Hedge Fund Essentials

Executive Summary

The hedge fund industry has come a long way from its hedged equity roots, when some of the earliest hedge funds — like Alfred Winslow Jones’ investment partnership created in 1949 — gained notoriety among academics and professional money managers for employing techniques like short selling and using leverage to enhance returns. Jones’ fund, for example, lost money in only 3 out of 34 years of business.¹ This ability to hedge market risk helped these funds build a reputation for outperforming traditional long-only investment portfolios — particularly in down markets — and for reducing overall volatility when added to an existing portfolio of stocks and bonds.

In a way, it’s come full-circle. In the industry’s early days, hedge fund investors consisted mainly of high- and ultra-high-net-worth investors, family offices, or others in-the-know. Then, beginning in earnest in the late 1990’s, institutional investors began entering in the space. Now, over the last decade, there is again growing interest in hedge funds and other alternative investments from advisors and their high-net-worth clients.

This paper covers, in brief, the essential features of the hedge fund landscape. We discuss the key reasons for investing in hedge funds and evaluate the types of strategies employed, including long/short equity, relative value, event-driven strategies, credit, managed futures, and multi-strategy funds that make use of combinations of strategies to seek excess returns across a spectrum of market conditions.

The paper then turns to the question of access to hedge funds and explains the process of due diligence, whereby investors evaluate the quality and competency of select hedge funds to determine their suitability and the potential for meeting the investor’s objectives. Due diligence is a topic that is covered in greater depth elsewhere, but this description provides a running start.

Moving on, we tackle the subject of fees and investment mechanics in the context of hedge funds. The paper offers insights on incentives, manager and investor alignment, asset allocation decisions, and hedge fund performance. Due to their unique strategy mix and investment process, hedge funds often require lock-ups and gates, where redemptions are concerned, in order to ensure liquidity through all phases of the investment fund cycle. However, stipulations on how fees are calculated are also a common feature of the investment agreement, with high water marks and hurdle rates serving to protect against managerial compensation that is disproportionate to actual performance.

Throughout the paper, charts and data that highlight and support the key points have been provided. We conclude the paper with a short glossary of essential terms.

For advisors and institutional investors alike, alternative investments, including hedge funds, are a valuable but complex feature of the investment universe today. Careful study and consultation with industry experts are the cornerstones for developing an informed view and making the optimal decisions about incorporating these offerings into a well-balanced and robust portfolio.

The Rise of the Hedge Fund Industry

The hedge fund industry can be traced back to 1949, when investor Alfred Winslow Jones established an investment partnership structured to be exempt from the regulations of the Investment Company Act of 1940, allowing Jones to employ techniques such as short selling and using leverage. Jones had notable success, losing money in only 3 out of 34 years of business², and became known as the “father of the hedge fund industry.” The term “hedge fund” is derived from the fact that Jones — seeking to lower the portfolio’s overall volatility by shorting and taking positions in negatively correlated assets that o set each other — described his fund as “hedged”. Today, however, ‘hedge fund’ is largely a misnomer, as the range of investment strategies and assets within the hedge fund universe has expanded. In fact, many fund managers do not actually employ hedging as a cornerstone of their strategy.

One of the easiest ways to understand what a hedge fund is, is to think of it in relation to mutual funds. The primary difference between the two is a regulatory one. Both are pooled investment vehicles, but mutual funds are publicly available to any investor, while hedge funds are private funds that follow specific regulatory exemptions setting limits on the number and type of investors that can participate, as well as how (and to whom) the funds can be marketed.

As a result, hedge fund managers have considerable investment flexibility. Not only can they invest in publicly traded stocks and debt securities, similar to mutual funds, but they can also be active in private markets, commodities, currencies, futures, swaps, or other derivatives. Further, they are not restricted from engaging in short selling — in effect betting that a particular investment will decline in value. In this way, fund managers can use short selling to build o setting positions in an effort to ‘hedge’ the portfolio. Lastly, they have the ability to structure compensation arrangements that may entail charging an incentive (or performance) fee³ in addition to a management fee — similar to Alfred Winslow Jones who set the standard of charging a 2% management fee and also taking 20% of gains.

Since its inception, the hedge fund industry has exhibited a significant upward growth trajectory, punctuated by “boom and bust” episodes, most notably with increases in popularity during the bear market of 1973-1974, the aftermath of the early 2000s technology bubble, and following the financial crisis of 2008. Over the last two decades, the number of funds and the aggregate assets under management (AUM) have risen steadily, from about 3,200 funds with approximately $143 billion AUM in 1998 to 11,000 funds with approximately $3.1 trillion AUM by late 2018;⁴ see Figure 1.⁵ In recent years, there has been a trend towards consolidation, with increased concentration of investor capital in medium-sized to very large funds.⁶

Why Invest in Hedge Funds?

At the most basic level, the ability to hedge investment risk has helped hedge funds to perform better in down markets than traditional long-only vehicles. Figure 2 depicts the lossmaking periods suffered by hedge funds and the S&P 500 Total Return (TR) Index during the global financial crisis and its aftermath, from 2008 to 2014, showing that the S&P 500 TR has seen more instances of drawdown and more severe drawdowns than hedge funds have experienced over the same period.

Historically, hedge funds have earned a return similar to stocks, but at a level of volatility that is closer to bonds. From January 1990 to September 2017, the annualized standard deviation of the HFRI Fund Weighted Composite Index was 6.6%, compared to 14.3% for the S&P 500 TR and 3.6% for the Barclays Aggregate Bond Index.⁷

As shown in Figure 3, the HFRI outperformed the S&P 500 TR for the majority of the period between 1990 and 2017 in terms of a thousand dollars invested. The exception was the brief period leading up to the dot-com bubble in the late 1990s, but hedge funds outperformed significantly once the bubble burst.

Taking a closer look, the long-term performance of hedge funds has tended to follow a cycle of ‘underperformance’ relative to stocks in rising markets, and outperformance relative to stocks in falling markets. As shown in Figure 4, stocks outperformed hedge funds during the bull markets from 1994 to 1999 and from 2002 to 2007. However, each bull market phase ended with a major bear market for stocks, during which time hedge funds outperformed. Because hedge funds typically maintain both long and short exposures, their outperformance relative to the index is not surprising.

Hedge funds, as an alternative investment with unique capabilities, offer diversification from a traditional stock and bond portfolio. Further, there are many types of hedge funds, focused on specific sectors and approaches. This range of hedge fund investment activities reflects an additional layer of flexibility and diversification, based on strategies that exhibit various characteristics across different market environments.

As previously mentioned, most hedge funds rely on exemptions from the Securities Act of 1933 and the 1940 Act, which limits their availability to “sophisticated” investors, including institutions and high-net-worth individuals. About two-thirds of the industry’s investors are institutions, with public and private pension funds contributing nearly half of all capital provided to hedge funds by U.S.-based institutions, as shown in Figure 5.⁸ Individual investors are typically required to be “accredited investors,” meaning “someone who has earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or someone who has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).⁹

A hedge fund investor could also be a “qualified purchaser,” which can be (i) a person with not less than $5,000,000 in investments; (ii) a company with not less than $5,000,000 in investments that is owned by close family members; (iii) a trust, not formed for the investment, with not less than $5,000,000 in investments; (iv) an investment manager with not less than $25,000,000 under management; or (v) a company with not less than $25,000,000 of investments.¹⁰

Investors may select from the broad array of hedge fund strategies available to meet various investment objectives. For many investors, the reason for allocating capital to hedge funds is not so much to achieve a higher absolute rate of return, but rather to improve a portfolio’s risk-adjusted returns, with hedge funds acting as a diversifier to lower the volatility overall.

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