How Do Hedge Funds Work (or don’t work)?

Although hedge funds have been in the news a lot lately, the average person probably has only a vague idea what they are. A few years ago my wife asked me what a hedge fund was, and I realized that I couldn’t give her a simple answer. Partly this was because there is no single answer, and partly it was because I couldn’t think of a way to do it without lapsing into financial buzzwords. So this post is in honor of my wife, who gave me the idea for it.

The term implies a fund that seeks to “hedge” or minimize the risks associated with an investment by making a second, related investment.  The second investment is structured such that its value moves in the opposite direction from the first investment.  Although this is only part of what these funds do, let’s start by considering a “hedged” investment.

In 2007, Jordan’s Furniture, a Boston-area retailer, held a sale in which customers who bought certain items of furniture were promised that they’d get their money back if the Boston Red Sox won the World Series that year.  This was the first investment – a risk taken to generate lots of sales, but with the possibility that the retailer would have to give back all its profits if a condition were met.  The second investment was an insurance policy taken out by Jordan’s with an insurer willing to pay out the money needed if the same condition were met, i.e. if the Sox did win.  The policy cost Jordan’s something, but it cost far less than the potential cost of paying back all the customers.  If the Sox had not won, Jordan’s would have paid out the insurance premium, but gained lots of sales.  If, as actually happened, the Red Sox won the Series, the insurance company paid the bills, Jordan’s got to keep the profits, and presumably they generated excess sales by the promotion.

Another type of hypothetical hedged investment might arise for a farmer who has a lot of acreage planted in soybeans.  Let’s say he knows that all told, it will cost him $1 per bushel to bring the crop to market in two months.  Today, trading on the futures market, he can sell a contract for delivery of soybeans in two months that will pay him $1.50 a bushel.  If he sells the futures contract, he has locked in a profit of 50 cents a bushel.  If there is a bumper crop in soybeans and the price in two months drops to $1.10, his profit is still guaranteed.  In this instance, the farmer said to hold both a “long” position (the soybeans in the fields) and a “short”position (the contract to sell soybeans in 2 months).

These are relatively simple examples of hedged transactions.  You can see that these paired investments are structured as “win-wins;” the farmer and Jordan’s were assured of a profit as long as nothing catastrophic happened (e.g., if Jordan’s insurer had suddenly gone bankrupt during the World Series).  Hedge funds need not confine themselves to “insurance” types of investments that confine their gains to a certain range.  Some do exactly this; they invest in hedge strategies that ensure a reliable gain with a very low probability of a loss.  But some hedge fund strategies involve big bets that lean very heavily in one direction; such investments can generate huge losses if the scheme fails.

For example, in 2005 it was believed that hedge funds had invested large amounts in General Motors-related securities.  It was rumored that they were buying GM’s bonds (in expectation that rates would drop and the bond values would increase) and simultaneously selling short GM’s stock (short selling involves borrowing stock to sell at its current price with the belief that the stock price will fall; if so, the borrowed stock can be replaced with stock bought at the new, lower price).  Unexpectedly, GM debt was downgraded (declared to be of lower quality by a bond rating agency), causing its bond values to plunge.  Simultaneously its stock share price rose because Kirk Kerkorian, already a large investor in GM, bought more GM stock.  As it turned out, it wasn’t true that funds had huge sums invested in this strategy, but anyone who did invest this way lost money as the prices of the two securities swung in exactly the wrong directions.  This kind of strategy is not a true hedge; it’s more like a bet.

There are several general characteristics of hedge funds, although there is tremendous variety among them.  This is my attempt at a list, though it is not exhaustive:

  • Hedge funds can invest in almost anything – stocks, bonds, options, futures, mortgage-backed securities or other derivative securities, commodities, currencies, insurance policies – there is practically no limit.  In practice, however, individual funds tend to limit themselves to areas of investment in which their managers have expertise.
  • Many, but not all, hedge funds increase their returns by investing borrowed money; this is called using leverage.  The amount of leverage can vary widely; it’s believed that some hedge funds have as much as 20:1 leverage, which means that they invest $20 of borrowed money for every $1 of capital.  Leverage can greatly amplify the magnitude of both gains and losses.  In 1998, the infamous Long Term Capital Management fund had invested $27 for every dollar of capital before its investments collapsed spectacularly.
  • Hedge fund managers generally receive much higher levels of compensation than mutual fund managers.  The typical hedge fund compensation scheme is referred to as “two and twenty:” a 2% management fee plus a 20% performance fee (i.e. 20% of the fund’s returns are paid out to the managers and the investors keep 80% of the profits).  This is a very important difference between hedge funds and traditional mutual funds.  For the most part, investment managers are prohibited from charging a fee that’s based on investment performance; hedge funds, which are under a different regulatory environment, may do so.  This fact provides a heavy incentive for successful investment managers to start hedge funds instead of mutual funds.
  • Only “accredited” investors are permitted to invest in hedge funds.  For an individual investor this means a person with a net worth of at least $1MM or income of at least $200K/year (or $300K/year when a spouse’s income is included).
  • Hedge fund Investors are often not permitted to withdraw invested funds at will.  There are periods when withdrawals cannot be made at all or there may be a fee for withdrawals made before a specified amount of time has elapsed.
  • Unlike mutual funds, hedge funds are typically organized as limited partnerships.  Many hedge funds are organized in tax havens like the Grand Cayman Islands or the Bahamas in order to provide tax benefits to the fund (though investors still have to pay tax on their returns).
  • Because hedge funds must invest large amounts without other investors discerning the strategy they are using, the funds typically operate under a good deal of secrecy.  This means that in comparison to a mutual fund, there is a much lower degree of disclosure to investors about how the fund is currently invested.  A hedge fund is rather like a “black box” into which an investor puts his or her money.

Hedge funds are obviously rather complicated investment vehicles, and this is another reason that investment in them is limited to people who have substantial assets.  The requirement limiting hedge fund access to accredited investors is intended to protect unsophisticated investors from the risks associated with these investments.  As noted before, the level of regulatory oversight applied to hedge funds has (so far) not been as heavy as that given to mutual funds.

If you’d like to read a “Short history of hedge funds,” here is a nice one from CFO.com.

Image by: jarek69

About the author

Thomas Fisher, CFP®
Thomas Fisher, CFP®

2 Comments

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  • Knowing nothing about hedge funds it would seem as though the key is the fund’s investment skill’s. How does an investor find the fund he or she is most comfortable with based on the areas they invest in if their dealings are secret ?
    If I know a little about commercial real estate how do I find a fund that deal’s in that area, and how much will they tell me about their future plans ??
    In Advance
    Thank You
    A babe in the woods

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