Loosely defined, hedge funds are the equivalent of unit trusts and mutual funds, but cater to accredited and institutional investors instead of retail investors. This is where the similarities end, as there is much more than meets the eye.
Hedge Funds Operate In The Wild West Of Investing
Unit trusts typically only take long-only exposures, which simply means they employ a buy-and-hold strategy. Hedge funds employ strategies that can range from simple (long/short) to complex (quantitative), meaning they can do literally anything. Good examples would be the main characters in the recent film, “The Big Short”.
It goes without saying that these more exotic strategies are riskier than your usual buy-and-hold strategy, and so requires much higher risk tolerance from investors (thus only available to a certain class of investors). As a result, returns are varied across and non-standard across the industry. Hedge funds can lose 100% of their capital or make 600% in a year, for example.
Unique Characteristics Of Hedge Funds
Hedge funds are not limited to stock markets, and can dabble in anything tradable, from FX to corporate bonds to mortgage-backed securities. Some employ specific strategies (eg. Activist Funds), to ultra-diversified ones (eg. Global macro: making bets on interest rates, commodities etc.)
Although changes have occurred across the industry, the standard model for fees (how fund managers get paid) has been the 2-20 agreement. This means the fund manager gets paid 2% of his AUM (assets under management) on an annual basis, and 20% of all profits made. This amount varies across different funds, and some managers demand more due to their reputation (eg. Paul Tudor Jones has a 4-23 agreement).
Without getting too much into details, hedge funds also hold themselves to different standards than normal retail funds. Generally, they look for absolute vs. relative returns, gate provisions, high watermark, and so on. Although these allow them to compete better, investing in them is also much more complex and should be left to the professionals.
Some Famous Examples of Hedge Funds
Historically, the biggest names in the business have been figures like George Soros, Paul Tudor Jones, Stanley Druckenmiller, and the list goes on. These are billionaires that have made their fortunes from the financial markets over decades.
Perhaps more interesting are the failures, such as the case of LTCM. With Nobel Prize winners on the board of directors, the fund notoriously blew up in 1998 after making losses of $4.6 billion. Due to the size of this hedge fund, the Federal Reserve had to intervene to prevent its collapse from causing a chain reaction across financial markets.
Singaporean local talent have also made their mark on the industry, and Singapore is home to several top hedge funds, such as Quantedge and Dymon Asia (both run by locals). Jim Rogers (who made his fortune alongside George Soros) has also moved to Asia and currently calls Singapore home.
Top Image Credit: DollarsAndSense.sg
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