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HEDGE FUNDS
You’ve undoubtedly heard the term hedge fund before. Most people have, traders and non-traders
alike. However, relatively few actually know what a hedge fund is, and fewer still know how hedge
funds work.
So … what is a hedge fund? This file takes some of the mystery out of hedge funds to give you a
better understanding about what they are, how they work, and what makes them such an enticing
investment opportunity for select investors.

Hedge Funds: The Basics

A hedge fund is a limited partnership. It’s a financial relationship that exists between a fund
manager (also known as the general partner) and the investors (also known as the limited
partners).
Let’s take a moment to look at how these two parties work together.
Fund Manager
The fund manager or general partner is the person steering the ship that is the hedge fund, creating
a strategy and managing the funds.
Their goal is to maximize investor returns and eliminate risk, regardless of whether the market is
moving up or down.
Investors
The investors, or limited partners, are the ones who contribute the money. However, not just
anybody can be a hedge fund investor.
Who Can Invest in a Hedge Fund?
Nope: Hedge funds aren’t accessible to just anyone with a bank account.
To be eligible to invest, you either must have a net worth of over $1 million (excluding a primary
residence), or you must have made over $200,000 for the past two consecutive years.
Hedge funds have a reputation for being very white collar, and now you can see why!

Benefits for Managers and Investors

Ideally, both parties benefit from the hedge fund relationship.
The investors benefit from having a fund manager who can take their investment and earn them
returns, increasing their wealth.
The fund manager is typically paid by a fee schedule that is referred to as “two and twenty,” which
means that they get a 2 percent asset management fee, and then 20 percent of any gains generated
through their work.
When you consider that some hedge funds have earnings in the billions, it’s not a stretch to say that
life can be sweet for hedge fund managers.

What Does a Hedge Fund Invest In?

A hedge fund can invest in just about anything. Some common investments might include land, real
estate, currencies, derivatives, and stocks, though they’re not limited to these categories.
Hedge Fund Strategies

1. Leverage
This is one of the riskiest strategies that can go wrong if the hedge fund doesn’t make the expected
returns. Using leverage or borrowing money for an investment in order to increase the returns is
exactly what many strategies are made of. Investors borrow huge amounts of money for an
investment that they are sure will make them huge returns and they would easily be able to return
the money. However, all that goes horribly wrong when the market crashes. When used wisely,
leveraging can help increase the returns. It is all about how much of leverage is being used.

2. Long Only

As the name suggests, the strategy here is about owning only long positions for a hedge fund
whether in stocks or any other asset. The idea is to always set a long position so that when the hedge
fund outperforms the benchmark, profit or alpha is generated.

3. Short Only

This is also a risky strategy and a difficult one as well. Using this strategy, a hedge fund only deals
with short stocks. The idea is to short sell a stock that the manager is certain will go down. When
the price does go down, you end up making a profit. However, if the market rises you will end up
having to pay more than you invested and might lose it all.

4. Long/Short

This is a hybrid of short only and long only strategy and it works when a company holds a long
position while selling stocks short as well. By holding a long position for those stocks that the
manager is certain will go up, they are anticipating returns whereas by short selling stocks that they
predict will go down, they will make a profit with these stocks as well. If both strategies work out,
the hedge fund will make huge returns.

5. Market Neutral

This is a unique strategy where equal parts of the portfolio are invested in long positions and short
positions. So, this brings the net exposure of a portfolio to 0 whereas the gross would be 100%. This
allows a hedge fund to make substantial returns regardless of whether the market goes up or down.

6. Relative Value Arbitrage

How this strategy works is that the manager purchases two bonds with the same date of maturity as
well as credit quality. However, the coupon price is different for both. The bond with the higher
priced coupon will sell at a premium whereas the lower priced coupon will stay at par or below it.
The manager then sells the bond with the premium and buys the below par bond. Both will
eventually mature at par which allows for the coverage and the short sell of the premium bond.

7. Equity Arbitrage
This strategy usually works for the hedge funds that are looking for stocks from firms that are
undergoing a takeover. They will short sell the stocks of the firm being taken over and hold a long
position for the stocks of the company that is taking over. This is done with the assumption that the
company being taken over will trade down and the company that is taking over will trade up.

8. Distressed Debt

This is a strategy which involves investing in the stocks of those companies that are currently in a
distressed situation and as a result the value of their stocks has gone down. This is done with the
belief that the reason the stocks have traded down is due to a financial situation which will
eventually improve and the value of the stocks will go up. This will end up making huge gains for
the hedge fund. Without doubt, this is a risky trade as the company might not come out of its
distress and instead go further down.

9. Event Driven

Using this strategy, hedge funds invest in any stocks or equity that will move up and down with the
market. However, the trick here is to look for any news that can make the market move up and
down. If the manager has a lead time of even a few seconds, they can make huge returns from the
market’s movement.

10. Quantitative

This works by looking at ways a hedge fund can make profits because of market abnormalities.
This is done by hiring computer programmers who analyze the statistical data to find hidden
alphas. However, this strategy is risky and there have been more than a few historical cases where
investors lost a large percentage of their asset value.

How to Pick a Hedge Fund

Interested in hedge fund investing? Here are some things to be sure to research and inquire
about with a potential fund manager:

What are the five-year annualized returns?

How big is the fund, and how big is the firm handling it?
Does it feature standard, rolling standard, or downside deviation?
What’s the minimum investment for this hedge fund?
What are the redemption terms?
How many months to recovery/maximum drawdown?
Pros and Cons of Hedge Funds
Like any type of investment, there are pros and cons to hedge funds. Here are some of the biggest
benefits and potential pitfalls:
Pros:
Ideally, a hedge fund is able to generate positive returns in both rising and falling markets.
Hedge funds can reduce overall portfolio risk and volatility and increase returns.
Investors can precisely customize an investment strategy.
As an investor, you’ll have access to some of the world’s most talented investment managers.
Cons:
You must have either a very big bank account or a large annual salary to be eligible to invest.
A concentrated investment strategy exposes hedge funds to huge losses.
Hedge funds use leverage. Use of leverage can turn what would have been a minor loss into a
significant loss.
A hedge fund requires investors to lock up money for a period of years. Withdrawals may only
happen quarterly or biannually.
Hedge Fund Risks
Hedge Fund Risks and Issues for Investors

The main reasons of investing in hedge funds is to diversify the funds and maximize the returns of
the investors, but high returns comes with a cost of higher risk since hedge funds are invested in
risky portfolios as well as derivatives which has inherent risk and market risk in it, which may
either give huge returns to the investors or turn them into losses and investor may incur negative
returns.

Hedge funds appear to be a very lucrative proposition for investors with High Risk and High
Return appetite. However, it does pose some challenges, especially for the investors investing
Millions and Billions of Dollars. There are some inherent issues of hedge funds that have also
increased significantly post the 2008 Financial crisis.
Hedge Fund Investors from most countries are required to be qualified investors who are assumed
to be aware of the investment risks and accept these risks due to the potentially large returns
available. Hedge Fund managers also employ comprehensive strategies of risk management for
protecting the hedge fund investors, which is expected to be diligent since the hedge fund manager
is also a significant stakeholder in the particular hedge fund. Funds may also appoint a “risk
officer” who will assess and manage the risks but will not be involved in the Trading activities of
the Fund or employing strategies such as formal portfolio risk models.

#1 – Regulatory and Transparency

Hedge funds are private entities with relatively less public disclosure requirements. This, in turn, is
perceived as a ‘lack of transparency’ in the immense interest of the community.
Another common perception is that in comparison to various other financial investment managers,
the hedge fund managers are not subjected to regulatory oversight and rigid Registration
requirements.
Such features expose the funds to fraudulent activities, faulty operations, mismatch of handling the
Fund in case of multiple managers, etc.
#2 – Investment Risks
Hedge funds share several risks as other investment classes are broadly classified as Liquidity Risk
and Manager Risk. Liquidity refers to how quickly security can be converted into cash. Funds
generally employ a lock-up period during which an investor cannot withdraw money or exit the
Fund.
This can block possible liquidity opportunities during the lock-up period, which can range from 1-3
years.
Many such investments employ leverage techniques, which are the practice of purchasing assets
based on borrowed money or using derivatives for obtaining market exposure over investors’
capital.
Another massive risk for all hedge fund investors is the risk of losing their entire investment. The
Offering Memorandum (Prospectus) of the hedge fund generally states that the investor should
have the appetite of losing on the whole amount of investment in case of unforeseen circumstances
without holding the hedge fund responsible.

#3 – Concentration Risk
This type of risk involves an excessive focus on a particular kind of strategy or investing in a
restricted sector to enhance returns.
Such risks can be conflicting for particular investors who expect vast diversification of funds to
enhance returns in various sectors.
E.g., the hedge fund investors may be having a defensive technique of investing the funds in the
FMCG sector since this is an industry that will be operating continuously with a broad scope of
expansion as per the changing customer requirements.
However, if the macroeconomic conditions are dynamic like inflation challenges, high input costs,
less consumer spending, in turn, will spur a downward spiral for the entire FMCG sector and
hamper overall growth.
If the hedge fund manager has put all the eggs in one basket, then the performance of the FMCG
sector will be directly proportional to the performance of the Fund.
On the contrary, if the funds have been diversified in multiple sectors like FMCG, Steel,
Pharmaceuticals, Banking, etc., then a dip in the performance of one sector can be neutralized by
the understanding of another industry.
This will largely depend on the macroeconomic conditions of the region where the investments are
being made and its future potential.

#4 – Performance Issues
Since the 2008 Financial crisis, the charm of the hedge fund industry is said to have waned out a bit.
This is due to various factors related to interest rate formation, credit spreads, stock market
volatility, leverage, and government intervention creating various hurdles that reduce opportunities
for even the most skillful fund managers.
One area from where the hedge funds earn is by taking advantage of volatility and selling them. As
per the below chart, the volatility index has been steadily declining downward since 2009, and it is
hard to sell volatility since there is none to take advantage of.

This deterioration in performance can be pinned to the overabundance of investors. The hedge
fund investors have now become very cautious in their approach and opt to preserve their capital
even in the worse of conditions.
As the number of hedge funds has swelled, making it a $3 trillion industry, more investors are
participating. Still, the overall performance has shrunk since more hedge fund managers have
entered the market, reducing the effect of multiple strategies that were traditionally considered
speculative.
In such cases, the skills of a fund manager can carve a niche for themselves by beating various
estimates and exceeding expectations of general market sentiment.

#5 – Rising Fees & Prime Broker Dynamism

Fund managers are now beginning to feel the effects of bank regulations, which have been
strengthened post the 2008 financial crisis, especially the Basel III regulations.
These updated rules require banks to hold more capital through a capitalization rate, which blocks
money towards regulatory requirements, leverage constraints, and increasing focus on liquidity,
impacting the capacity and economics of banks.

It has also resulted in an evolving shift in how the Prime broker’s view hedge fund relationships.

Prime brokers have started demanding higher fees from the hedge fund managers for providing their
services, which in turn has an impact on the performance of the hedge fund and, in turn making them
less lucrative in an already squeezing margin business.

This has caused fund managers to evaluate how they obtain their financing or, if required, to make
radical changes to their strategies.

This has made the investors jittery, especially for those whose investments are in the “lock-up”
period.
#6 – Mismatch or Incomplete Information
The fund managers must reveal the performance of the Fund regularly. However, the results can be
fabricated to match the directions of the fund manager since the offering documents are not
reviewed or approved by the state or federal authorities.
A hedge fund may have little or no operating history or performance and hence may use
hypothetical measures of execution, which may not necessarily reflect the actual trading done by
the manager or advisor.
Hedge fund investors should do a careful vetting of the same and question possible discrepancies.
E.g., a hedge fund could have a very complicated tax structure that may expose possible loopholes
but not understood by the typical investor.
A fund manager may invest in P-Notes of the Indian stock market but routed through a tax haven.
However, the manager may make such an investment by making all tax payments misleading the
investors.
A hedge fund may not provide any transparency regarding its underlying investments (including
sub-funds in a Fund of Funds structure) to the investors, which in turn will be difficult for the
investors to monitor.
Within this, there exists a possibility of getting the trades done through trading expertise and
experience of third-party managers/advisors, the identity of which may not be disclosed to the
investors.

#7 – Taxation
Hedge funds are generally taxed as Partnerships to avoid instances of “Double Taxation” and the
Profits and Losses being passed on to the investors.
These gains, losses, and deductions are allocated to the investors for the respective fiscal year as
determined by the General Partner.
This is detrimental to the investors since they will be the ones to bear the tax liabilities and not the
hedge fund.
The Fund’s tax returns are usually prepared by the accounting firm, which provides audit facilities
to the hedge fund.
Expenses are also passed on to the investors, depending on whether the hedge fund is a “Trader” or
an “Investor” insecurities during the year. The difference in treatment may change every year, and
the differences are:
If the Fund is treated as a Trader, the investors may deduct their share of funds’ expenses,
If the Fund is treated as an Investor, they may only deduct their share of funds’ expenses if that
amount exceeds 2% of the investor’s Adjusted Gross Income.
Additionally, investors may also require state or local income tax returns with the Federal tax
returns.
The drawback for the offshore investors, if not a tax-exempt, is that their Profits shall be credited
net of all expenses and tax liabilities.
For instance, the U.S. Government taxes all offshore profits at very high rates and imposing a non-
deductible interest charge on taxes owed on any deferred income once the shares of the Fund are
sold or distributed.
In the case of dividends, a “With-holding tax” is also imposed on the offshore investors, which is
generally in the range of 25%-30% depending on the country from where the investment is made
and the taxation treaty shared with such nations.
Hence, if for local investors, the tax liability would be in the range of 15%, for offshore such
penalties can climb to as much as 35%.

#8 – Problem of Plenty
Presently, the biggest problem faced by the hedge fund industry is the existence of far too many
hedge funds.
If an investor wants to multiply his investment and generate a continuous trend of positive alpha
(returns above the risk-adjusted return), the hedge fund needs to be exceptional regularly.
The issue for the hedge fund investors here is in which Fund they shall proceed with their
investments.
Most of the small hedge funds are currently struggling with the burden of additional costs being
imposed along with Prime brokerage fees. As a result, for a fund to survive, it needs to have a good
rise in its Assets under Management (AUM) to at least $500mm for countering the increasing costs
and risk appetite it needs to spur for earning large returns.
A fund in such instances will need around three years to break even after it can earn profits and
breach its “high-water mark” limit for charging Performance Fees.

Conclusion
Hedge funds are a type of investing that employ sometimes high-risk methods in hopes of realizing
high gains for investors.
Due to the relatively high level of risk and the stringent income standards for investing, these funds
are only accessible to a fairly elite echelon of investors.
However, even if you’re not this level of investing (yet), traders even at a much more humble level
can still learn from what hedge fund managers are doing, sectors they’re investing in, and what’s
moving their money.
Moreover, by looking at what hedge funds are doing, you can gain direction for your stock research
on StocksToTrade and gain insight about what’s moving the market.

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