A hedge fund is a company that takes money from people and invests it to make a profit.
Understanding Hedge Funds
Hedge funds usually take money from high net-worth individuals or other companies. These people, or companies, are clients of the hedge fund.
Note that the money the client hands over to the hedge fund belongs to the client. The hedge fund controls how the money is invested but does not take ownership of the funds.
How do hedge funds make money?
They make money by taking a cut of the profits from the investment of their clients’ money.
What if they lose money?
If the hedge fund loses money, the clients bear all the losses.
How much of a cut do hedge funds make? (Hedge Fund Fee Structure)
In the past, it was common to charge a 2% management fee along with a 20% performance fee.
A management fee is a fixed yearly fee and hedge funds will collect it whether the fund makes a loss or a profit.
The management fee, which is usually 2%, is deducted from the total amount invested by the client.
As an example, if a client invests $100 million with a hedge fund, they will need to pay $2 million as a management fee. It doesn’t matter if the fund makes or loses money that year, this fee has to be paid.
Hedge funds will typically deduct the management fee every month, pro-rated from the total yearly fee.
A performance fee is collected from the total amount of profits a fund makes. If the fund loses money, the performance fee is $0 (it does not return money to investors).
The usual 20% performance fee is deducted from any profits the fund makes.
For instance, if the client places $100 million with a hedge fund and the hedge fund makes $20 million from that $100 million, the hedge fund’s cut is 20% of that $20 million or $4 million.
Clients usually pay performance fees on a quarterly basis.
Trend of Decreasing Fees
Hedge fund fees have consistently declined over the years as poor returns have led to pressure by clients for lower fees.
Active vs Passive Fund Management
Hedge funds fall under the category of active management. This means that the fund manager and his/her team make day-to-day decisions regarding investments.
Mutual funds are a good example of passive management. The mutual fund manager makes broad investment decisions and reviews them sporadically.
Alpha vs Benchmark-Tracking
Alpha funds are a type of fund that aims to make profits no matter how the market is performing.
Benchmark-tracking funds are a type of fund that attempts to perform better than an index. An index offers a value for comparison, derived from the performance of a group of stocks or other assets.
They choose a specific index as a reference target and aim to outperform it.
A common target index is the S&P 500 and several benchmark-tracking fund have set their aim to outperform it. If the S&P 500 gains, they must gain more. If the S&P 500 loses, they are content if they lose less.
Quantitative vs Non-Quantitative Fund
Quantitative funds use mathematical or high-tech methods to generate profits. Such methods include:
- analyzing and exploiting big data
- alternative data (credit card information, location data, etc.)
- computing speed
- machine learning
Non-quantitative funds use qualitative methods to generate alpha. Such methods include reading annual reports, talking to a company’s management, evaluating a company’s CEO and understanding the macroeconomic conditions of a country.
Examples of Hedge Funds
Here are some famous hedge funds.
- Bridgewater Associates (Qualitative)
- Renaissance Technologies (Quantitative)
- AQR Capital Management (Mixed)
How are Hedge Funds Important to You?
If you are rich and are choosing which hedge fund to put your money in, then knowing how hedge funds work is useful.
Otherwise, hedge funds are not important to you.