Hedge Fund Definition: Types, Strategies, Risks (2024)

A hedge fund is a limited partnership of private investors, whose money is managed by professional fund managers who engage in active investing strategies. Apart from stock picking, fund managers may use leverage and trade non-traditional assets to beat benchmark returns.

Hedge funds examples include, but are not limited to, Bridgewater Associates, one of the largest hedge funds based in the US. Another example is Man Group, a UK-based hedge fund.

Key takeaways

How do hedge funds work?

There are a few key features that may help in understanding hedge funds.

Clients: Hedge funds tend to be tailored for institutional investors such as pension funds and insurance companies as well as high-net worth individuals.

Fees: Hedge funds would typically charge its clients a management or a performance fee, or both. A management fee is normally a percentage of assets under management (AUM) and tends to be around 2%. It covers the daily expenses and overheads of the fund and is designed to compensate the management team for their time and expertise in managing the fund’s investments. It is a fee that is generated whether the fund performs well or not. However, some hedge funds have performance-based management fees that are only paid if the fund meets certain targets. A performance fee is a percentage of the profits earned by the fund - this is typically around 20%.

Initial investment: The initial investment in a hedge fund tends to be higher than the other types of investment funds and can range from $100,000 to $2 million upwards.

Lock-up period: The lockup period refers to a window of time when investors are not able to redeem or sell shares of a particular investment. The lock-up period is used to help preserve liquidity and maintain market stability, hedge funds utilise lock-up periods to maintain the stability and liquidity of the portfolio.

Why is it called a hedge fund?

The reason behind the name is that these types of funds use a full array of hedging strategies in order to reduce portfolio volatility. Hedging is a strategy that tries to limit risks in financial assets.

Using market strategies to offset the risk of any adverse price movements, put simply, fund managers in hedge funds, will hedge one investment by making a trade in another. The first hedge fund was launched in 1949, by Alfred Winslow Jones and was called the A.W. Jones & Co Hedged Fund, because it used a hedging strategy to reduce the risk of investments.

Types of hedge funds

There are several types of hedge funds investors can choose from:

• Global macro hedge fund: These are actively-managed funds that speculate on broad market fluctuations caused by economic or political events. Fund managers may invest in company stocks, bonds, currencies, commodities, derivatives (such as futures or options contracts) and other instruments. They would analyse global fiscal and monetary policy alongside geopolitical trends to make decisions.

• Equity hedge funds: An equity fund would invest predominantly in stocks. The aim is usually to beat stock-market benchmarks, such as S&P 500 (US500) in the US, and FTSE 100 (UK100) in the UK.

• Relative value hedge fund: These types of funds rely on arbitrage, which is when you seek to generate profit from small differences in price between similar, or identical securities.

• Activist hedge fund: This type of hedge fund would take an active position in the management of companies in which it invests, which means it would act as an activist shareholder of the stock. The activism tends to occur after the hedge fund has gained majority holding of a company, as it may then force fundamental changes to increase the target company’s valuation. This may include cutting costs, or changing the board of directors.

Hedge fund investment strategies

There are various strategies and tactics hedge fund managers use, depending on their overall investing strategy. Some of the most popular hedge fund strategies include:

Long andshort positions

This strategy involves the manager maintaining both long and short positions in assets. For example, a fund manager may buy stocks that they believe are undervalued while short-selling those that they think are overvalued.

Short-only

A short-only fund - also known as a short-biassed fund, is a type of hedge fund that is designed to make profits from declining stocks. This means the fund manager will only take short positions in securities, meaning it profits when the price of the security does go down.

Merger arbitrage

This strategy is also known as risk arbitrage and involves purchasing and selling the respective stock of two merging companies simultaneously, in order to create riskless profits. Due to there being uncertainty around whether the merger deal will be completed, the stock price of the target company sells at a price below the acquisition price.

A merger arbitrageur will then review the probability of the merger not closing on time or at all and then purchase the stock before the acquisition, in the hope of making a profit once the deal is complete.

Fixed-income

This strategy is when the fund invests in long-term government, corporate and bank bonds and other derivatives, which pay a fixed rate of interest. They’re called fixed-income because these assets offer the investor a return in the form of fixed periodic payments.

Event-driven

A fund that follows this strategy would take advantage or maintain a position in companies that are experiencing mergers, share buybacks, bankruptcy, a restructuring, or any other significant event. For example, a hedge fund may buy debt of a company that is facing financial distress, or short-sell a stock of a firm that filed for bankruptcy.

Other strategies

Other strategies that may be used by hedge funds include but are not limited to:

• Value-oriented

• Long bias

• Sector-focussed

• Market neutral strategy

  See Also

  Hedging your bets: Risk mitigation for investments

• Convertible arbitrage

• Capital structure arbitrage

Hedge funds vs. Mutual funds

Both hedge funds and mutual funds are investment funds, yet there are key differences between them.

A hedge fund company would tend to target high-net-worth individuals and institutions, while mutual funds are typically servicing retail clients. Hence the initial capital requirements would be higher for hedge funds than mutual funds.

A hedge fund would also tend to employ more aggressive strategies to beat the benchmarks, while mutual funds can also be passive investment vehicles (tracking an index).

Mutual funds tend to be available to any investor, but they have more restrictions in what they can trade, the main aim of a mutual fund manager is to outperform a benchmark index. Hedge funds also tend to be less liquid than mutual funds, and investors' capital is tied up for longer periods of time.

Hedge funds examples

As mentioned earlier, there are a few notable hedge fund examples. Below are a few of them.

• Elliott Management Corporation: This US investment management fund is one of the largest activist funds globally, founded in 1977. Its founder is Paul Singer, a US hedge fund manager and philanthropist. In 2022, the group agreed to acquire television ratings group Nielson for $16bn. In 2022, it raised $13bn in its biggest-ever capital haul, according to Bloomberg.

• Bridgewater Associates: Founded in 1975 by Ray Dalio, who let go of the reins in October 2022. This month the group's CEO Nir Bar Dea announced that the company will be cutting 8% of its workforce and putting a cap on its flagship investment fund, Pure Alpha, which has generated an average annual return of 11.4% since its inception in 1991.

• Man Group: London headquartered hedge fund, Man Group, was founded in 1783 and has a trading history spanning over 250 years and was founded by James Man as a sugar cooperage and brokerage. The firm transformed into a hedge fund in the 1970s. In 1994, it was listed on the London Stock Exchange and in 2014, it acquired and integrated with Numeric Holdings LLC, now Man Numeric. The group is now led by CEO Luke Ellis, who took over in 2016.

Risks of investing in hedge funds

All investing contains risk. With hedge funds, however, these risks would be more specific.

• Lock-up period: Once an investor relinquishes their capital, they can’t get it back immediately, as it’s “locked up”. This refers to a period following the date of investment and can last between one to three years. Hence hedge funds tend to be relatively less liquid.

• Large positions: Hedge funds tend to make big bets and deploy more aggressive strategies to maximise returns and minimise losses. If the market moves against them, hedge funds can face huge losses.

• Leverage: Hedge fund managers may use leverage on some (or all) positions. Leverage can magnify both profits and losses.

How to compare hedge funds

There are various tools that investors can use to analyse and compare the performance of hedge funds.

Sharpe Ratio: This ratio helps to determine whether the risk an investor has taken has paid off versus the returns they may have seen without taking on risk. The higher the ratio, the better performance of the hedge fund.

Sortino Ratio: This ratio is a risk-adjusted performance measure that evaluates an investment's return in relation to its downside risk. It uses a risk-free rate, but subtracts that from the portfolio's average rate of return, rather than the known rate of return. It then divides the return difference by the standard deviation of the downside.

Alpha: Alpha measures the performance of an investment and compares it to a suitable benchmark index, such as the S&P 500. A hedge fund’s aim would be to beat the benchmark.

Conclusion

Hedge funds are actively-managed investment funds tailored for high networth clients and institutions. They typically have higher initial capital requirements, a lock-up period and typically aim to beat the benchmarks by deploying uncommon trading strategies.

The various types of hedge funds range from global-macro and equity to relative value and activist hedge funds. They tend to use more aggressive strategies in order to maximise profit and minimise losses. Some of them include long/short, short-only, merger arbitrage, and many more.

There are quite a few differences between hedge funds and mutual funds. The latter focus on retail clients and may be passive investment vehicles. They also require less capital and don’t have lock-up periods.

The risks associated with hedge funds include (but are not limited to) liquidity risks due to lock-up period, large sizes of positions, and the use of leverage, which magnifies profits and losses.

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