Hedge Fund is a type of alternative investment that uses pooled funds that employ different strategies to obtain an active return, or alpha, for its investors.
These hedge funds can be managed aggressively or make use of derivatives and financial leverage in domestic and international markets with the aim of generating high returns (either in an absolute sense or above a specific market benchmark).
It is important to note that hedge funds are generally only accessible to accredited investors, as they require less SEC regulation than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles.
Understanding Hedge Funds
Each hedge fund is built to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and are therefore often classified based on investment style.
There is substantial diversity in risk and investment attributes among the styles.
Legally, hedge funds are typically established as private investment limited companies that are open to a limited number of accredited investors and require a large initial minimum investment.
Hedge fund investments are illiquid, as they often require investors to keep their money in the fund for at least a year, a period known as the lock-up period. Withdrawals may also occur only at certain intervals, such as quarterly or semi-annually.
How to choose a hedge fund
With so many hedge funds in the investment universe, it is important for investors to know what they are looking for to streamline the due diligence process and make timely and appropriate decisions.
When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each. These guidelines may be based on absolute values, such as returns exceeding 20% per year over the previous five years, or they may be relative, such as the five highest-performing funds in a particular category.
Here are Hogan’s top 10 tips for choosing a hedge fund:
1. Consider your motivations for investing
Many people think investing in hedge funds is about performance. However, hedge funds are most valuable for the diversification they bring to a portfolio. If you are in it solely for performance, you may be disappointed. Be clear about what you expect from the investment at the outset.
2. Know the manager
Ensure that the hedge fund managers are experienced fund managers who have a proven ability to deliver consistent returns in many different environments.
3. Understand the investment objective
Don’t invest in a fund that you don’t understand. Ask for a detailed explanation of the fund strategy and what type of assets it invests in. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your investment goals.
4. How liquid is the fund?
Consider your long- and short-term financial goals. Most hedge funds have notice periods, and you may not be able to get your money out as quickly as you had hoped. Ensure that the fund’s liquidity matches your investment objectives. Would the investment tie up your assets to the point that you couldn’t easily access your wealth if you needed it quickly? Plan your investments so that you have enough liquidity to meet your needs and goals.
5. Understand the risks
Think about the amount of volatility you are comfortable with. Most hedge funds are risk-mitigating investment strategies as opposed to return-seeking investment strategies, but there are exceptions. Ensure that the objectives of the hedge fund are consistent with yours.
6. There are no shortcuts in selecting a hedge fund
Take your time when selecting one. There are over 100 hedge funds in South Africa today, and most claim to have a unique edge over the rest. They all have different strategies and sub-strategies, and have very different risk and return profiles that profit during varying market conditions. This all needs to be carefully analysed.
7. Make sure the hedge fund has significant investments from fund managers
The common denominator for all good hedge funds is co-investment in the underlying hedge fund by the management team. This is one of the core tenets of hedge fund selection – that the investor’s success is strongly aligned with that of the hedge fund manager.
8. Consider the age of the fund
You can obtain a better picture of a fund’s performance by looking at how it has performed over longer periods and how it has weathered the ups and downs of the market.
9. Consider the size of the fund
Some hedge funds invest in a small number of stocks – a few successful stocks can have a significant impact on the fund’s performance. But as these funds grow larger and increase the number of stocks they own, each stock has less impact on the fund’s performance. This may make it more difficult to sustain and repeat past results.
10. What does the fund cost?
Understand what your fees are paying for. Is the level of fees consistent with an acceptable probability of success for the investor?
The history of Hedge Funds
A former writer and sociologist at Alfred Winslow Jones’ company, AW Jones & Co. launched the first hedge fund in 1949. While writing an article on current investment trends for Fortune in 1948, Jones was inspired to try his hand at investing. Money Management. He raised US$100,000 (including US$40,000 out of his own pocket) and set out to try to minimize the risk of holding long-term stock positions by shorting other stocks. This investment innovation is now known as the classic long/short equity model.
Jones also employed leverage to improve returns.
In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner.
As the first money manager to combine short selling, the use of leverage, sharing risk through a partnership with other investors, and a compensation system based on investment performance, Jones earned his place in the history of trading . investments like the father of the hedge fund.
Hedge funds dramatically outperformed most mutual funds in the 1960s and gained further popularity when a 1966 article in Fortune highlighted an obscure investment that outperformed all mutual funds on the market by double digits during the 1960s. previous year and in high double digits in the last five years.
However, as hedge fund trends evolved, in an effort to maximize returns, many funds moved away from Jones’ strategy, which focused on stock picking along with hedging, and opted to engage in riskier strategies based on long-term leverage . These tactics led to large losses in 1969-70, followed by several hedge fund closures during the bear market of 1973-74.
The industry was relatively quiet for more than two decades until a 1986 article in Institutional Investor touted the double-digit performance of Julian Robertson’s Tiger Fund.
With a high-flying hedge fund once again capturing the public’s attention with its stellar performance, investors flocked to an industry that now offers thousands of funds and an ever-growing range of exotic strategies, including trading currencies and derivatives, such as futures and options.
High-profile fund managers left the traditional mutual fund industry en masse in the early 1990s, seeking fame and fortune as hedge fund managers.
Unfortunately, history repeated itself in the late 1990s and early 2000s as several high-profile funds, including Julian Robertson, failed spectacularly. Since that time, the hedge fund industry has grown substantially.
Today, the hedge fund industry is huge: total assets under management in the industry are valued at over $3.2 trillion according to the Preqin Global Hedge Fund Report 2018.
According to statistics from research firm Barclays hedge, the total number of assets under management for hedge funds increased by 2,335% between 1997 and 2018.
The number of operating hedge funds has also grown. There were about 2,000 hedge funds in 2002. Estimates vary on the number of hedge funds operating today. This number had crossed 10,000 by the end of 2015.
However, losses and poor performance led to liquidations. By the end of 2017, there were 9,754 hedge funds according to research firm Hedge Fund Research.
Key Features
They are only open to “accredited” or qualified investors: Hedge funds are only allowed to take money from “qualified” investors: people with an annual income exceeding $200,000 for the last two years or a net worth greater than $1 million, excluding your primary residence. As such, the Securities and Exchange Commission considers qualified investors to be sufficiently suitable to handle the potential risks that come from a broader investment mandate.
They offer greater investment freedom than other funds: a hedge fund’s investment universe is only limited by its mandate. A hedge fund can basically invest in anything: land, real estate, stocks, derivatives and currencies. Mutual funds, on the other hand, have to basically stick to stocks or bonds and are generally long-term.
They often employ leverage: Hedge funds will often use borrowed money to amplify their returns. As we saw during the 2008 financial crisis, leverage can also eliminate hedge funds.
Fee structure: Instead of charging just an expense ratio, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as “Two Twenty” , a 2% asset management fee and then a 20% cut of any profits generated.
There are more specific characteristics that define a hedge fund, but basically, because they are private investment vehicles that only allow wealthy people to invest, hedge funds can do whatever they want as long as they disclose the strategy up front to investors.
This wide latitude may sound very risky, and sometimes it can be.
Some of the most spectacular financial explosions have involved hedge funds. That said, this flexibility provided to hedge funds has led to some of the most talented money managers producing amazing long-term returns.
It’s important to note that “hedging” is actually the practice of trying to reduce risk, but the goal of most hedge funds is to maximize investment return .
The name is primarily historical, as early hedge funds attempted to protect against the downside risk of a bear market by shorting the market.
(Mutual funds generally do not enter into short positions as one of their primary objectives.)
Today, hedge funds use dozens of different strategies , so it is not accurate to say that hedge funds only “hedge risks.” In fact, because hedge fund managers make speculative investments , these funds can carry more risk than the overall market.
Below are some of the risks of hedge funds:
Hedge Fund Manager Pay Structure
Hedge fund managers are known for their typical 2 and 20 pay structure, whereby the fund manager receives 2% of assets and 20% of profits each year. It’s the 2% that get the flak, and it’s not hard to see why.
Even if the hedge fund manager loses money, he still gets 2% of the assets. For example, a manager overseeing a $1 billion fund could earn $20 million a year in compensation without lifting a finger.
That said, there are mechanisms in place to help protect those who invest in hedge funds.
Many times, fee limitations, such as offshore marking, are used to prevent portfolio managers from receiving the same payment twice. Fee limits can also be set to prevent managers from taking on excessive risk.
Fund Absolute Performance Guidelines
The first guideline an investor should establish when selecting a fund is the annualized rate of return.
Let’s say we want to find funds with a five-year annualized return that exceeds the return of the Citigroup World Government Bond Index (WGBI) by 1%. This filter would remove all funds that underperform the index over long periods of time, and could be adjusted based on the index’s performance over time.
This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and many others.
But if these are not the types of funds the investor is looking for, then you should also establish a guideline for the standard deviation.
Once again, we will use the WGBI to calculate the standard deviation of the index over the past five years. Suppose we add 1% to this result and set that value as the guide for the standard deviation. Funds with a standard deviation greater than the guideline can also be removed from this consideration.
Unfortunately, high returns don’t necessarily help identify an attractive fund.
In some cases, a hedge fund may have employed a strategy it favored, causing performance to be higher than normal for its category.
Therefore, once certain funds have been identified as high performers, it is important to identify the fund’s strategy and compare its returns with other funds in the same category. To do this, an investor can establish guidelines by first generating a pairwise analysis of similar funds. For example, one could set the 50th percentile as the guideline for screening funds.
Now an investor has two guidelines that all funds must meet for further consideration. However, applying these two guidelines still leaves too many funds to evaluate in a reasonable period of time. Additional guidelines should be established , but additional guidelines will not necessarily apply to the remaining universe of funds.
Fund Relative Performance Guidelines
To facilitate the investor’s search for high-quality funds that not only meet the initial return and risk guidelines but also meet the strategy-specific guidelines , the next step is to establish a set of relative guidelines.
Relative performance metrics should always be based on specific categories or strategies. For example, it would not be fair to compare a leveraged global macro fund with a market-neutral long/short equity fund.
To establish guidelines for a specific strategy, an investor can use an analytical software package (such as Morningstar) to first identify a universe of funds using similar strategies. Then a pairwise analysis will reveal many statistics , broken down into quartiles or deciles, for that universe.
The threshold for each guideline can be the result for each metric that meets or exceeds the 50th percentile.
An investor can loosen the guidelines using the 60th percentile or tighten the guideline using the 40th percentile.
Using the 50th percentile on all metrics generally filters out all but a few hedge funds for further consideration. Additionally, setting the guidelines in this way allows flexibility to adjust the guidelines as the economic environment can affect the absolute returns of some strategies.
Here is a solid list of top metrics to use to set guidelines:
- Five-year annualized returns
- Standard deviation
- Rolling standard deviation
- Months of maximum recovery/reduction
- Downward deviation.
These guidelines will help eliminate many of the funds in the universe and identify a viable number of funds for further analysis.
Other Fund Consideration Guidelines
Bill Ackman is director of Pershing Square Capital, one of the largest investment funds in the world.
An investor may also consider other guidelines that may further narrow the number of funds to analyze or identify funds that meet additional criteria that may be relevant to the investor. Some examples of other guidelines include:
Fund Size / Company Size
The guideline for size can be a minimum or maximum depending on the investor’s preference.
For example, institutional investors often invest such large amounts that a fund or company must have a minimum size to accommodate a large investment. For other investors, a fund that is too large may face future challenges by using the same strategy to match past successes. Such could be the case for hedge funds investing in the small-cap space.
Earnings record
If an investor wants a fund to have a minimum history of 24 or 36 months, this guideline will eliminate any new funds.
However, sometimes a fund manager will leave to start their own fund and even though the fund is new, the manager’s performance can be tracked over a much longer period of time.
Minimum investment
This criterion is very important for smaller investors, as many funds have minimums that can make proper diversification difficult.
The fund’s minimum investment can also give an indication of the types of investors in the fund. Higher lows may indicate a higher proportion of institutional investors, while lower lows may indicate a higher number of individual investors.
Terms of exchange
These terms have implications for liquidity and become very important when an overall portfolio is highly illiquid.
Longer lock-up periods are more difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges during the portfolio management process. A guideline to remove funds that have lock-ups can be implemented when a portfolio is no longer liquid, while this guideline can be relaxed when a portfolio has adequate liquidity.
Regulations for hedge funds
Hedge funds are so big and powerful that the SEC is starting to pay more attention, particularly because violations like insider trading and fraud seem to occur much more frequently.
However, a recent act has loosened how hedge funds can market their vehicles to investors.
In March 2012, the Jumpstart Our Business Startup s Act (JOBS Act) was signed into law.
The basic premise of the JOBS Act was to encourage small business financing in the United States by easing securities regulation.
The JOBS Act also had a major impact on hedge funds: In September 2013, the ban on hedge fund advertising was lifted .
In a 4-1 vote, the SEC approved a motion to allow hedge funds and other companies that create private offerings to advertise to whomever they want, but they can still only accept investments from accredited investors.
Hedge funds are often key providers of capital to startups and small businesses due to their broad investment freedom. Giving hedge funds the opportunity to raise capital would indeed help small business growth by increasing the pool of available investment capital.
Hedge fund advertising involves offering the fund’s investment products to accredited investors or financial intermediaries through print media, television and the Internet.
A hedge fund that wants to solicit (advertise to) investors must file a “Form D” with the SEC at least 15 days before it begins advertising.
Because hedge fund advertising was strictly prohibited before lifting this ban, the SEC is very interested in how advertising is being used by private issuers, which is why it has made changes to Form D filings.
Funds making public applications will also be required to submit a modified Form D within 30 days of the completion of the offering. Failure to follow these rules will likely result in a ban on the creation of additional securities for a year or more.
Hedge fund controversies
Several hedge funds have been implicated in insider trading scandals since 2008. One of the most high-profile insider trading cases involves the Galleon Group managed by Raj Rajaratnam.
The Galleon Group made more than $7 billion at its peak before being forced to close in 2009. The company was founded in 1997 by Raj Rajaratnam.
In 2009, federal prosecutors charged Rajaratnam with multiple counts of fraud and insider trading . He was convicted of 14 charges in 2011 and began serving an 11-year sentence. Many Galleon Group employees were also convicted over the scandal.
Rajaratnam was caught obtaining insider information from Goldman Sachs board member Rajat Gupta.
Before the news became public, Gupta allegedly passed along information that Warren Buffett was making an investment in Goldman Sachs in September 2008 at the height of the financial crisis.
Rajaratnam was able to buy substantial amounts of Goldman Sachs stock and make huge profits on those stocks in one day.
Rajaratnam was also convicted on other charges of insider trading. Throughout his tenure as a fund manager, he cultivated a group of industry experts to gain access to exclusive information.
Hedge Fund Income Taxes
When a US domestic hedge fund returns profits to its investors, the money is subject to capital gains tax.
The short-term capital gains rate applies to gains on investments held for less than one year, and is equal to the ordinary income tax rate.
For investments held for more than a year, the rate is no more than 15% for most taxpayers, but can be as high as 20% at high tax levels. This tax applies to both US and foreign investors.
If an offshore hedge fund is established outside the United States, generally in a low-tax or tax-free country, that accepts investments from foreign investors and tax-exempt U.S. entities, the investors do not incur any U.S. tax liability . .US on distributed profits.
Ways Hedge Funds Avoid Taxes
Many hedge funds are structured to take advantage of carried interest.
Under this structure, a fund is treated as a partnership. The founders and fund managers are the general partners, while the investors are the limited partners.
The founders also own the management company that manages the hedge fund. The managers earn the performance fee of 20% of the interest generated as a general partner of the fund.
Hedge fund managers are compensated with this carried interest; Your fund income is taxed as a return on investments rather than a salary or compensation for services provided. The incentive fee is taxed at the long-term capital gains rate of 20% compared to ordinary income tax rates, where the maximum rate is 39.6%. This represents a significant tax saving for hedge fund managers.
This trade deal has its critics, who say the structure is a loophole that allows hedge funds to avoid paying taxes.
The carried interest rule has not yet been repealed despite multiple attempts in Congress. It became a hot topic during the 2016 primary elections.
Many prominent hedge funds use reinsurance companies in Bermuda as another way to reduce their tax liabilities.
Bermuda does not charge a corporate income tax, so hedge funds created their own reinsurance companies in Bermuda.
Hedge funds send money to reinsurance companies in Bermuda. These reinsurers, in turn, invest those funds back into the hedge funds. Any profits from the hedge funds will go to reinsurers in Bermuda, where they owe no corporate income tax.
Hedge fund investment earnings grow without any tax liability. Taxes are only due once investors sell their holdings in the reinsurers.
The business in Bermuda must be an insurance business. Any other type of business will likely incur penalties from the US Internal Revenue Service (IRS).
For passive foreign investment companies. The IRS defines insurance as an active business. To qualify as an active business, the reinsurance company cannot have a pool of capital that is much larger than what it needs to support the insurance it sells. It is unclear what this standard is, as it has not yet been defined by the IRS.
Conclusions
Hedge funds are excellent tools for asset management. This investment instrument is generally only accessed by very large investors or institutional investors.
Funds of this type seek to obtain high returns while minimizing risks and the level of capital available must be taken into account when investing in them while assuming a high degree of uncertainty.
Due to their characteristics, investment funds can be a tool for tax evasion and must be strictly regulated to avoid non-compliance with the law.
