When it comes to nontraditional investors, hedge funds are perhaps the most historically opaque category. Their investment strategies are constantly changing, with each fund executing a unique approach to securing profits. Over the past few years, we’ve watched on as many of them have shifted strategies and stepped into new spaces such as venture capital — in 2021, nontraditional investors, which include hedge funds, contributed $342.2B to overall US VC.
To better track their future activities and strategic trends, it’s important to develop an understanding of their inner workings. In this 101 article, we’ll break down the basics of hedge funds and shed light on how they make money, who invests in them, some of the common strategies they use, and the risks and benefits they involve.
What is a hedge fund?
Hedge funds are alternative investment funds that pool money from professional investors and invest it into the public market. Their main goal is to outperform the S&P index and realize returns in any market environment.
Typically managed by institutional investors, hedge funds utilize a wide array of complex and nontraditional investment strategies – such as derivatives and short selling – to generate profits. While their strategies are often diversified to mitigate risk, hedge funds are generally considered a high-risk, high-reward investment with a steep barrier to entry.
Why are they called hedge funds?
The concept of hedging in finance is not unlike a garden hedge. While garden hedges are used as an alternative to traditional fences to protect and secure property, financial hedging is a strategy used to limit or reduce a portfolio’s exposure to risk.
When the first hedge fund was created in 1949, its founder, sociologist Alfred Winslow Jones, pioneered the strategy of hedging his stock portfolio with short sells, with the idea that this methodology would protect his investments from potential market downturns. Since then, hedge funds have put a variety of other strategies into practice, but the name has stuck around.
Who can invest in a hedge fund?
Due to the high-risk nature of investing with a hedge fund and the high minimum investment required, participation is generally reserved for accredited institutional investors – such as pensions or insurance companies – or high-net-worth individuals.
Not only are hedge fund investors expected to provide large sums of capital and take on high levels of risk, they also must be able to tolerate very low liquidity. Hedge funds usually have a lock-up period that requires investors to keep their money in the fund for at least a year, and withdrawals are limited to certain periods of time.
How do hedge funds make money?
Hedge funds have two main sources of revenue — management fees and performance fees. These can vary from fund to fund, but are typically structured following the 2-and-20 rule.
Management fees
Management fees are calculated as a percentage of assets under management, or AUM, typically around 2%. These fees are intended to cover daily expenses and overhead and are incurred regularly.
Performance fees
Performance fees are calculated as a percentage of the profits from investing, typically around 20%. These fees are intended to incentivize greater returns and are paid out to employees to reward their success.
In recent years, fund managers have faced mounting pressure to reduce management fees and step away from this traditional approach. The COVID-19 pandemic also may have accelerated the upending of the 2-and-20 fee structure.
What makes hedge funds unique?
Hedge funds vs. mutual funds
While both hedge funds and mutual funds tend to invest largely in public company stock, they pool money from different sources and collect fees in different ways.
Mutual funds can raise capital from anyone in the general public, whereas hedge funds are restricted to institutional investors and high net worth individuals.
Additionally, mutual funds are only allowed to collect management fees and not performance fees in accordance with the Investment Act of 1940. Hedge funds, which do not follow the act, charge both management and investor performance fees.
Hedge funds vs. private equity funds
Hedge funds and private equity (PE) funds are both considered alternative assets and are restricted to qualified institutional investors. The two biggest differences between them are the way the funds are structured and the types of companies they invest in.
Hedge funds are structured as open-end funds, allowing investors to contribute money at any time, with withdrawals taking place at certain times throughout the year.
On the other hand, PE funds are structured as closed-end funds. Raised capital is locked up and held in long-term investments, tying up the money until it’s released by a fund manager, often taking several years.
These differing structures are largely due to the types of companies each fund type is invested in; hedge funds mostly make public market investments, while PE funds invest in the private markets.
How do hedge funds invest?
Hedge funds use many combinations of complex, high-risk strategies to generate high returns. Each hedge fund will generally employ their own unique strategies and sub-strategies to achieve this goal. Here are a few examples of such strategies:
Equity
This is the most common hedge fund strategy, balancing long and short positions in the public markets to drive higher returns and reduce risk.
Sub-strategies:
- Long-short: These positions have a net-long market exposure, meaning managers do not hedge their entire long market value with short positions.
- Market neutral: When short and long positions have equal market value, managers can expect lower risks, but also lower expected returns.
Event-driven
This is when a fund makes an investment due to a one-time event that is expected to radically affect a company’s security prices.
Sub-strategies:
- Merger arbitrage: Simultaneously purchasing and selling the respective stock of two merging companies, this is generally viewed as a “riskless” profit.
- Distressed funds: This is when a manager purchases debt from a company that has, or is very likely to, file for bankruptcy.
Relative value
This is a newer strategy that requires access to market data and looks for inconsistencies and errors in how the market is pricing individual securities. It focuses more on market behavior than specific companies.
Sub-strategies:
- Convertible arbitrage: This is when a manager capitalizes on mispricing between convertible bonds and their underlying stock.
- Volatility arbitrage: This means profiting from differences between forecasted future price volatility and implied volatility.
Global macro
This is an investment into a wider view of securities (stocks, bonds, commodities, derivatives) that aims to predict how global forces such as weather, politics, and warfare might cause a shift in the financial markets.
What are the benefits and risks of investing in a hedge fund?
Benefits
- Diversification: Hedge funds can utilize a diverse range of investment methods far beyond individual investors. Short selling, derivatives and alternative assets help diversify a portfolio and increase the chances of successful returns however the market may be performing.
- High returns: Working with a hedge fund means your investment is being managed by experienced market professionals who develop strategies designed to outperform the market. Institutional investors can potentially expect much higher profits as a result.
Risks
- Investment risk: To generate their high returns, hedge funds often seek out highly risky investments. Investors could potentially lose large amounts of capital by participating. In addition, fund managers can suspend investor redemptions, or repayment of shares, regardless of when an investor may have subscribed. This could prevent investors from withdrawing their money or exiting a fund.
- Market risk: While hedge funds were founded on the principle that hedging investments with short-sells and derivatives would protect them from market downturns, this is not always the case. Historical performance suggests that behavior of the market and the reliability of the chosen strategy can still affect a fund’s performance and, in turn, an investor’s returns.
- Operational risk: From misappropriation of funds to outright fraud, hedge funds are no stranger to operational risk. Failure to comply with regulations or faulty internal processes can pose a risk to hedge fund investors.
What are some of the largest hedge funds?
According to PitchBook’s data, these are some of the top hedge funds around the world based on AUM as of August 28, 2023.
Carne Global Financial Services
Location: Dublin, Ireland
AUM: $2.00Tn
Summary: Provides distribution support for the asset management industry
Most recent deal: Purchased the business division of GAM Investments in a LBO via financial sponsor Vitruvian Partners, announced June 2023
Geode Capital Management
Location: Boston, Massachusetts
AUM: $803.47B
Summary: Employs an equity long/short strategy and uses the volatility and quantitative style of investments in equity, options, and commodity
Most recent deal: Invested an undisclosed amount of development capital into American construction company TRI Pointe Homes in July 2022
Apollo Capital Management
Location: Sydney, Australia
AUM: $500.00B
Summary: Multi-strategy hedge fund manager investing in crypto assets
Most recent deal: Contributed to a $9M early-stage venture funding round for cryptocurrency platform Maverick Protocol in June 2023
Asset Management One International
Location: London, U.K.
AUM: $451.00B
Summary: Employs multi-strategy and fundamental equity investment strategies in real estate investment trusts.
T&D Asset Management
Location: Tokyo, Japan
AUM: $451.00B
Summary: Employs long-short equity, multi-strategies, and low-volatility strategies for ESG investments
Eurizon Capital Real Asset SGR
Location: Milan, Italy
AUM: $419.02B
Summary: Invests in infrastructure and real estate technology
Most recent deal: Acquired 90% of railway maintenance company Tecnofer in an LBO for EUR $79.78M alongside Ersel, an Italian wealth management firm
STP Investment Services
Location: West Chester, Pennsylvania
AUM: $400.00B
Summary: Employs a long-short equity strategy in financial services and software
Most recent deal: Acquired 100% of web development company WealthSite through an LBO in December 2022
Eurizon SLJ Capital
Location: London, U.K.
AUM: $351.40B
Summary: Specializes in foreign exchange and a top-down approach, preferring a discretionary style
Nickel Digital Asset Management
Location: London, U.K.
AUM: $330.00B
Summary: Employs a multi-strategy and absolute market-neutral arbitrage strategy in financial services and cryptocurrency investments
Mellon
Location: Boston, Massachusetts
AUM: $307.20B
Summary: Employs macro, credit, and equity multi-strategy investments alongside fund of fund equity and risk parity
Most recent deal: Acquired The Boston Company Asset Management and merged it with Mellon Capital Management and Standish Mellon Assets to create Mellon in January 2019
How can I track hedge funds on PitchBook?
As of August 28, 2023, we track 25,105 hedge funds on our platform, so you can perform due diligence, benchmark funds, raise capital, and make competitive analysis with ease. According to some of our hedge fund clients, “Accurate tracking of private company investor and board memberships has given us greater insights into networking opportunities” and “PitchBook allows us to conduct due diligence on private companies before meeting with them, helping us secure a higher client win rate.”
Our data includes detailed information on performance, strategy and sub-strategy, net asset value, geographic focus, and more. All information is verified and vetted before it enters our platform, ensuring you have access to the high-quality data you need to assess hedge fund opportunities all in one place.
