Hedge Funds Explained: What Investors Should Know

If you’ve participated in the financial markets, the term hedge fund probably sounds familiar. But it may seem somewhat opaque. What is a hedge fund, exactly? How do hedge funds work? Both are important questions worth exploring.

The Idea Behind Hedging

To put it simply, the term hedging is generally considered to be a risk-reduction strategy—in real life or the financial markets. Let’s use an example from everyday life. Did you know that if you purchase car insurance, you’re sort of a derivatives trader? Even though you may have never bought a call or put option, the simple act of purchasing car insurance is a hedging strategy. You’ve essentially purchased a put option on your car (the right to make a claim on the insurance company). But keep in mind that unlike call and put options, purchasing car insurance doesn’t give you the right to sell your car at a specific strike price or sell the policy in the secondary market. 

Let’s hope you never get into a car accident, but if you did, you’d exercise the rights in your put option and transfer the liability and damage risk over to the insurance company. For this right, you paid a premium. You’ve hedged your downside risk.

“Hedging isn’t necessarily in the limelight when the stock markets are performing well like they did during the pandemic,” said Michael Kealy, education coach at TD Ameritrade. 

How Do Hedge Funds Work?

Hedge funds are pooled investments designed to use strategies that might reduce risk and produce absolute returns (noncorrelated to popular benchmark indices) in different markets and market conditions. Unlike buying a stock and hoping prices go up over time, rising asset prices may not be necessary to generate returns in a hedge fund.

This concept may be difficult to wrap your head around, but that’s the main difference between hedge funds and other pooled investments. 

When considering hedge fund returns, it’s probably a good idea to look at absolute and relative returns. “Absolute returns are the returns of the fund itself (how much the fund returned in a certain time span) whereas relative returns are based on comparing the hedge fund to a benchmark,” noted Kealy. For example, you can identify the relative return of a long/short hedge fund by comparing it to some sort of benchmark that operates in the long/short space.

Examples of Hedge Funds

There are different types of hedge funds. Some hedge funds may follow an equity long-only investment strategy. Others may follow an equity long/short portfolio where the hedge fund managers seek to eliminate some directional risk in stock ownership by going long and short different stocks in a custom portfolio.

Some hedge fund strategies fall under the arbitrage banner. Arbitrage is the simultaneous purchase and sale of an asset in different markets to capitalize on temporary price discrepancies. For example, a hedge fund manager might seek to potentially profit from the pricing discrepancy between a convertible bond and the underlying shares it converts to. Some hedge funds seek to profit from price differentials of companies in proposed mergers and acquisitions. Overall, hedge funds are nimbler than the traditional mutual fund that holds a basket of stocks for the long term.

Who Can Invest in Hedge Funds?

Hedge funds are typically tailored for accredited investors in the private capital markets. The Securities and Exchange Commission (SEC) defines accredited investors as those whose net worth is greater than $1 million or whose annual income exceeded $200,000 in each of the last two years, or a joint spousal income that surpassed $300,000 and is likely to do so again. A general partner, executive officer, or director of the company issuing the unregistered securities is also considered an accredited investor. “The SEC has expanded the definition of accredited investors by including professional designations for state registered investment advisors and people who work for private funds,” Kealy said.

Still, hedge fund managers do have some sway over investor decision making. You may hear about hedge funds dialing back on certain investments, seeing a spike in total assets, or bulking up on certain asset classes such as cryptocurrencies. Although cryptocurrencies may be extremely volatile, they still offer an opportunity for returns. “Some investors may be reluctant to invest directly in cryptocurrencies, but hedge funds could provide them professional management so investors don’t need to make their own decisions about which crypto to invest in,” Kealy explained.

Occasionally, the financial press likes to throw open the books on hedge fund holdings when made public in 13F regulatory filings. “Some hedge funds have achieved almost legendary classification because of their returns, and this hits the news waves and makes individual investors pay attention,” Kealy added.

But even accredited investors need to do their due diligence so they can understand all the reward and risk factors associated with a particular hedge fund strategy. And that may take some research. 

Hedge Fund Fees

Hedge funds are known to have some interesting fee structures. One of the most popular is the “2-and-20” fee structure—the fund has a 2% annual management fee to offset some of the administration expenses and a 20% high-water mark performance fee. The performance fee is basically to compensate the hedge fund manager.

For example, if a fund starts off with $10 million in assets under management (AUM) and during the first year gained 10% or $11,000,000, the manager would be entitled to 20% of the $1 million or $200,000. But if during the second year the fund lost 5%, the manager would not be entitled to the performance fee until the fund surpassed the original $1 million in profits again.

Nowadays, with so much competition between funds for investors’ capital, hedge fund fee structures are getting more competitive. “Accredited investors might be the clientele for hedge funds because they may be able to absorb a big loss in addition to the high fees. Where there’s a substantial degree of risk, there’s also a substantial degree of possibility of outperforming the overall market,” Kealy mentioned.

Do Your Due Diligence

Hedge funds are sophisticated investment strategies and can utilize leverage, derivatives, short selling, and arbitrage to potentially achieve absolute (noncorrelated) returns for investors. Hedge funds can be a way to get exposure to various assets whose longer-run potential may be appealing. They can potentially act as a true diversifier against a directional portfolio of stocks and bonds.

While TD Ameritrade doesn’t offer access to hedge funds, investors’ ability to participate in hedge fund strategies in the public markets is growing. “Investors could consider investing in publicly traded private equity firms that are responsible for a lot of hedge fund investing,” commented Kealy. As with any investment made with hard-earned capital, investors need to do their homework to understand what they’re investing in.