Overview of Hedge Funds

The term "hedge fund" first originated in the 1940s after alternative investor Alfred
Winslow Jones created a fund that sold stocks short as part of its investment
strategy.12 The assets managed by hedge funds have increased over the years, with
the estimate reaching $3.0 trillion in the third quarter of 2019.3 At the same time, ever
since the 2008 financial crisis, hedge funds have not performed well compared to
the Standard & Poor’s 500 (S&P 500) index.45 This article provides a detailed
overview of how hedge funds work and who tends to invest in them, as well as the
rewards and risks associated with these funds for an investor.

How Do Hedge Funds Work?

Hedge funds are privately-owned companies that pool investors' dollars and reinvest
them into complicated financial instruments with the aim of getting positive
returns.6 Specifically, they are set up as limited partnerships or limited liability
companies, which offer pass-through tax treatment and limited personal liability for
managers and partners.7 Hedge fund legal documents describe how the fund is
structured and may outline what the manager can invest in.8

These legal documents also provide information as to how the managers are
compensated. Hedge fund managers are paid an annual management fee, and may
be paid a performance fee if they meet a benchmark called the hurdle rate. Most
managers have been paid pursuant to the "two and 20" rule - i.e., an annual 2% of
total assets for the management fee plus 20% of the profits over the hurdle rate for the
performance fee.910 Recently, however, certain investors have begun to pay some
of the newer hedge funds a lower amount in fees.

They appear to be following the "1.4 and 17" rule - i.e., an annual 1.4% of total assets
for the management fee plus 17% of the profits over the hurdle rate for the
performance fee.1112

Who Invests in Hedge Funds?

Hedge funds are limited to wealthier investors, who can afford the higher fees and
risks associated with hedge fund investing, and institutional investors.6 Institutional
investors are large firms that make investment decisions on behalf of individual
members or shareholders, and some of the most common institutional investors
include pension funds, mutual funds, and insurance companies.1314 Hedge fund
investors generally need to be accredited investors under the federal securities laws,
and must meet certain net income or earned income thresholds.15

Investors invest in hedge funds for varying reasons. Some believe that they can
achieve higher-than-average returns, while others seek diversification beyond stocks
and bonds.1617 According to a 2019 institutional investor survey conducted by J.P.
Morgan, 73% of all respondents considered portfolio diversification among the top
three reasons they invest in hedge funds; 58% indicated access to select or niche
opportunities; and 1% noted access to leverage.18

That said, while institutional investors have invested heavily in hedge funds, that has
begun to change. As of 2016, 65% of the hedge fund industry's capital came from
institutional investors.19 But most recently, these investors have shifted their focus to
other investment options, such as exchange-traded funds (ETFs), private equity, and
real estate.2021

How Do Hedge Funds Offer Rewards?

Hedge funds offer financial rewards based on (among other things) the way managers
are paid, the types of financial vehicles they can invest in, and the dearth of financial
regulation that govern them.

First, since hedge fund managers are compensated based on the returns they earn,
they are driven to achieve above-market returns.2223 This can attract investors who
are frustrated by the fact that funds like mutual funds are paid fees regardless of fund
performance.6

Second, hedge fund managers are able to make outsized returns when they correctly
predict the market's rise or fall. Hedge fund managers specialize in using
sophisticated derivatives, which enable them to create leverage and profit even when
the stock goes down.24

Third, since hedge funds are not as well regulated as the stock market, managers
have more flexibility with investing in financial vehicles that are speculative but offer
higher returns.25 That said, the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the "Dodd-Frank Act"), which was enacted in 2010, does regulate
some aspects of the hedge fund industry.26 Among other things, the Dodd-Frank Act:

 required all hedge fund managers above $150 million to register with the U.S.
Securities and Exchange Commission;
 limited the amount of hedge fund investments banks can make, and prevented
banks from using hedge funds to boost their own corporate profits;
 called for greater regulation of derivatives; and
 created the Financial Stability Oversight Council, which would look for hedge
funds and other financial companies that were growing too large and would
need to be recommended to be regulated by the Federal Reserve. 27

According to certain empirical studies, the hedge fund industry appears to have
adjusted well to the heightened requirements under the Dodd-Frank Act.28

What Are the Risks Associated With Hedge Funds?

Hedge funds are subject to greater risk primarily on three grounds. First and foremost,
hedge funds are able to leverage more speculative positions, which are more subject
to losses when the market falls.2923 Hedge fund managers are more inclined to take
such positions, since as explained above, they are paid based on performance.

Second, hedge funds are illiquid investments, and as a result, they may not be
redeemable at the investor's option. In other words, investors may not be able to take
out the money they invested in the hedge fund at the time they want out. And third,
funds of hedge funds typically invest in several private hedge funds that are not subject
to the U.S. Securities and Exchange Commission's registration and disclosure
requirements. This lack of oversight creates additional risk.

Source: https://www.thebalance.com/what-are-hedge-funds-3306246