Hedge Funds

What are Hedge Funds and What Do They Do?

A Short History

In 1949 Australian born Alfred Jones began “hedging” his long term holdings in a fund he started by selling short other stocks as well as utilizing leverage to increase his returns.[1] Thus began the first hedge fund.  Jones is credited with adding the traditional 20% incentive fee for manager compensation as well as becoming the first manager to use a partnership structure reducing individual risk.  For these reasons, he is known as “the father of the hedge fund.”1

In time, variations to Jones’ original style emerged.  Instead of hedging positions by shorting stocks, managers became more interested in the potential for increased returns by speculating with short positions and having no position on the other side for a hedge.  While the potential for returns utilizing this strategy were greater, the risks of losing capital also increased.  Between 1969 and 1974, large losses mounted in hedge funds and resulted in many funds closing down.[2] These highly speculative strategies have diluted the term “hedge fund,” and today, the term almost does nothing to describe the fund’s activities.

Hedge Fund Characteristics

1. High Fees

Hedge fund managers typically charge a 1-2% investment fee on assets that is charged no matter how the fund performs.  On top of that, there are incentive fees that managers earn off of any profits that are made by the fund.  A typical number for this incentive is 20% of profits.  Hedge funds also come with the stipulation that any losses must be recouped for investors before the manager can take the 20% fee.  This is known as the funds high water mark.  For example, if a fund loses 5% in year 1 and gains 15% in year 2, the manager cannot take the incentive fee for year 2’s gains until the loss of the 5% in year 1 is made up for.  The incentive structure is something that is heavily debated from an ethical and fairness standpoint and will be addressed in later sections.

2. Light Regulation

Hedge funds are largely unregulated pooled investment vehicles, with a highly incentivized fee structure, that focus on absolute returns for shareholders.[3] By contrast, mutual funds face greater regulation and are focused on performance relative to a benchmark.  For example, a mutual fund that invests in the largest blue chip stocks will have as its appropriate benchmark the Dow Jones Industrial Average.  Such a fund is a success if it beats this index and a failure if it underperforms.

Mutual funds are also required to register with the Securities and Exchange Commission (SEC).  The funds are subject to oversight on aspects such as required diversification and rules on distributions.[4] Hedge funds are not required to register with the SEC (this rule may change) and are not limited in the investments they use.  The only codes and regulations hedge funds share with mutual funds relate to fraud and the duties of fiduciaries.  As the funds are lightly regulated, hedge fund investments are opaque.  Some funds do not reveal their investments/strategies to protect proprietary secrets.

3. Liquidity

Hedge funds have significant minimums that investors must meet in order to invest in the fund.  While a typical mutual fund may have a $5,000 minimum investment, a typical hedge fund minimum is usually $1 million.  Hedge fund investors are therefore, wealthy individuals, trusts, or institutions looking for high returns.  Hedge funds charge these significant minimums to take advantage of increased volume efficiencies.  With these large minimums, many hedge funds require their investors to be “accredited investors.”  The SEC defines an accredited investor as:[5]

1)     A bank, insurance company, registered investment company, business development company, or small business investment company;

2)    An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;

3)    A charitable organization, corporation, or partnership with assets exceeding $5 million;

4)    A director, executive officer, or general partner of the company selling the securities;

5)    A business in which all the equity owners are accredited investors;

6)    A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;

7)    A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or

8)    A trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchase a sophisticated investor makes.

These qualifications ensure the investor can bear large losses and will not be devastated financially if such losses occur.  Supposedly, the qualifications also ensure a higher level of investor sophistication.

4. Lock-Up

Hedge fund investors cannot simply withdraw their money whenever they like.  As mentioned above, because the funds require large minimums, hedge fund managers try to take advantage of volume efficiencies and often invest in very illiquid securities.  Managers therefore, insist investors keep their money in the fund for a specified period of time (“lock-up period”) and can only withdraw the funds at specified times with advanced notice.  The withdrawal periods are typically every quarter with lockups for 1 or 2 years (although 5 year lockups are not uncommon) and anywhere from 30-90 days advanced notice is required.  These provisions allow managers to trade without regard for the need to sell into a market to meet liquidity needs and reduce the risk to other investors of large withdrawals.

5. Leverage

Hedge funds are allowed to and do use borrowings to increase their returns.  Hedge fund leverage (the amount of debt) can vary from zero to high double digits.  In an environment of low interest rates, it is normally profitable for hedge funds to borrow money and then invest that money into any financial instrument the fund wants.

Strategies and Hedge Fund Returns

Hedge funds employ a plethora of strategies to accomplish their objectives.  The funds take extreme measures to protect the proprietary nature of these strategies.   For the sake of simplification, hedge funds fall into three main categories.  From these categories emerge diverse strategies.[6]

1. Arbitrage

The first category is arbitrage.  These strategies take advantage of price inefficiencies.  They usually involve extremely high volume, high turnover transactions.  Trading software, derivatives, and highly computerized exchanges have made it possible for arbitrage strategies to become successful.[7] An example of an arbitrage opportunity is when a fund buys a corporate convertible bond and sells short the equity for which the convertible bond is exchangeable.  This attempts to take advantage of a bond that is cheap relative to the stock of the issuing company.[8]This kind of arbitrage involves some risk.  Pure arbitrage is theoretically riskless.  For example, suppose the same stock trades at a slightly different price on two different stock exchanges.  The arbitrageur would simultaneously buy the cheaper stock and sell it on the more expensive exchange, thus locking in the spread, and engaging in a perceived riskless transaction.

2. Event-Driven

The second category of hedge fund strategy is event-driven strategies.  Merger arbitrage is the best example of this category where the hedge fund manager bets on a merger to happen by buying the stock of the target company while simultaneously shorting the acquirer.[9] If done in large enough volumes, this strategy can be profitable because in mergers and acquisitions (M&A), the share price of the target company tends to rise while the acquirer’s share price usually decreases.

3. Directional

The third broad category is Directional or Tactical Strategies.  This represents the bulk of hedge fund strategies as these include long/short strategies, market neutral strategies, etc.[10]

Hedge funds are known to perform better in bear markets, as they can use hedging strategies, shorts, and other transactions that reduce exposure to downside risk.  In rising markets, however, it is not uncommon for hedge funds to underperform.  For a clear analysis of long term hedge fund performance see this smart money article: http://www.smartmoney.com/investing/mutual-funds/the-truth-about-hedge-funds-1302121763886/?cid=1122


Ethical Analysis of Hedge Funds

1. Transparency and Disclosure

See, “Disclosure: The Bernie Madoff Case”

2. Agency Problems

Hedge fund fee structures are rather unique and are accused of causing conflicts of interest.  Consider a situation in which a manager loses a significant amount of money in a year as we witnessed in 2008.  In order to get paid the incentive fee, the manager would have to make up the losses before the fee on profits would take effect.  The dilemma for the manager becomes:  do I stay and attempt to make these losses back which would most likely take a few years, or close this fund down and start another one?  Unfortunately, some managers chose the latter option.  It is not illegal to close a losing fund, return money to investors, and start a new fund with a clean slate and a new high water mark.[11] Is it, however, ethical?

A utilitarian analysis leads to the conclusion that this act is unethical.  The investors in the losing fund are left with less money than they started, and instead of having a manager who wants to try and recoup the losses, investors are forced to find another fund or investment with their reduced capital from the first.  Investors may also be affected by a loss in faith in the fund industry and be skeptical of most managers going forward.  If the new fund makes money, then investors will be forced to pay an incentive fee on profits instead of having the fee waived by the first fund.  The only party who is better off in this situation is the manager because he will get his incentive fee if he makes a profit in the new fund, without having to make up losses from the fund that was closed.  However, the loss of reputation can also have a negative effect on the manager’s ability to raise future capital for new funds.  Overall, the consequences of the act of closing a fund down instead of trying to recoup losses causes more harm than good.

A virtuous person would strive to make their investors whole again after losing them a great deal of money.   Someone possessing the virtue of loyalty will do everything possible to make this right.  In the hedge fund world, it means sticking with the current fund and deferring the incentive fee until all losses are recouped.  One may say it is cowardly to cut and run from a fund that has lost investors’ money.  This act of cowardice is not one a virtuous person would do.

3. Fund Lock-Ups

During the financial crisis, some hedge funds outraged investors when these investors were not allowed to withdraw their money from the funds.  This freeze was implemented regardless of whether investors had already reached their respective lock-up periods.  Hedge fund managers were concerned that selling into a down market would devastate returns.  Standard subscription agreements outline the power of a manager to freeze withdrawals during times of extreme volatility.  However, this point is not normally highlighted during discussions between management and potential investors.  Is it ethical to freeze someone’s money, even though the subscription agreement gives a manager such power?

Applying a utilitarian approach, the answer is that it is ethical for a manager to freeze investor’s assets during extreme conditions.  The provision is added to the subscription agreements to protect investors.  As described above, hedge funds invest in all kinds of securities and impose lock-up, freeze, and limited liquidity provisions to ensure the ability to invest in illiquid securities that may provide large upside.  During times of great market volatility, freeze provisions protect other investors in the fund from large withdrawals that would reduce the value of the fund even more.  Selling into markets like the ones in 2008 and 2009 can have devastating effects.  Sometimes the smarter thing to do is to ride out the downturn.  In providing the greatest good to the greatest number of investors, a manager would be smart to not make exceptions and allow withdrawals during turbulent times.  The consequences of a few withdrawals on the rest of the portfolio and the rest of the investor pool may harm more people.

By: Ryan Wagner

[1] McWhinney, James E.  A Brief History of the Hedge Fund.  Investopedia.  Obtained 11/14/2010.  http://www.investopedia.com/articles/mutualfund/05/HedgeFundHist.asp.

[2] Ibid.

3  Harper, David, CFA, FRM.  Hedge Funds Hunt for Upside, Regardless of the Market. Investopedia.  Obtained 11/14/2010.  http://www.investopedia.com/articles/03/112603.asp.

[4] Clark, Timothy M.  Hedge Fund Exit Strategies. Forbes.  November 6, 2008.  www.forbes.com.

[5] Accredited Investors. US Securities and Exchange Commission Official Website.  Obtained November 14, 2010.  http://www.sec.gov/answers/accred.htm.

[6] Harper, David, CFA, FRM.  Hedge Funds Hunt for Upside, Regardless of the Market. Investopedia.  Obtained 11/14/2010.  http://www.investopedia.com/articles/03/112603.asp.

[7] Ibid.

[8] Ibid.

[9] Ibid.

[10] Ibid.

[11] Herscher, Penny.  Hedge Fund Ethics and How They’ll Lead to More Regulation. Huffington Post.  January 23, 2009.  www.huffingtonpost.com.