What is a Hedge Fund?

Jack Kramer & Nick Martell April 30, 2020

Forbes 30 Under 30 in media, appeared on CBS, Cheddar. Registered representatives of
Robinhood Financial LLC.

DEFINITION

Hedge funds in some ways operate like mutual funds, pooling investor money into
strategic investments — except hedge funds focus on more intense, alternative, and
often riskier opportunities that regular investors can’t access.

For illustrative purposes. This list is not exhaustive of the potential investments available to hedge fund managers.

🤔 Understanding a hedge fund

Hedge funds act in some ways like mutual funds, but kicked up a notch. They
similarly manage piles of money, seeking enhanced returns for investors. One key
difference is how and what a hedge fund manager pursues — They typically take on
more sophisticated or aggressive investments, from obscure real estate deals to
complicated stock trading strategies, requiring deep research and relationships.
Hedge funds are less regulated than mutual funds, but are only allowed to manage
the money of “accredited investors” — institutions, endowments, or wealthy
investors who meet specific minimum wealth/income requirements (not mom-and-
pop investors).

EXAMPLE

The largest hedge fund manager in the world at the end of 2018 was Bridgewater
Associates, based in Connecticut. Bridgewater manages $132.8B in assets from
over 350 institutional investors, including major pensions, university endowments,
and the central banks of entire countries. It then puts that money to work with more
complicated strategies, like “currency overlays,” to try to beat the returns of the
market’s general movements. In 2018, CNBC reported that Bridgewater’s specific
“Pure Alpha” fund brought a 14.8% return for investors, while the general market
(measured by the S&P 500) actually declined. But in 1982, the fund incorrectly
believed a recession was approaching, losing so much money it almost shut down.

Takeaway
Hedge funds are trying to play chess in a world of
checkers…
While ETFs tend to passively track market indexes and mutual funds pool and invest
the money of any type of investor, hedge funds use intense research and trading
strategies to pursue risky opportunities that most investors won’t have access to —
they’re limited to “accredited investors” because they’re so sophisticated and
complex. And it’s all in the hope that greater risk will bring greater reward.
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Tell me more...
The players with hedge funds
How hedge funds make money
Some hedge fund strategies
So who can invest in a hedge fund?

The players with hedge funds

There are two key players you’ve got to know to understand hedge funds. These are
the primary positions that interact with and run a hedge fund:
Limited Partner: They go by “LP” for short and are the investors whose money is
managed by the General Partner (more on that below) — All the LP funds are pooled
together into the fund. Since hedge fund strategies can be particularly risky, the LPs
generally have to be “accredited,” as institutions or wealthy individuals with a
certain minimum amount of money. LPs in hedge funds tend to be significant
sources of money themselves, including university endowment funds or pension
funds for firefighters or major financial institutions or entire government funds (aka
“sovereign funds”).
General Partner: They go by “GP” and are responsible for managing the fund. The
GP is a pro fund manager who directs the LPs investment using whatever strategy
the hedge fund employs, which could be anything from simply buying and selling
stocks to more complicated strategies involving foreign currencies, bonds, real
estate, or options contracts. GPs are sometimes used synonymously with “the fund”
itself since they’re the people who are paid to manage the fund for a living.

How hedge funds make money

“Two and twenty” (aka “2 and 20”). Get to know it. That’s a common model of how
the hedge fund’s general partners (GPs) make a living managing the money of their
investors, the limited partners (LPs). The funds are typically organized as limited
partnerships for tax purposes, and earn money through “two and twenty” fees. Two
and twenty fees occur at two different points in the fund’s development. The concept
was developed with the earliest hedge funds and has inspired related fee concepts
(variations on “2 and 20”) that are growing in popularity.
This is a key difference between hedge funds and other types of funds. While mutual
funds feature an expense ratio (aka a “management fee”), most hedge funds also
charge a “performance fee,” snagging some of the profits from their investments
(most venture capital funds do the same thing). Here’s how it breaks down.
The 2% “asset management” fee: When an investor (the LP) invests its money
through a hedge fund, the hedge fund manager (the GP) automatically takes a 2%
fee for managing the whole operation. This often goes toward the fund’s operations,
like paying for office space and salaries. This can be a bit controversial because the
hedge fund earns it even if the fund is losing money or if the markets are uncertain
and the fund just lets the money hang out on the sideline, uninvested — it’s still
getting paid 2%. Here’s an example:
A major university invested $150M in a hedge fund.
$147M would actually be invested in whatever the fund’s pursuing.
That’s because $3M (2% of $150M assets under management by the hedge fund) is
typically taken by the fund as its management fee.
The 20% “performance” fee: After the hedge fund has invested the investors’
money, it often earns return on that investment. Before sending that profit back to
the LPs, the GP takes a cut — A hefty 20% of those total profits. The purpose here is
to align incentives, encouraging the fund to pursue major returns despite major
risks because they can earn more money than off the simple 2% management fee.
But unlike the management fee, a performance fee isn’t levied unless a profit is
earned. This is the treat the hedge fund strives for after all its hard work crunching
numbers and scouring for deals. A performance fee could motivate a hedge fund
manager to take greater risks in the hope of generating a larger return. Here’s a
hypothetical example of how the performance fee goes down.
A GP is managing a fund of $100M.
A couple companies that the hedge fund invested in have Initial Public Offerings
(IPOs), allowing the fund to sell its shares in those companies for a $20M profit from
the original $100M investment (a 20% return — Not too shabby).
The LPs will receive $16M of that profit.
That’s because $4M (20% of the $20M profit from the hedge fund’s investment) is
kept by the fund as a performance fee for the strong investment.
Keep in mind, this example is just to walk you through how the “2 and 20” model
works for a completely made-up hedge fund, and was simply created to illustrate
our explanation — The hypothetical return does not represent the performance of
any funds. Investing in hedge funds gets more complicated and involves a high
degree of risk.
This illustration shows the typical “2 and 20” fee structure for many hedge funds. It’s
intended to show the concept that a hedge fund receives a 2% management fee,
based on the size of the fund (that part’s upfront and ongoing based on the total
number of assets being invested) and a 20% performance fee, based on the returns
generated by the fund (that part’s determined at the end of the year only if the
investments have a positive return). You can learn more about each fund’s particular
fee structure in the Private Placement Memorandum (PPM). This list is not
exhaustive of the potential investments available to hedge fund managers.

Some hedge fund strategies

The name says it all. Hedge funds. The concept is based on “hedging” — Hedge fund
managers may pursue one risky opportunity and “hedge” (manage its risk) by
coupling it with another investment that seeks to limit potential losses.
Hedge funds pursue a variety of strategies for their investments. Some core
strategies used are buying “long” (purchasing a stock as a long-term investment),
selling “short” (selling the stock at a high price in anticipation of buying it back at a
lower price to earn a profit), options (buying or selling contracts to purchase at a
future date and specific price), and more.
Hedge funds also use more complicated forex (foreign exchange) transactions and
quantitative trading techniques. They react based on interest rate changes and new
alternative investment opportunities. Hedge funds are also well known for investing
heavily in research to ensure maximum access to and analysis of publicly-available
information with due diligence, developing insights along the way.
Hedge funds are also able to pursue these more complicated strategies because
investors are “locked-up” — Unlike a stock that you can sell anytime, hedge funds
require that investors be unable to “cash out” their investments immediately.
Investors have to wait for long stretches of time typically while their funds are being
put to use (this is why hedge funds are known as “illiquid” investments).

So who can invest in a hedge fund?

Not everyone. Hedge funds are risk-focused investments pursuing market-beating
returns. But that requires intense, aggressive, and complicated strategies, so hedge
funds are generally limited to institutional investors and “accredited investors.”
Institutional: Your typical hedge fund investors (the LPs in the fund) have a
significant amount of money to put to work (it’s a key reason why they’re able to take
on significant risk and why they’re pursuing large returns). Here are some typical
institutional investors:
University endowments
Pension funds
Financial institutions
Funds of funds
Sovereign government funds
Central banks
Accredited investors: Wealthy individuals can also invest in hedge funds if they
meet the government’s qualifications of being “accredited” (aka regulators believe
they’re sophisticated enough investors to understand the risk and wealthy enough to
afford losing all of their potential investment). These are the requirements:
$1M minimum net worth (excluding the value of your “primary residence”).
And income of least $200K each year for the last two years ($300K combined income
if you’re married)
Now it gets counter-intuitive. You’d think that because hedge funds pursue risky
investing strategies, they’d be more regulated — But they aren’t. These funds are
limited to just the sophisticated accredited investors, because they’re less regulated
than most consumer facing funds, like mutual funds are ETFs. For this reason, it’s
especially important to understand how hedge funds work, their strategies, the fee
structure, and any other details if you’re able to invest in one.
For example, while mutual funds are required to show certain types of performance
numbers for investors (like the fund’s performance over the last year), hedge funds
don’t have to show this. But just like mutual funds, hedge funds are held to the
same standards and regulations when it comes to fraud, like stealing money or lying
about their underlying investments to investors.
Pursuing a hedge fund also means an investor should dive deep into the Private
Placement Memorandum (“PPM”). Similar to an S1 with an Initial Public Offering
(IPO), the PPM provides critical background info on the fund, its focus, strategy,
potential, and concerns. It’s more than disclosure material, revealing both the
positive and negative elements of the hedge fund, so you can make a knowledgeable
and informed choice.
We’re big fans of how the Securities & Exchange Commission (SEC) offers some
helpful info on government regulation of hedge funds and accredited investors here.
Worth a read.
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Robinhood Financial LLC is not implying that any monitoring is being done by
Robinhood Financial LLC of any information contained on the third-party website.
Robinhood Financial LLC is not responsible for the information contained on the
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guarantee their accuracy and completeness.
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