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Chapter 1
Hedge Fund Fundamentals
Training is everything. The peach was once a bitter almond; cauliflower is nothing but cabbage with a college education.
—Mark Twain
This chapter provides a brief 20,000-foot-view introduction to hedge funds and provides a context for the content of this book. In this chapter I briefly cover the history of hedge funds, important definitions, the hedge fund ecosystem, media portrayal of hedge funds, five industry trends, regulations, and the future of hedge funds.
Why important: This chapter is the foundation for the rest of this book. If you have more than five years of industry experience, you may want to skim this chapter and skip to the chapter review questions to check your level of industry knowledge.
What this chapter is not: This book is not a thorough review of hedge fund investment strategies or analytics; those topics are already covered in dozens of other texts, including two that are required in the Certified Hedge Fund Professional (CHP) Designation Program. See these required books and other recommendations at HedgeFundBookstore.com.
What is a hedge fund? The one-sentence definition of a hedge fund is “a private investment vehicle that charges its investors two types of fees: a management fee and a performance fee.” Any more specific definition will lead to conflicts in the industry today, as it has grown in many directions. The management fee is a standard fee based on total assets under management and it typically runs between 1 and 2 percent. The second type of fee typically charged by hedge funds is a performance fee; typically this is 10 to 20 percent and is charged based on the performance achieved by the fund. If a hedge fund has 10 percent positive performance for a single year and its performance fee is 20 percent, the hedge fund's management would get to keep 2 percent of that 10 percent gain as part of their profits, a reward for achieving these positive returns for their investors.
Watch a video explaining what a hedge fund is and is not, here: HedgeFundTraining.com/What-is-a-Hedge-Fund?
HEDGE FUND MECHANICS AND STATISTICS
It is important to know that while these fee figures just mentioned are typical, the hedge fund industry has become competitive and diverse. There are now hedge funds operating that charge a 0 percent management fee while others charge 3 percent. Wide variations in performance fee levels may also be seen. One important aspect of this dual-level fee structure is the incentive it sets in place for hedge fund managers. While many hedge fund managers have already invested their own assets in the portfolio they are managing, remunerating the managers based on positive performance and not just total assets under management rewards those who can achieve consistent year-after-year gains. This in turn leads to rich compensation for those who can outperform the majority, and it attracts the best of talent to the industry. A portfolio manager can potentially earn two to three times as much working for a hedge fund as he could working for a similar size mutual fund or long-only optimization firm.
Investments made in hedge funds are typically seen as medium to long term for several reasons. The main reason is liquidity. Most hedge funds have lock-up periods of one to two years, and many restrict redemptions for as long as three years after the initial investment is made. A lock-up period simply means that the investor may not redeem his invested funds until this period has expired. These lock-up periods are put into place so that the hedge fund may invest in various assets and will have more control and flexibility in the timing of its purchasing and selling of these assets over time. Without lock-up periods, a manager may make a long-term investment in a security, for example, and a new investor could come and request his assets back during a weak point in the markets, forcing the manager to sell the security at a loss to meet that redemption request. While lock-up periods help managers in running their funds, they are seen as a major concern and drawback by institutions and high net worth (HNW) investors. While this book does not cover hedge fund replication or publicly traded hedge funds, these are two areas worth additional research if this topic is of interest to the reader.
There are between 100,000 and 150,000 professionals who work directly within the hedge fund industry and another 1,000,000-plus professionals who work with hedge funds in some way, indirectly or as part of a broader platform of services. There are between 10,000 and 25,000 hedge funds in existence today, depending on whose statistics and databases you trust most, and new funds are launched daily. The average hedge fund has just around $40 million in assets under management (AUM), while many start with just $500,000 to $5 million, and a larger group runs over $1 billion in assets.
To watch a video on hedge fund liquidity and lock-up periods, please type this URL into your Web browser: http://HedgeFundTraining.com/Liquidity
Additional Common Hedge Fund Terms
- Hurdle rate: A hurdle rate is a set performance figure that must be achieved before any performance fees will be calculated or paid to the hedge fund manager. For example, a hedge fund may have its hurdle rate set at 3 percent so that any performance above 3 percent will be considered outperformance. Hurdle rates avoid having investors pay high fees for low-single-digit portfolio performance.
To watch a video on the definition of a hurdle rate, please type this URL into your Web browser: http://HedgeFundTraining.com/Hurdle
- High-water mark: A high-water mark is a tool by which hedge fund managers can assure investors that they will not be charged performance fees after portfolio losses until the fund has made up those past losses. In other words, if a hedge fund manager has a loss of 5 percent in one year, he may not be paid any performance fees in the following year until he has first regained that loss, restoring the fund to the high-water mark point. Again, the high-water mark protects investors from paying the performance fee until the manager has made up the ground he previously lost in the portfolio.
To watch a video on the definition of a high-water mark, please type this URL into your Web browser: http://HedgeFundTraining.com/High
- Gating clause: A gating clause allows a hedge fund manager, under certain circumstances, to restrict or completely cut off redemptions from the portfolio due to market illiquidity or specific sets of circumstances set forth in the contract. This term has been highly debated recently due to hundreds of funds “closing the gate” or enacting this clause in their agreements with investors.
For more definitions, please see the Glossary at the back of this book.
HISTORY OF HEDGE FUNDS
Financial journalist, author, and sociologist Alfred W. Jones started the first hedge fund in 1949 while working for Fortune. The fund was started on the belief that the movements of individual securities were due to both the performance of that specific security and the performance of the broader markets. His strategy was to address this by investing in securities that seemed to be positioned to outperform the market, while shorting (see ) or selling those securities that seemed likely to underperform the market. The goal was to neutralize or cancel out market risk by allowing the portfolio to hedge against negative market movements. This is how the first hedge fund was created. This idea was unique in that it was designed to do well, or at least relatively well, during volatile or even bear market conditions.
This new method of managing portfolios of equities started becoming popular in the 1960s, and by the 1970s there were over 150 hedge funds in existence managing close to $1 billion in assets. Some early hedge fund managers were Warren Buffett, Michael Steinhardt, and George Soros. Since then hedge funds have evolved to include commodities, bonds, real estate, and other types of assets.
Over time, the term hedge fund took on the broader definition of a general private investment partnership, which typically includes management and performance fees as the only common denominator. Even this definition is now becoming dated as more hedge funds and firms that run hedge funds become publicly traded companies. Hedge funds are hard to understand as a whole because they are diverse and somewhat secretive. Hedge funds are secretive because of strict advertising and public offering rules as well as to keep their investment process, trading strategy, and positions from their competition. The hedge fund industry is very competitive and entrepreneurial.
To watch a video on the history of the hedge fund industry, p...
