003c Hedge Funds
Chapter 3c of 'There are no grown ups'
What is it?
A hedge fund is an open ended investment vehicle, although, some hedge funds close their doors to new investors when they reach a certain size. If your strategy is to be nimble, move money quickly, and take advantage of price discrepancies between markets, it may work with USD 250m under management, but try to make that USD 2.5Bn, or USD 25Bn, and the strategy will not work if the markets are not ready to take bets that are 10x, or 100x, as large. Hedge funds dealing with major currencies, government bonds, interest rates, and futures/swaps/options based on them, face almost limitless liquidity, and so may not be constrained by size in the way that a stock arbitrage fund might be.
Hedge Funds are a subset of the Open Ended Investment fund market, in many ways structurally similar to Mutual Funds, but set apart by
- Regulatory status, who can invest & minimum investment
- Lock up periods
- Liquidity restrictions (typically no daily dealing price)
- Leverage / use of derivatives
- Strategy: bets Vs investments, shorter holding period
- Charging structure
Leverage (gearing)
Most Hedge funds deploy leverage, sometimes vast amounts. Leverage of thousands of percent is not unusual.
LTCM had 2,500% (A gearing ratio of 25 to 1) even if only comparing their $4.8bn equity capital with the $125+bn in assets. Those assets included derivative products involving an underlying notional $1.25 trillion ($1,250 billion).
How do you buy / sell the investment
In the UK, USA, & most other jurisdictions, the first step before buying into a hedge fund is to certify, or prove, to the fund manager (or an introducing intermediary) that you meet ‘professional / accredited / sophisticated investor’ criteria based in your net worth / income / being (now or previously) a regulated investment professional. This status, as well as being a prerequisite for hedge fund investment, typically excludes you from the usual consumer protection regulations[6]. These are products for rich people / institutions that can afford to loose the whole of their investment. To some people, such warnings only serve to burnish the allure of Hedge Funds: the idea that being admitted to invest in a hedge fund is a badge of success, of admission to a high-rolling club, creates a non-financial incentive in terms of boosted ego. Those that sell hedge fund investments know this, and will use it to their advantage whenever they can. If you find yourself being flattered, remembering that they want your money and don't like or care about you as an individual, may help you resist. Making a large investment for non-financial reasons[7] is likely to be disastrous. Being accompanied by your spouse, especially if you have been married a long time, may serve as a brake on rash investments, but under no circumstances should you see an investment salesperson accompanied by someone you want to impress, such as a recently acquired girlfriend or boyfriend. Actually avoiding dealing with salespeople altogether is probably wise (as detailed elsewhere in these posts).
Most Hedge Funds have a minimum investment of US$100,000, or more (USD 1 million is not unusual). While an investment trust or unit trust may hold a balanced portfolio of stocks, allowing you to think of the investment as already diversified, this is not usually the case with a Hedge Fund. So, if you want the risk-reducing benefits of diversification, you might be looking at 5+ hedge funds. Even at $100,000 each that would be $500,000.
What happens to the investment vehicle when you buy or sell?
Although the sums may be typically larger, and the charging structure more lucrative for the investment manager, the mechanics of what happens to the money when you buy/sell are similar to those seen in humbler Open Ended Investment Companies (Unit Trust / Mutual Fund):
Restrictions on selling
Lock in periods are common.
While some hedge funds will be quite flexible for outgoing investors, others have only a single ‘redemption day’ each month, or even each quarter, on which investors can sell.
If the fund includes illiquid assets that can’t be sold quickly, selling may be more a process than an event: You might get 90% of the proceeds quite quickly (within 30 days) but have to wait much longer (until after the annual audit, or until an asset can be sold) for the final 10%
Funds holding illiquid assets may also impose a ‘gate’ that maximizes the amount that can be redeemed on any particular redemption day. Investors are usually treated on a first-come-first-served basis, so that if you ask to redeem but the gate threshold has already been met/exceeded, you will be told you cant sell on the redemption day. If you are lucky you will then be first in the queue for the next redemption day next month/quarter.
Who gains / loses when you buy it?
he Fund manager gains by getting your money on which they expect to charge fees. If you are paying a 2% per year management fees, and hold he fund for 5 years, even if it makes no money, then the fund’s manager will have pocketed c10% of your initial investment
Who gains / loses when you sell it?
As above, the fund manager sees a revenue stream leaving (they may make something from the exit fee, if there is one – see on)
Who makes the investment management decisions?
The investment manager / management company
How can the investment management company be fired if they are doing a bad job?
Generally they can’t
How does the investment manager make more money for themselves out of the fund?
The good way: They grow your investment, and so get to charge you 2% of a larger number in future years.
On ‘success’: They get a ‘performance fee’ of 20% of the gains (or gains over a threshold, such as inflation, or central bank base rates, or the index). This is all very well when the success is down to great judgment, but what if all the fund has done is to borrow money and track the index with a 3 (or 5, or more) times leverage? In good years it will do 3 times as well as the index, in bad years, it will lose 3 times as much.
Typical cost of buying
All being well, you have a good chance of avoiding ‘front load’ fees. After all, once you have invested, you will be paying royally for the privilege. If you are particularly unlucky you may pay to get in.
Typical annual management costs
2% of assets + 20% of profits
Sometimes 1.5% of assets + 15% of profits
Typical ‘Total Expense Ratio’ (not including crossing the spread)
There is a lot of truth in the saw that ‘A Hedge fund is a charging structure with an investment strategy attached’[8].
Talk of a ‘typical hedge fund’ is pretty meaningless. Other than the charging structure, two different funds may have almost nothing in common. A Long Only Equity fund may have more in common with a Unit Trust than a Global Macro fund, or an Arbitrage fund.
The investment style will determine the level of investment turnover, with some hedge funds having very high rates of turnover, so the cost of dealing fees, etc can be much higher than in a typical mutual fund holding its average investment for 15 months.
Typical cost of selling:
Most funds will impose, at the very least, a ‘soft lock up’ fee of 2-3% on investments redeemed within a year (this is better than the ‘Hard Lock up’ of a prohibition on selling within the first year)