Hedge fund

Hedge funds are widely touted for two things: they rely on manager skill rather than passive market returns, and they have little correlation with basic movements in the stock and bond markets. Primarily, hedge funds emphasize alpha: the ability to earn a positive return by capitalizing on particular market insights or market inefficiencies. Criticisms revolve around whether a given manager is simply amplifying beta, or passive market returns, through leverage.

Risk and return

Sullivan (2021) calculates that as of 2019, over a 19 year period, "after accounting for risk and costs, hedge funds have subtracted a cumulative $21.1 billion in value for investors". That study shows that hedge fund performance, as a group, has deteriorated significantly in the second half of the period.

Estrada (2022) compares the risk and returns of hedge funds with US stocks and stock-bond mixes over various periods.. He concludes that "extremely simple strategies that combine stocks and bonds, which can be implemented with just two index funds or ETFs, have outperformed hedge funds in terms of return and risk adjusted return over the last 10, 15, and 20 years". Hedge funds are often presented as uncorrelated with stock returns, but the author found that "the correlation between hedge funds and stocks was a very high 0.89, 0.85, and 0.83 over the last 10, 15, and 20 years".

Fees

One factor that might lead to this disappointing performance is the large fees that hedge funds charge. A typical fee structure is "2 and 20": 2% of the assets and 20% of the returns. Estrada (2022) writes that "assuming a 10% annual return and a 30-year holding period (the fees) reduces the terminal value of an investment by nearly 70%".

In aggregate, fees realized by hedge fund managers are even higher than contractual fees, according to Ben-David et al. (2020). They look at fees earned by nearly 6000 hedge funds between 1995 to 2016 and calculate that "total fees paid amount to 63.6% of the cumulative gross returns when including management fees", including 49.6% in incentive fees, compared with a nominal average incentive fee of 19% of gross profits.

Performance comes, performance goes. Fees never falter.

— Warren Buffet, Chairman's Letter, Berkshire Hathaway Inc., Annual Report 2017, p. 12

Origins

The first recognized hedge fund was inaugurated in 1949, by Alfred Winslow Jones, a sociology student become finance writer. His idea was to buy stocks he liked long, and sell the ones he didn't like short. That would smooth the volatility of returns (this was before Harry Markowitz arrived at his Nobel-Prize winning about risk reduction through diversification). Other pioneers of hedge fund investing include George Soros and Julian Robertson.

Short sales

Just as investors can buy stocks through a margin account and be subject to a margin call should the stock fall, they can short stocks by borrowing them and selling them into the market. Should the stock rise, the borrower might have to make good on the stock loan, and repurchase the stock.

Leverage

A margin account, like a mortgage, provides a leveraged return. In the hedge fund world, leverage comes in many different forms. Stocks generally require a 50% margin, Treasury bonds 2% and futures contracts (for currencies, bonds and stock indexes) 10%. Normally, the money not invested is held in an interest-bearing account with a prime broker, who provides market access as well as borrowing facilities.

Many hedge funds report leverage as a function of market exposure. Thus a manager who is 50% long and 30% short is 80% exposed to the market. However, some strategies can create zero market exposure by leveraging $2 for every $1 in capital; they would invest $1 on the long side and $1 on the short side.

Types of hedge funds

Hedge funds fall into three broad categories: event-driven, relative-value and directional.

Event-driven funds include merger arbitrage and special situations investing. In merger, or risk arbitrage involves taking a stance on proposed deal. Typically, the arbitrageur shorts the acquisitor and buys the target company's equity. Special situations investing looks a great deal like deep-value investing, sometimes with an activist bent. It often involves taking a position in a struggling company, sometimes through its shares, sometimes through its bonds, in order to influence the turnaround.

Relative-value funds are often market neutral. They seek to immunize beta to give scope to manager skill. A market-neutral equity fund will often have equal dollar positions in longs and shorts, and is generally driven by statistical or quantitative models – hence the appellation: "quants." A simple technique is pairs trading: going long one company in a given industry and shorting another. An important component of the return, apart from the the divergence between longs and shorts, is the short rebate: money earned from the cash received from the short sale held by the prime broker on the margin collateral for the short. Another strategy is convertible arbitrage. Convertible bonds or debentures have a call option on a company's shares. Hedging, however, is complex, since the value of the bonds is determined both by interest rates and the value of the shares in relation to the strike price – the price at which the bonds are convertible into shares.

Directional or opportunistic strategies have a view on the market. Long/short equity funds often use the same sorts of models as market-neutral funds, but are not committeed to equal long and short positions. Global Macro funds are guided by top-down views of investment prospects. Typically, they use futures contracts to express those views on, for example, currencies or commodities. Managed futures, by contrast, are generally model-driven and seek price-level trends on futures exchanges, without having a global economic view.

Accredited and sophisticated investors

In Canada, hedge funds originally fell under the less-restrictive regime of pooled funds. Pooled funds are offered by asset managers in the pension space, where the full prospectus disclosure of mutual funds (or stocks) is generally not required. To be eligible for a pooled fund, one had to be able to invest between $97,000 and $150,000, depending on the province. These are known as the sophisticated investor exemptions.

More recently, in the wake of changes in U.S. regulations, there is the accredited investor exemption. That requires one of (a) $1 million in financial assets; (b) an income of $200,000 for the past three years; or (c) a joint income of $300,000.

Further reading

• Lowenstein, Roger. "When Genius Failed: The Rise and Fall of Long-Term Capital Management," Random House, 2001
• AIMA-Canada. "Strategy Paper Series."