What is Hedge Fund?

“Hedge Fund” is an investment vehicle most professional and institutional investors are familiar with. In 1949, Alfred Winslow Jones, born in Melbourne, Australia and an American sociologist and Journalist, created the first hedge fund called A.W. Jones Partners near Wall street1. He used leverage to buy as many stocks, and short selling to avoid the market risk. Thus, he referred to his fund as being "hedged". Jones’ hedge fund was not widely known in the first 15 years. Until 1966, a legendary reporter Carol Loomis wrote an article to remove the veil2. Jones’ hedge gained over 670% return in the preceding 10 years, compared with a 358% gain for the leading mutual fund of the period. During the first 20 years of business, the fund gained almost 5,000%. If you invested $10,000 in 1949, the amount reaches $480,000 after 20 years.
Hedge Funds are distinct from mutual funds and regarded as alternative investments. Although majority of hedge funds invest in liquid assets, they use trading tools like leverage and short selling and operate with greater flexibility than mutual funds (usually highly regulated). Hedge funds are partnerships formed between fund manager and investors. Hedge funds are private placement, and often structured as a limited partnership or limited liability company with little regulation. Today, hedge funds commonly are set up in tax exempt countries, like Cayman Island or BVI, and structured as Segregated Portfolio Company (SPC), Limited Liability Company (LLC), or Unit Trusts. Most of hedge funds managed by SFC-licensed hedge fund managers are operated in Cayman Island. According to BarclayHedge database, total assets under management for the hedge fund as of 1st Quarter 2019 is $3,01 trillion3, and number of hedge funds is around 6,000. 4

Rank3 Hedge Fund Manager AUM
(billions of USD)
1 Bridgewater Associates $132.8
2 AQR Capital Management $83.7
3 Man Group $59.1
4 Renaissance Technologies $57.0
5 Two Sigma Investments $38.0
6 Millennium Management $35.3
7 Elliott Management $35.0
8 Marshall Wace $34.8
9 Davidson Kempner Capital Management $31.4
10 Baupost Group $31.0
11 Citadel LLC $30.0
12 BlackRock $29.9
13 D.E. Shaw & Co. $28.8
14 Select Equity Group $26
15 Farallon Capital $25.3

The Main Characteristics of Hedge Funds:

  1. Qualified Investors
  2. Hedge funds usually take money from accredited individuals and institutional investors, for It is common for a hedge fund to require at least $100,000 or even as much as $1 million to participate. Regulators think that qualified investors are more capable to handle potential investment risk.

  3. Absolute return
  4. Absolute return is a return that an investment achieves over a period of time. Fund managers’ ultimate goal is to maximize capital appreciation, regardless of market benchmarks or indicators (market would rise or fall). Managers use their risk adjusted techniques and skills to pursue market-agnostic return.

  5. Diverse strategies
  6. The term “hedge” is commonly used to define opposite direction trades used to mitigate market risks, which is now referred to as the long/short strategy. Nowadays, hedge funds managers have access to trade across diverse investment tools, underlying assets and regions, The most commonly used strategies by hedge funds includes Arbitrage, CTA/Managed Futures, Distressed Debt, Event Driven, Fixed Income, Long/Short Equity, Macro Funds, Multi-Strategy, and Relative Value5

  7. Align the interests of fund managers and investors
  8. Hedge funds typically charge their funds a standard 2-20 fee model. 2% management fee is designed to cover the operating costs of the manager, and 20% performance fee is calculated whereas the funds make profit. This standard fee model is designed by Alfred Winslow Jones back to 1949, invoking the Phoenician sea captains who kept a fifth of the profits from successful voyages. (suggests that Phoenicians were widely known as the best sailors and trader, and captain is responsible so long as the ship exists)

  9. Lower volatility
  10. Empirical study6 suggests that hedge funds has a better return and lower volatility than mutual funds. Hedge funds have a no or low correlation with the main markets, for the its market-agnostic nature.

  11. Improve risk adjusted return
  12. As a standalone asset class, hedge funds have historically demonstrated better risk-adjusted returns. This ability to earn returns with lower correlations to traditional assets make hedge funds an efficient addition to portfolios. In other words, this diversified portfolio will generate higher expected returns per unit of risk incurred

Hedge funds is a popular asset class in asset allocation for applicable investors and institutions, like to equities and fixed-incomes. In the hedge funds universe, investors must perform sophisticated due diligence to individual hedge fund, including manager, structure, investment strategies, prospectus, and etc. The process is time consuming and costly, but with the right choice will definitely benefit the overall portfolio.

1 https://www.valuewalk.com/alfred-winslow-jones/
2 https://www.businessinsider.com/alfred-winslow-jones-started-the-first-hedge-fund-2016-8
3 https://www.pionline.com/article/20180917/INTERACTIVE/180919948/the-largest-managers-of-hedge-funds
4 https://www.barclayhedge.com/databases/hedge-fund-database/
5http://www.eurekahedge.com
6http://arno.uvt.nl/show.cgi?fid=129398

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Published on 10 August 2019