A hedge fund is an investment vehicle with a money manager who takes a percentage of the profits earned for investors. There are $2 trillion invested globally in such funds. The US alone has over 10,000 hedge funds.
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Despite or perhaps because of its size, hedging funds is still the domain of a limited number of institutional investors and some very rich individuals. Of the $2 trillion, around $1.3 trillion in assets are managed by just 225 money managers. Most operate out of New York, with Manhattan-based offices in or near Wall Street.
But before these funds made a business out of it, the term hedging was originally applied in the markets by investors and companies who took both long and short positions in the markets to reduce their exposure to risk. For example, an airline company that buys a lot of fuel could take positions both ways on oil futures. This would safeguard them regardless of whether the price of fuel went up or down.
But it is now a generic term for funds with diversified portfolios. Their job is to reduce risk for investors in a volatile market. The general idea is that investors should end up with a net profit regardless of whether the markets are up or down.
One of the 225 top money managers referred to above is Paulson & Co., which manages assets worth $35.1 billion. Its founder John Paulson had the foresight to short subprime mortgages in 2007 just prior to the housing market crash. These are the kind of informed decisions that attract large institutional investors like university endowments and pension funds.
A hedge fund has more leeway than mutual funds to make any desired investment. They can develop and use all kinds of strategies including short-selling, arbitrage and asset backed lending. They can register offshore and leverage huge transactions with relatively low investments.
A hedge fund does not have to register with the U. S. SEC, and there are no disclosure requirements regarding their investments or finances. This allows them to build up a successful strategy without letting other funds know about it. In the aftermath of the credit crunch in 2008-09, the lack of regulation on these funds has been hotly debated.
The way it works is that a money manager starts up a hedge fund with a prospectus and an operating agreement, and seeks out investors. The prospectus details the hedge fund’s strategy and investment types, along with a leverage limit. The agreement will specify the fees charged by the manager.
The fees normally include a management fee for covering operational costs and a performance fee for generating earnings. The 2 by 20 rule became famous after intense scrutiny over “carried interest” and the billions of dollars hedge fund managers were making in 2008-09 even as investors were wiped out. Managers with a 2 by 20 agreement get 2 percent of the asset value and 20 percent of profits each year.
So a hedge fund manager handling assets worth $1 billion gets to keep $20 million a year for doing virtually nothing. If the investment makes a profit and the asset value climbs to $1.2 billion, then the manager also gets 20 percent of the $200 million profit. In this case, the manager makes $20 million plus an additional $40 million, for a total of $60 million.
Of course, non-performing funds won’t survive for long. Even so, the exorbitant fees and profit sharing arrangements can only work for deep pocketed investors making massive investments who can survive an occasional dip in value now and then. This is another reason why hedge funds sign up only institutional investors and individuals with a lot of money to invest.
While hedging as a concept is supposed to reduce risk, it is ironic that ordinary investors are shut out because of potential risks and the secretive nature of these investments. Sometimes, even large funds that have been doing well for years will get wiped out due to a single bad decision. The Paulson & Co. Referred to above reportedly earned $15 billion for investors in 2007 by brilliantly shorting subprime mortgages.
The same Paulson & Co then turned around and lost more than 40% of its value in 2011 due to a bad bet on the banking industry. They lost a huge amount of money by wrongly assuming that Citigroup Inc. And Bank of America Corp. Were ready to bounce back after the recession. The lesson here is that investors have to do their own homework to make sure a hedge fund, no matter how famous or big, has a diversified portfolio to even out market volatility and continue adding value to assets regardless.
