Hedge fund


A hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex trading and risk management techniques to aim to improve investment performance and insulate returns from market risk. Among these portfolio techniques are short selling and the use of leverage and derivative instruments. In the United States, financial regulations require that hedge funds be marketed only to institutional investors and high-net-worth individuals.
Hedge funds are considered alternative investments. Their ability to use leverage and more complex investment techniques distinguishes them from regulated investment funds available to the retail market, commonly known as mutual funds and exchange-traded funds. They are also considered distinct from private equity funds and other similar closed-end funds as hedge funds generally invest in relatively liquid assets and are usually open-ended. This means they typically allow investors to invest and withdraw capital periodically based on the fund's net asset value, whereas private-equity funds generally invest in illiquid assets and return capital only after a number of years. Other than a fund's regulatory status, there are no formal or fixed definitions of fund types, and so there are different views of what can constitute a "hedge fund".
Although hedge funds are not subject to the many restrictions applicable to regulated funds, regulations were passed in the United States and Europe following the 2008 financial crisis with the intention of increasing government oversight of hedge funds and eliminating certain regulatory gaps. While most modern hedge funds are able to employ a wide variety of financial instruments and risk management techniques, they can be very different from each other with respect to their strategies, risks, volatility and expected return profile. It is common for hedge fund investment strategies to aim to achieve a positive return on investment regardless of whether markets are rising or falling. Hedge funds can be considered risky investments; the expected returns of some hedge fund strategies are less volatile than those of retail funds with high exposure to stock markets because of the use of hedging techniques. Research in 2015 showed that hedge fund activism can have significant real effects on target firms, including improvements in productivity and efficient reallocation of corporate assets. Moreover, these interventions often lead to increased labor productivity, although the benefits may not fully accrue to workers in terms of increased wages or work hours.
A hedge fund usually pays its investment manager a management fee and a performance fee. Hedge funds have existed for many decades and have become increasingly popular. They have now grown to be a substantial portion of the asset management industry, with assets totaling around $3.8 trillion as of 2021.

Etymology

The word "hedge", meaning a line of bushes around the perimeter of a field, has long been used as a metaphor for placing limits on risk. Early hedge funds sought to hedge specific investments against general market fluctuations by shorting other, similar assets. Nowadays, however, many different investment strategies are used, many of which do not "hedge" risk.

History

During the US bull market of the 1920s, there were numerous private investment vehicles available to wealthy investors. Of that period, the best known today is the Graham-Newman Partnership, founded by Benjamin Graham and his long-time business partner Jerry Newman. This was cited by Warren Buffett in a 2006 letter to the Museum of American Finance as an early hedge fund, and based on other comments from Buffett, Janet Tavakoli deems Graham's investment firm the first hedge fund.
The sociologist Alfred W. Jones is credited with coining the phrase "hedged fund" and is credited with creating the first hedge fund structure in 1949. Jones referred to his fund as being "hedged", a term then commonly used on Wall Street to describe the management of investment risk due to changes in the financial markets. Jones also developed the popular 2-and-20 structure of hedge funds, in which hedge funds charged investors a management fee of 2% on total assets and a 20% fee on realized gains.
In the 1970s, hedge funds specialized in a single strategy with most fund managers following the long/short equity model. Many hedge funds closed during the recession of 1969–1970 and the 1973–1974 stock market crash due to heavy losses. They received renewed attention in the late 1980s.
During the 1990s, the number of hedge funds increased significantly with the 1990s stock market rise, the aligned-interest compensation structure, and the promise of above average returns as likely causes. Over the next decade, hedge fund strategies expanded to include credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy. US institutional investors, such as pension and endowment funds, began allocating greater portions of their portfolios to hedge funds.
During the first decade of the 21st century, hedge funds gained popularity worldwide, and, by 2008, the worldwide hedge fund industry held an estimated US$1.93 trillion in assets under management. However, the 2008 financial crisis caused many hedge funds to restrict investor withdrawals and their popularity and AUM totals declined. AUM totals rebounded and in April 2011 were estimated at almost $2 trillion., 61% of worldwide investment in hedge funds came from institutional sources.
In June 2011, the hedge fund management firms with the greatest AUM were Bridgewater Associates, Man Group, Paulson & Co., Brevan Howard, and Och-Ziff. Bridgewater Associates had $70 billion in assets under management as of 2012. At the end of that year, the 241 largest hedge fund firms in the United States collectively held $1.335 trillion. In April 2012, the hedge fund industry reached a record high of US$2.13 trillion total assets under management. In the middle of the 2010s, the hedge fund industry experienced a general decline in the "old guard" fund managers. Dan Loeb called it a "hedge fund killing field" due to the classic long/short falling out of favor because of unprecedented easing by central banks. The US stock market correlation became untenable to short sellers. The hedge fund industry today has reached a state of maturity that is consolidating around the larger, more established firms such as Citadel, Elliot, Millennium, Bridgewater, and others. The rate of new fund start ups is now outpaced by fund closings.
In July 2017, hedge funds recorded their eighth consecutive monthly gain in returns with assets under management rising to a record $3.1 trillion.

Notable hedge fund managers

Hedge fund strategies are generally classified among four major categories: global macro, directional, event-driven, and relative value. Strategies within these categories each entail characteristic risk and return profiles. A fund may employ a single strategy or multiple strategies for flexibility, risk management, or diversification. The hedge fund's prospectus, also known as an offering memorandum, offers potential investors information about key aspects of the fund, including the fund's investment strategy, investment type, and leverage limit.
The elements contributing to a hedge fund strategy include the hedge fund's approach to the market, the particular instrument use, the market sector the fund specializes in, the method used to select investments, and the amount of diversification within the fund. There are a variety of market approaches to different asset classes, including equity, fixed income, commodity, and currency. Instruments used include equities, fixed income, futures, options, and swaps. Strategies can be divided into those in which investments can be selected by managers, known as "discretionary/qualitative", or those in which investments are selected using a computerized system, known as "systematic/quantitative". The amount of diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market, multi-manager, or a combination.
Sometimes hedge fund strategies are described as "absolute return" and are classified as either "market neutral" or "directional". Market neutral funds have less correlation to overall market performance by "neutralizing" the effect of market swings whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.