What Are Hedge Funds?

by ABC

HedgeFunds1
Hedge funds are thinly regulated private investment funds for high net worth individuals and institutions. They tend to be extremely quantitative and highly leveraged in their investing approach, coming up with proprietary “black-box” models to determine their trades.

Hedge funds became popular in the 1990s when their numbers doubled, but they had a spectacular run from the early 2000s until world economies started to unravel in late 2008. Hedge fund managers were reported to be earning hundreds of millions and in some cases, billions in fees in producing hyper-returns for their clients.

Hedge funds have all forms of trading strategies including market neutral, distressed, global macro, convertible arbitrage, fixed income arbitrage and fund of funds, among others.

Hedge Fund Fee Structure

Their managers earn an annual management fee, usually between 1-3% of assets under management. They also take a chunk, typically 20-25%, of profits earned by the fund during the fiscal year. Many hedge funds require multi-million investments and long lock-up periods which means that the funds you invest cannot be redeemed for a specified period.

Unlike mutual funds, hedge funds are not subjected to the regulations of the SEC and the managers do not have to be registered investment advisors.  Consequently, they take far more risks and frequently invest in options and futures, buy on margin using borrowed money, short stocks and make large bets on currencies and commodities. They trade in large volumes and either rack up considerable capital gains or capital losses.

High-Risk Trading

The high risks incurred by hedge funds came to light at the start of subprime crisis when two Bear Sterns hedge funds, which were heavily invested in sub-prime derivatives, were almost wiped out on the back of plummeting assets. Eventhough these hedge funds had only a total of US$1.6bn in assets, through extreme leveraging, they owned more than US$10 billion in mortgage-backed and other derivatives.

At its height, there were 10,000 hedge funds in business, and possibly half of them have folded since. Stepped up regulation for hedge funds is expected and competitive tax advantages are likely to be terminated. Previously, profits earned by hedge funds were taxed as capital gains, and they could keep money overseas as a tax-deferral strategy.

However, top hedge funds survived the disaster of 2008 and just as the industry is undergoing increased regulatory scrutiny, those flush with cash are also being looked to take private equity stakes in distressed banks.

Why do I need to know about hedge funds?

It’s important to know that hedge funds are high risk investment vehicles so if you ever get the chance to invest in one – make sure you tread cautiously!

Photo Credit: lostulysses

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