Hedge fund

Hedge fund is a private investment fund that participates in a range of assets and a variety of investment strategies intended to protect the fund's investors from downturns in the market while maximizing returns on market upswings.

Hedge funds are distinct from mutual funds, individual retirement and investment accounts, and other types of traditional investment portfolios in a number of ways. As a class, hedge funds undertake a wider range of investment and trading activities than traditional long-only investment funds, and invest in a broader range of assets, including equities, bonds and commodities. By taking a long position on a particular asset the manager is asserting that this position is likely to increase in value. When the manager takes a short position in another asset they would be asserting that the asset is likely to decrease in value. Most hedge fund investment strategies aim to secure positive return on investment regardless of overall market performance. Hedge fund managers typically invest their own money in the fund they manage, which serves to align their interests with investors in the fund. Investors in hedge funds typically pay a management fee that goes toward the operational costs of the fund, and a performance fee when the fund’s net asset value is higher than that of the previous year. The net asset value of a hedge fund can be billions of dollars, due to investments from large institutional investors including pension funds, university endowments and foundations. Worldwide, 61% of investment in hedge funds is from institutional sources as of February 2011. As of 2009, hedge funds represent 1.1% of the total funds and assets held by financial institutions. The estimated size of the global hedge fund industry is US$1.9 trillion.

Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. Because hedge funds are not sold to the public or retail investors its advisers have historically not been subject to the same restrictions that govern other investment fund advisers, with regard to how the fund may be structured and how strategies are employed. However, hedge funds must comply with many of the same statutory and regulatory restrictions as other institutional market participants. Regulations passed in the United States and Europe after the 2008 credit crisis are intended to increase government oversight of hedge funds and eliminate any regulatory gaps.

Industry size

Estimates of industry size vary widely due to the absence of central statistics, the lack of an agreed definition of hedge funds and the rapid growth of the industry. As a general indicator of scale, the industry reached a peak in the second quarter of 2008 when it managed $1.93 trillion. The credit crunch caused assets under management (AUM) to fall sharply through a combination of trading losses and the withdrawal of assets from funds by investors. In April 2011, it was estimated that hedge funds had total AUM of almost $2 trillion, approaching the amount held prior to the credit crisis.

As of January 1, 2011 the largest 225 hedge fund managers in the United States held a total of $1.297 trillion. The largest manager in 2010 was Bridgewater Associates at $58.9 billion assets under management. In 2009, the largest hedge fund manager was JP Morgan Chase ($53.5 billion) followed by Bridgewater Associates ($43.6 billion), Paulson & Co. ($32 billion), Brevan Howard ($27 billion), and Soros Fund Management ($27 billion).

History

Sociologist, author, and financial journalist Alfred W. Jones is credited with the creation of the first hedge fund in 1949. Jones believed that changes in asset prices can be attributed partly to factors specific to the asset in question and partly to trends in the market as a whole. To neutralize the effect of overall market movement, he balanced his portfolio by buying assets whose price he expected to increase in the future, relative to the overall performance of the market, and selling short assets whose price he expected to decrease. He saw that price movements due to the overall market would balance out because, if the overall market rose, the loss on shorted assets would be cancelled by the additional gain on longed assets and vice-versa. By taking this approach his investment strategy was market neutral, as returns depended only on him picking the right stock, not on whether the stock market went up or down. Jones referred to his fund as being "hedged" to describe how the fund managed risk exposure from overall market movement. This type of portfolio became known as a hedge fund.

Jones added a 20% performance fee in 1952 and converted his fund to a limited partnership, and thereby became the first money manager to combine a hedged investment strategy, leverage and shared risk, with compensation based on investment performance. At this time, only a few investors had adopted Jones' investment structure as it was not well known in the financial community. Attention was drawn to the fund and Jones' strategies in 1966 when Carol Loomis, a writer for Fortune magazine, wrote an article about Jones called "The Jones Nobody Keeps Up With". The article noted that Jones’ fund outperformed the best mutual funds even after the 20% performance fee and this news led to great interest within the financial community.

By 1968 there were around 200 hedge funds, and the first fund of hedge funds was created in 1969 in Geneva. Many of the early funds ceased trading due to the market downturns in 1969–70 and 1973–74 as they did not manage their risk. In the 1970s hedge funds typically specialized only in one strategy, and most fund managers followed the long/short equity model created by Jones. Hedge funds lost their popularity during the downturn of the 1970s but received renewed attention in the late 1980s, following the success of several funds profiled in the media. During the 1990s the number of hedge funds increased significantly, with investments provided by the new wealth that was generated in the 1990s stock market rise. The increase in the number of hedge funds resulted from traders and investors being attracted to the aligned-interest compensation structure and the freedom of participating in an investment vehicle that was not benchmark-driven. Over the next decade there was also a marked diversification in the strategies funds utilized, including: credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy, among others. This industry expansion led to hedge funds becoming more heterogeneous than they had before.

Fees

A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund. Hedge funds use varying fee structures, however they typically charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit, although this charging structure has come under pressure recently as fund returns have declined.

Management fees

As with other investment funds, the management fee is calculated as a percentage of the fund's net asset value. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Management fees are usually expressed as an annual percentage, but calculated and paid monthly or quarterly.

The business models of most hedge fund managers provide for the management fee to cover the operating costs of the manager, leaving the performance fee for employee bonuses. However, the management fees for large funds may form a significant part of the manager's profits. Management fees associated with hedge funds have been under much scrutiny, with several large public pension funds, notably CalPERS, calling on managers to reduce fees.

Performance fees

Performance fees (or "incentive fees") are one of the defining characteristics of hedge funds. The manager's performance fee is calculated as a percentage of the fund's profits, usually counting both realized and unrealized profits. By motivating the manager to generate returns, performance fees are intended to align the interests of manager and investor more closely than flat fees. In the business models of most managers, the performance fee is largely available for staff bonuses and so can be extremely lucrative for managers who perform well. Several publications provide estimates of the annual earnings of top hedge fund managers. Typically, hedge funds charge 20% of returns as a performance fee. However, the range is wide with highly regarded managers charging higher fees. For example Steven Cohen's SAC Capital Partners charges a 35–50% performance fee, while Jim Simons' Medallion Fund charged a 45% performance fee.

Average incentive fees have declined since the start of the financial crisis, with the decline being more pronounced in funds of hedge funds (FOFs). Incentive fees for single manager funds fell to 19.2 percent (versus 19.34 percent in Q1 08) while FOFs fell to 6.9 percent (versus 8.05 percent in Q1 08). The average incentive fee for funds launched in 2009 was 17.6 percent, 1.6 percent below the broader industry average.

Performance fees have been criticized by many people, including notable investor Warren Buffett, who believe that, by allowing managers to take a share of profit but providing no mechanism for them to share losses, performance fees give managers an incentive to take excessive risk rather than targeting high long-term returns. In an attempt to control this problem, fees are usually limited by a high water mark.