Hedge Funds

CA. Vipul Garg

I don’t think that hedge funds are bad per se. I think they’re just one more financial tool. And in that sense, they’re useful. ~ Barack Obama

First of all, we should ask what is a hedge fund?

A Hedge fund is a private investment partnership and funds pool that uses varied and complex proprietary strategies and invests or trades in complex products, including listed and unlisted derivatives.

Put simply, a hedge fund is a pool of money that takes both short and long positions, buys and sells equities, initiates arbitrage, and trades bonds, currencies, convertible securities, commodities and derivative products to generate returns at reduced risk. As the name suggests, the fund tries to hedge risks to investor’s capital against market volatility by employing alternative investment approaches.

Hedge fund investors typically include high net worth individuals (HNIs) and families, endowments and pension funds, insurance companies, and banks. These funds work either as private investment partnerships or offshore investment corporations. They are not required to be registered with the securities markets regulator and are not subject to the reporting requirements, including periodic disclosure of NAVs.

There are many strategies a hedge fund may use to generate returns. One such strategy is global macros, where the fund takes long and short positions in large financial markets based on the views influenced by economic trends. Then there are funds that work on market-neutral strategies. Here, the goal of the fund manager is to minimize market risks by investing in long/short equity funds, convertible bonds, arbitrage funds, and fixed income products.

Another type includes event-driven funds that invest in stocks to take advantage of price movements generated by corporate events. Merger arbitrage funds and distressed asset funds fall into this category.

As of June 30, 2014, there were 158 alternative investment funds (pooled-in investment vehicles for private equity, real estate, and hedge funds). Some examples of hedge funds include names like Munoth Hedge Fund, Forefront Alternative Investment Trust, Quant First Alternative Investment Trust and IIFL Opportunities Fund. There are others such as Singlar India Opportunities Trust, Motilal Oswal’s offshore hedge fund and India Zen Fund.

The minimum ticket size for investors putting money in these hedge funds is Rs 1 crore. According to Eureka hedge India Hedge Fund Index, which tracks hedge funds in India, the category generated 5.07 per cent return in 2015 compared to 38.84 per cent logged in 2014.

It is well known that hedge funds are less regulated relative to traditional mutual funds enabling fund managers to take long/short positions in almost any financial instruments and use extremely high levels of leverage. Hedge fund managers are given almost full discretion in determining investment strategies, portfolio composition, and level of leverage. Highly skilled managers can actively respond to changes in market conditions and quickly adjust their portfolios and exposures to changes in various risk factors. Therefore, it is natural that such exposure is dynamic and time-varying.

Hedge funds adopt diverse investment strategies and provide investors with options to select hedge funds that best fit to their risk preference. Since hedge funds can go both long and short and/or can invest in most types of financial instruments, risk levels can vary from neutral to extremely high. Hedge fund managers usually announce risk characteristics or investment strategies of their funds to investors. Hedge funds likely exhibit different exposures to the changes in risk factors based on their investment strategies. For instance, Fixed-income funds primarily invest in fixed-income securities, which are usually issued by corporations, banks, and governments. As the name implies, the interest payments are often fixed with respect to frequency and amount. As such, they are less exposed to equity market volatility and their performance tends to be stable and less sensitive to the equity market movements. However, equity hedge funds are highly exposed to changes in micro- and macro-economic conditions, as well as firm earnings and cash flow. Depending on investment strategies, hedge funds possibly achieve different levels of returns given the same or similar market environments. Therefore, it seems somewhat contradictory that a set of risk factors is used to estimate performance of hedge funds pursuing many different investment strategies, or that an aggregate hedge fund portfolio is used to represent those hedge funds by offsetting unique features of funds in each category.

Hedge fund investors are considered to be relatively well educated and knowledgeable in various aspects of investing suggesting that a significant part of any investment decision is based on analytics and underlying information. However, a sophisticated investor would still make a biased decision if the analysis is based on biased information or benchmarks. To be able to make unbiased performance analysis of hedge funds that use a variety of investment strategies, we need to develop a customized set of risk factor for each investment strategy. Our assertion is also related to a well-known fact that hedge funds actively respond to changes in market condition by adjusting their portfolio accordingly. This means that hedge funds can be very flexible as needed in adjusting their exposure to risk factors. However, traditional asset pricing models assume constant beta over the sample period. We therefore argue that constant-beta models do not work well since hedge funds actively and continuously respond to market conditions. Instead, asset pricing models need to be flexible so that they can catch and reflect responses to the changes in the market conditions.

How hedge funds make money?

The inner workings of hedge funds are as elusive as their outward appearance. The general public usually does not know how hedge funds generate revenue and how they manage to pay their employees record salaries and pay rent for the prime properties where their offices are located. The general population is unaware of the various fees that are charged by the funds to their investors and how investors continue to make money despite this big barrage of fees levied on them.

This article will explain the several types of fee that are charged by the hedge funds in order to sustain their operations.

Management Fee

Management fee is the revenue that keeps the operation of the hedge fund going. The rent of the hedge fund’s office, the salary of hedge fund’s staff and all other operational expenses are made out of the management fee. The management fee is usually in the range of 1% to 2% of assets under management. Although this fee is expressed as an annual figure, it is usually charged monthly. Management fee as a percentage of assets under management is reduced as the size of the fund gets bigger. This is what gives bigger hedge funds the benefit of economies of scale and results in lower transaction costs for the investors.

Also, the management fee is charged on the value of investor’s equity in the fund. Therefore if the fund experiences a loss and the value of the assets go down, so does the fee generated by the management. This ensures that the incentives of the management are aligned with that of the investors.

Incentive Fee

Incentive fee is charged by the hedge fund management based on the performance of the fund. For instance, if the fund generates a return of 25% on assets under management, then a portion of the 25% is retained by the hedge fund management as their incentive. Usually, this works out to about 20% of the profits generated.

The incentive fee is used by all hedge funds. This fee ensures that the incentives of the investors as well as management are aligned i.e. the management treats the investor’s money like their own.

Hurdle Rate

Many investors feel that it would be inappropriate for the hedge funds to charge an incentive fee on any and every return that they generate. For instance if the fund generates a 3% return and the management charge a 20% incentive fee on that, it would be unfair.

A low rate like 3% can be generated by investing in a risk free security like treasury bonds as well. This kind of dismal performance should not be rewarded.

Therefore, these funds follow the concept of a hurdle rate. This rate is the minimum benchmark which is expected from the fund. Performance above this benchmark is rewarded with an incentive fee. However, performance up to this level is ignored. For instance, if 3% is the hurdle rate and the fund generates 8% return. In this case, the incentive fee would be charged on the additional 5% only and not the entire 8%.

Surrender Fee

Hedge funds provide investors with an opportunity to divest their money whenever they feel that the fund is not doing well. Such meetings are usually held monthly. However, if one investor decided to pull out his/her money, the interests of the other investors are affected too.

For instance, there are transaction costs incurred while liquidating the money. Also, the total budget is reduced and hence the investment strategy has to be modified. To recover these costs as well as to deter the investors from withdrawing their money, a surrender fee is charged to the client. However, many funds that are very confident about their performance usually do not charge such a fee.

Threshold

Hedge fund investors are wary of the management charging them extra fee even though their investments are not growing. For instance, if the value of a stock goes up by 20%, then falls back 10% and rises again to reach the same level, the hedge fund might charge the incentive fee twice, even though the value of the stock is range bound and not increasing all the time.

It is for this reason, that each time the value of investment sets a new high, it is considered as a threshold. Next time the incentive fee is only paid using the value of that threshold as the base price. Range bound movements do not entitle the fund to receive.

Retrospective Fee

Hedge fund management usually does not refund the incentive fees that they have charged in general. However, some hedge funds want to attract more clients. Therefore, if the fund incurs a loss and the incentive fee has been charged, the fund management returns a portion of the fee that it had earlier collected. This is done to convince the investors that the hedge fund does understand their interests and is fully committed to it.

Financing Fee

Some hedge funds are highly leveraged. Obtaining such leverage costs money in the form of interest payments. Hence, these funds charge these payments to the investors in the form of a financing fee.

Apart from the above mentioned fee, there are a multitude of fees that might be charged by the fund to the investors on a case to case basis. However, despite these several fees investors still make a lot of money compared to other investment options. This is the reason why they eagerly invest in these funds.

World’s Top 10 Hedge Fund Firms: (AUM in Hedge funds)

  1. Blackrock Advisors ($789.57 Billion as on June 30th, 2021)

  2. AQR Capital Management ($224.8 Billion as on Mar 31st, 2020)

  3. Bridgewater Associates ($154 Billion as on Mar 31st, 2021)

  4. Renaissance Technologies ($130 Billion as on June 3rd, 2021)

  5. Man Group ($123.6 Billion as on December 31st, 2020)

  6. Elliott Management ($113.5 Billion as on December 31st, 2020)

  7. Two Sigma Investments ($68.9 Billion as on March 31st, 2021)

  8. Millenium Management ($42 Billion as on December 31st, 2019)

  9. Davidson Kempner Capital Management ($34.8 Billion as on January 31st, 2021)

  10. Citadel Investors ($33.1 Billion as on March 31st, 2021) 

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