in the US and Europe. These rules aimed to watch hedge funds more closely and fill in any gaps in how they were regulated. Even though they can use many different tools and strategies, hedge funds can be very different from each other. They have different ways of investing, different risks, and different expected returns. Many hedge funds try to make money even when the overall market is struggling. However, they can still be risky investments.
Hedge funds usually pay their managers two types of fees. One is a management fee, which is a percentage of the money they manage (often 2% per year). The other is a performance fee, which is a percentage of the profits they make (often 20% of the yearly increase). Hedge funds have been around for many years and have become very popular. By 2021, they managed about $3.8 trillion in total.
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What's in a Name?
The word "hedge" means a fence or boundary, and it's used here to mean limiting risk. Early hedge funds tried to protect their investments from general market changes. They did this by betting against other similar investments. Today, however, many hedge funds use different strategies, and not all of them "hedge" or limit risk in the same way.
How Hedge Funds Started
In the 1920s, during a time when the US stock market was booming, rich investors had many private ways to invest their money. One famous example was the Graham-Newman Partnership. Warren Buffett, a very famous investor, even called it an early hedge fund.
But the person usually given credit for creating the first modern hedge fund and coining the term "hedged fund" was Alfred Winslow Jones. He started his fund in 1949. He used the word "hedged" because it was a common term on Wall Street for managing investment risks due to market changes.
In the 1970s, most hedge funds focused on one main strategy: buying some stocks they thought would go up and selling others they thought would go down (called "long/short equity"). Many hedge funds closed down during tough economic times in the early 1970s because they lost a lot of money. They became popular again in the late 1980s.
During the 1990s, the number of hedge funds grew a lot. This was partly due to the rising stock market and the idea that managers would make more money if the fund did well. Over the next ten years, hedge fund strategies became much wider. They started including things like distressed debt (investing in companies in trouble) and using computer models for investing. Large organizations like pension funds also started putting more of their money into hedge funds.
In the early 2000s, hedge funds became popular worldwide. By 2008, they managed about $1.93 trillion. However, the financial crisis of 2007–2008 caused many hedge funds to limit how much money investors could take out. Their popularity and total money managed went down. But they bounced back, reaching almost $2 trillion by 2011. By then, most of the money (61%) came from large organizations.
By 2017, hedge funds had grown even more, reaching a record $3.1 trillion in total money managed.
Famous Hedge Fund Managers
Here are some well-known people who manage or have managed hedge funds:
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- George Soros of Quantum Group of Funds
- Ray Dalio of Bridgewater Associates, which is one of the world's largest hedge fund firms.
- Steve Cohen of Point72 Asset Management.
- John Paulson of Paulson & Co..
- Kenneth Griffin of Citadel, managing over $62 billion by 2022.
Hedge Fund Strategies
Hedge funds use many different ways to invest. These strategies are usually put into four main groups: global macro, directional, event-driven, and relative value. Each strategy has its own risks and ways of making money. A fund might use just one strategy or combine several for flexibility and to manage risk.
The fund's prospectus (also called an offering memorandum) tells potential investors about the fund's investment plan, what it invests in, and how much leverage it might use.
Strategies can also depend on how investments are chosen. Some are "discretionary," meaning managers pick them. Others are "systematic," using computer programs to select investments.
Sometimes, hedge fund strategies are called "absolute return" strategies. This means they aim to make money no matter what the market is doing. They can be "market neutral" (less affected by overall market changes) or "directional" (betting on market trends).
Global Macro Strategies
Hedge funds using a global macro strategy make big bets on stocks, bonds, or currencies. They do this based on what they think will happen with major global economic events. For example, they might invest if they expect a country's economy to grow or shrink.
These managers look at "big picture" economic trends around the world. They identify chances to profit from expected price changes. Global macro funds have a lot of flexibility. They can use borrowed money to make large investments in many different markets. However, timing is very important for these strategies to work well.
Directional Strategies
Directional investment strategies try to profit from market movements, trends, or differences when choosing stocks. These strategies can use computer models or rely on fund managers to pick investments. They are more affected by the overall market's ups and downs than market-neutral strategies.
One common directional strategy is "long/short equity." Here, hedge funds buy stocks they think will go up (long positions) and sell stocks they think will go down (short positions). This helps to balance out some of the risk.
Event-Driven Strategies
Event-driven strategies focus on special situations or "events" that affect a company's value. These events include things like company mergers, acquisitions, or even bankruptcies. Managers using this strategy try to find investment opportunities before or after these events happen. They bet on how the company's stock or other investments will move.
Large investors like hedge funds often use these strategies. They have the knowledge and resources to analyze these complex company events.
There are three main types of corporate events:
- Distressed Securities: This involves investing in companies that are facing serious financial trouble or bankruptcy. The goal is to buy their bonds or loans at a low price, hoping they will recover.
- Risk Arbitrage: This usually involves buying and selling stocks of two or more companies that are merging. The goal is to profit from small price differences between the companies' stocks. The risk is that the merger might not happen.
- Special Situations: These are events that change a company's stock value. Examples include a company reorganizing itself, buying back its own shares, or selling off assets.
Relative Value Strategies
Relative value strategies look for small price differences between related investments. For example, they might find that one security is priced unfairly compared to another similar one. Hedge fund managers use different analyses, like mathematical or technical methods, to find these differences.
These strategies often have very little connection to the overall market's performance. They include:
- Fixed Income Arbitrage: Finding price differences between related bonds.
- Equity Market Neutral: Buying and selling stocks in the same sector to profit from differences, while also protecting against broader market changes.
- Convertible Arbitrage: Profiting from price differences between a company's convertible bonds and its regular stocks.
Risks of Hedge Funds
For investors who already have a lot of stocks and bonds, putting money into hedge funds can help spread out risk. This means their overall investment portfolio might be less risky. Hedge fund managers often try to make returns that don't move exactly with the market. They also aim for returns that match what investors want, based on how much risk they are willing to take.
While hedging can reduce some risks, it might increase others, like problems with operations or models. So, overall risk is reduced but not completely gone. One report found that hedge funds were about one-third less volatile (meaning their prices didn't swing as wildly) than the S&P 500 stock index between 1993 and 2010.
Managing Risk
In most countries, investors in hedge funds are expected to be "qualified investors." This means they are assumed to understand the risks involved. They accept these risks because of the chance for high returns. Fund managers use many strategies to protect the fund and its investors. Large hedge funds often have very advanced ways of managing risk.
It's common for funds to have special officers whose job is just to assess and manage risks. These officers are not involved in the actual trading. They use different ways to measure risk, looking at how much the fund uses borrowed money, how easily assets can be sold, and the investment strategy.
Besides market risks, investors also check for "operational due diligence." This means they look for risks like errors or fraud within the hedge fund itself. They consider how the fund is run, if its strategy can last, and if the company can grow.
Transparency and Rules
Hedge funds are private, so they don't have to share as much information publicly. This can sometimes make them seem less transparent. Some people also think their managers aren't watched as closely by regulators as other financial managers. This might make them more prone to mistakes or fraud.
However, new rules in the US and Europe since 2010 require hedge fund managers to report more information. This has led to greater transparency. Also, large investors are pushing for better risk management. Hedge funds are now sharing more details with investors, including how they value investments and their trading positions.
Risks Like Other Investments
Hedge funds share many risks with other types of investments. These include:
- Liquidity Risk: This is about how easily an asset can be bought or sold for cash. Like private equity funds, hedge funds often have a "lock-up period." During this time, investors cannot take their money out.
- Manager Risk: These risks come from how the fund is managed. For example, a manager might "drift" away from their area of expertise. Other risks include problems with valuing investments, putting too much money into one strategy, or having too much exposure to a single investment.
Many investment funds use leverage, which means borrowing money to invest more. While leverage can increase potential profits, it also increases the chance of bigger losses. Hedge funds that use leverage usually have strong risk management practices. Compared to big investment banks, hedge funds actually use less leverage.
Some funds, including hedge funds, are seen as having a greater "appetite for risk." They aim to make the most money possible, based on what investors and managers are comfortable with. Managers who invest their own money in the fund have an extra reason to watch risks closely.
Fees and Pay
Fees Paid to Hedge Funds
Hedge fund management companies typically charge two main fees:
- Management Fees: This is a percentage of the total money managed by the fund. It's usually between 1% and 4% per year, with 2% being common. These fees cover the fund's running costs.
- Performance Fees: This is usually 20% of the fund's profits each year. These fees are meant to encourage managers to make good returns.
Most performance fees include a "high water mark." This means the manager only gets a performance fee if the fund makes new profits, after recovering any losses from previous years. This stops managers from getting paid for wild ups and downs. Some fees also have a "hurdle." This means the manager only gets a fee if the fund's performance goes above a certain benchmark, like a specific interest rate.
Some hedge funds also charge a "redemption fee" if investors take out their money too early. This fee is usually kept by the fund and shared among all investors. It discourages short-term investing.
Pay for Managers
Hedge fund management companies are often owned by their managers. So, any profits the business makes go to them. Performance fees (and any extra management fees) are usually given to the owners as profit. The very top hedge fund managers can earn huge amounts of money, sometimes billions of dollars in a good year.
The earnings for the top hedge fund managers are often higher than in any other part of the financial industry. However, most hedge fund managers earn much less. If they don't make profits, they might not get significant performance fees.
In 2011, the highest-paid manager earned $3 billion. The average earnings for the top 25 managers in the US was $576 million.
How Hedge Funds Are Set Up
A hedge fund is an investment vehicle often set up as an offshore corporation, a limited partnership, or a limited liability company. An investment manager (a separate company) runs the fund. Many hedge funds also use other companies for support, like banks, administrators, and accounting firms.
Prime Broker
Prime brokers help hedge funds with their trades. They provide borrowed money and securities for strategies like short selling. They can also hold the fund's assets and help with trading.
Administrator
Hedge fund administrators are usually in charge of valuing the fund's investments and handling its operations and accounting. A key job is calculating the fund's net asset value (NAV). This is the price at which investors buy and sell shares in the fund. It's very important for the NAV to be calculated accurately and on time.
Administrators also handle new investments and withdrawals. While US hedge funds don't have to use an administrator, most do. This helps avoid conflicts of interest and provides more transparency.
Auditor
An auditor is an independent accounting firm that checks the fund's financial statements. They make sure the fund's NAV and total money managed are correct.
Distributor
A distributor helps market the fund to potential investors. Many hedge funds don't have a separate distributor; the investment manager handles the marketing themselves.
Where Funds Are Based and Taxes
The legal structure of a hedge fund and where it's based often depend on the tax rules for its investors. Many hedge funds are set up in offshore financial centers (like the Cayman Islands) to avoid certain taxes for foreign or tax-exempt investors. This helps make it easier for people from different countries to invest without being taxed multiple times.
US tax-exempt investors, like pension plans, often invest in offshore hedge funds to keep their tax-exempt status. The investment manager, usually based in a major financial city, pays taxes on its management fees in its own country. In 2011, about half of all hedge funds were registered offshore and half onshore. The Cayman Islands was the top offshore location.
Regulation of Hedge Funds
Hedge funds must follow the laws and rules of the countries where they operate. In the US, hedge funds have different rules than mutual funds. Mutual funds have very detailed regulations under the Investment Company Act of 1940. Hedge funds are usually exempt from many standard rules because they only accept "accredited investors" (wealthy individuals or large organizations).
In 2010, new rules were put in place in the US (the Dodd-Frank Act) and Europe (the AIFMD). These rules required hedge fund managers to register with regulators and share more information. This increased transparency and oversight.
The hedge fund industry has also tried to regulate itself. In 2007, some leading hedge fund managers created voluntary "Hedge Fund Standards." These standards aimed to promote transparency and good management in the industry.
United States Rules
In the US, hedge funds must follow rules about reporting and keeping records. Many also fall under the Commodity Futures Trading Commission, which prevents fraud. The Securities Act of 1933 requires companies to register with the SEC before offering securities to the public. Most hedge funds are offered as "private placements," meaning they are not sold to the general public.
The Investment Advisers Act of 1940 had rules against fraud and set limits on the number and types of investors. It also said that hedge funds didn't have to register with the SEC if they only sold to accredited investors.
The Dodd-Frank Act, passed in 2010, changed things. It now requires hedge fund managers with more than $150 million in assets to register with the SEC. They must also file reports about their assets and trading positions. This means more hedge funds are now under government supervision.
European Rules
In the European Union (EU), hedge funds are mainly regulated through their managers. In the United Kingdom, where many European hedge funds are based, managers must be approved by the Financial Conduct Authority (FCA). Each country has its own specific rules, like limits on using derivatives in Portugal or leverage in France.
The EU's AIFMD directive aims to better monitor and control alternative investment funds. It requires all EU hedge fund managers to register with national regulators and share more information. It also requires them to hold more capital.
Offshore Funds
Some hedge funds are set up in offshore centers like the Cayman Islands or Dublin. These places have different rules about investors, privacy, and how independent the fund manager is.
Performance of Hedge Funds
It's hard to get performance data for individual hedge funds. They don't have to report their results publicly, and they often don't advertise. However, some industry journals and databases do provide summaries.
One estimate suggests that the average hedge fund made 11.4% profit per year. This was 6.7% more than the overall market, before fees. Another estimate found that between 2000 and 2009, hedge funds did better than other investments and were less volatile. During that time, stocks fell by 2.62% per year, while hedge funds rose by 6.54% per year. However, more recent data shows that hedge fund performance has gone down since about 2009.
Hedge Fund Indices
Just like there are stock market indexes (like the S&P 500) that show how the market is doing, there are also hedge fund indexes. But these are more complicated. Hedge funds aren't traded on exchanges, and they don't have to publish their returns.
There are different types of hedge fund indexes:
- Non-investable indices: These try to show the average performance of hedge funds based on databases. But they can have problems. For example, funds might only report good results, or funds that fail are removed, which can make the average look better than it really is.
- Investable indices: These try to fix the problems of non-investable indices by creating products that investors can actually buy. But to do this, the hedge funds in the index must agree to certain terms, which means the index might not include the most successful managers.
- Hedge fund replication: This newer method uses math to create a model of how hedge funds perform. Then, they build an investment portfolio that tries to copy that performance.
Closures
In 2016, more hedge funds closed down than during the 2009 recession. Some large pension funds pulled their money out of hedge funds. They felt that the funds' performance wasn't good enough to justify the high fees they charged.
Even though the hedge fund industry reached over $3 trillion in 2016, the number of new hedge funds starting up was lower than before the 2007-2008 financial crisis. There were 729 new hedge funds in 2016, fewer than the 968 that opened in 2015.
See also
In Spanish: Fondo de cobertura para niños
- Alternative investment
- List of hedge funds
