What are Hedge Funds?

October 20, 2012 in Hedging and Hedge Funds

Hedge fund deninition







That’s not a hedge fund! A real hedge fund has little to do with plants and vegetation, and plenty to do with the other green stuff – your investment dollars, a.k.a, greenbacks.

Hedge Fund Definition and Description

A hedge fund is in fact a specialized investment vehicle, but strangely, a regulatory definition of the term ‘hedge fund’ is hard to find. But here is one from the SEC:

“Form PF defines “hedge fund” generally to include any private fund having any one of the three common characteristics of a hedge fund: (a) a performance fee that takes into account market value (instead of only realized gains); (b) high leverage; or (c) short selling.”

Thus a hedge fund may pay its advisers a remuneration (performance fee) that is calculated regardless of the gains actually realized, and based on the market value of the assets under management. Again, the hedge fund may be heavily borrowed, or have very high exposure in the markets through the use of derivatives or other instruments. Lastly the fund indulges in short-selling (selling a security or asset it does not possess – yes, that is possible!).

But let us not stay within the confines of this definition and look at some more characteristics of this investing vehicle.

Hedge funds are usually privately held and raise their funds directly from investors (often called “accredited” investors who may be wealthy individuals or institutions) and are not listed on an exchange. Retail investors generally do not get access because of their relative financial unsophistication and limited resources.

Investors are usually bound by the rules of the hedge fund, which may be specific and unique to the fund, and this may result in a reduction in the liquidity of the investment – often there are restrictions on redemption, such as ‘lock-up’ periods.

So far, hedge funds have been lightly regulated and taxed, but after the financial crisis of 2008, there have been persistent demands for more comprehensive regulation of hedge funds and this may happen in the not too distant future.

Hedge funds have acquired immense financial power in recent years, as their free-wheeling investing and speculative style along with nimble-footed trading in various asset classes, which is substantially unfettered by geographic or regional boundaries, allows them to generate super-normal returns. That is not to say that they are infallible – investors have burnt their fingers with hedge funds too – the famous case of Long Term Capital Management and its spectacular implosion springs immediately to mind. No matter that it was run by Nobel Prize winners and elite traders!

Talking of elite traders, hedge funds are known to employ the best financial and trading brains in the management of their investments, which is why the performance fees in many cases are very high, sometimes as much as 20-25%, almost like a partnership. Hedge funds are also able to invest in cutting edge equipment, technology and software that give them an edge in evaluating, trading and monitoring off-the-beaten-track assets and investments.

Hedge Funds Market Size

According to data from research firm BarclayHedge, hedge fund assets under management (AUM) grew from $118.23 billion in 1997 to $1.7089 trillion by the end of the second quarter of 2012.

Hedge funds assets under management (Hedge fund AUM)

More recent data for the third quarter of 2012 according to a Press Release from Hedge Fund Research says that total hedge fund assets as at the end of the third quarter 2012 stood at a record $2.19 trillion!

These figures look like an astonishing growth story, but experts estimate that this is still a small percentage of the total non-hedge fund assets under management out there.

Returns on Hedge Funds

For all their high profile and size, what did hedge funds earn for their investors?

The chart below shows returns have been fairly good though somewhat erratic and decidedly bad during the 2008 financial crisis and in 2011, when the European debt crisis took center-stage.

Return on Hedge funds

Hedge Funds – Me?

O.K. so you may not yet be ready to entrust your hard-earned dollars to a hedge fund manager, but yet, even as an ordinary retail investor, it pays to understand hedge funds and their often market-moving strategies. A wealth of information is available on their investments through statutory filings and also reports in the press – these could help to sharpen your own investment focus and make you a better market player. You could study and read about legendary hedge fund managers and how they made their billions.

And take heart: No less a person than David Rubenstein, co-founder of buy-out firm Carlyle Group LP feels it is only a matter of time before the ordinary investor would gain access to firms such as his, hedge funds and alternative investment vehicles.

So, keep reading, and stick with us as we bring you more on hedge funds in this series.

You may also check:

1) Types of Hedge Funds
2) Hedge Funds – Pros & Cons
3) Hedge Fund and Long-term Capital Management


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