Understanding Hedge Funds: Strategies, Risks, and Performance Metrics

What Are Hedge Funds?

The term Hedge Funds refers to an investment that raises funds from institutional or accredited investors and then invests them in liquid and publicly traded financial assets. Hedge funds are privately managed investment funds that employ various strategies to generate multiplied returns. They are considered risky investments and often target wealthy individuals. Mutual funds typically follow a buy-and-hold strategy while hedge funds have the flexibility to invest in various asset classes, including equities, bonds, currencies, etc. Hedge funds are also different from private equity and other closed-end funds, as they often use borrowed money to create leverage.

History and Evolution of Hedge Funds

The International Monetary Fund (IMF) states that the modern history of hedge funds started with Alfred Winslow Jones, a sociologist and journalist who studied market behavior during the 1930s and 1940s. In 1949, he established one of the earliest hedge funds, employing leverage and short selling to “hedge” his stock portfolio against declines in stock prices. Hedge funds have become increasingly popular to diversify risk and distribute costs. They aim to capitalize on market inefficiencies. Its four most common types are long-short equities, event-driven strategies, macro, and fixed-income arbitrage.

People started taking interest in hedge funds in the 1960s after a Fortune magazine wrote about Jones’ outperformance. Many hedge funds were formed due to their popularity. However, during the recession in 1969-70s, the stock market crashed and led to the first hedge fund crash. Later, this industry started expanding again in the 1980s because of growing interest and good performance.

How do Hedge Funds Differ from Mutual Funds?

There are several features that distinguish hedge funds from mutual funds.

• Hedge funds are only limited to wealthy individuals because they need high investments whereas any individual can invest in mutual funds. Mutual funds have much lower investments compared to hedge funds.
• Hedge funds measure the investment returns in absolute terms while mutual funds have a specific index to measure.
• Hedge funds use different strategies for higher returns whereas mutual funds follow the same traditional method of getting returns.
• Both the funds have different fees structures where hedge funds charge a lot of fees (around 10-20%) as compared to mutual funds (around 0.5-1%).

Read more about Hedge Funds vs. Mutual Funds in detail.

What Are the Top Strategies Used by Hedge Funds?

Hedge funds are often structured as limited partnerships, with the fund manager acting as the general partner and investors as limited partners. This structure allows hedge fund managers to charge performance-based fees, typically around 20% of profits, in addition to a management fee, usually around 2% of assets under management (AUM).

Main hedge funds strategies include global macro strategies, directional hedge fund strategies, event driven hedge funds strategies, relative value arbitrage strategies, long/short strategies, and capital structure strategies.

To learn about each strategy in detail, visit Hedge Fund Strategies by Corporate Finance Institute.

What Are the Risks and Rewards of Investing in Hedge Funds?

There are significant rewards and risks of investing in hedge funds.

One of the greatest rewards is the potential for high returns. Hedge fund managers often have the flexibility to implement investment strategies that can generate substantial profits even in tough market conditions. Secondly, these funds offer investors the opportunity to diversify their portfolios beyond traditional asset classes. By investing in a hedge fund, an investor gains exposure to alternative strategies and asset classes that may not be available through conventional investment strategies. This also reduces overall portfolio risk. Hedge funds are also known for their flexibility as they provide investors with the ability to customize investment strategies.

Moving on to the risks, there could be potential losses when the use of leverage, short selling, and complex derivatives experience extreme volatility in the market. Also, they are not subject to the same level of regulatory and disclosure requirements as mutual funds. This lack of transparency can make it challenging for investors to fully understand the risks associated with a particular hedge fund. High management and performance fee structures are also a significant cost for investors. Investing in hedge funds also involves a high degree of manager risk because the fund's success is largely dependent on the skill and decision-making of the fund manager. A manager’s poor judgment of the market or lack of experience could make investors lose money.

How Is Hedge Fund Performance Measured?

Evaluating hedge fund performance requires a deeper analysis than just looking at returns. Hedge funds employ a variety of strategies. Below are the four common performance metrics used to assess hedge funds as suggested by Harvard Business School.

1. Sharpe Ratio: This ratio is one of the most widely used metrics for evaluating hedge fund performance. It measures the risk-adjusted return and the higher the Sharpe Ratio, the better the fund's returns have been relative to the risk taken. This ratio compared multiple assets to each other rather than the market.
2. Alpha: This measures the fund manager's ability to generate returns above a benchmark index, adjusted for risk. Alpha (α) is the difference between an asset or portfolio’s return and a benchmark’s return, relative to the amount of risk taken. Positive alpha indicates that the hedge fund has outperformed the market on a risk-adjusted basis, while negative alpha suggests underperformance.
3. Beta: Beta (β) is the measure of an asset or portfolio’s risk compared to the market’s risk. A beta of 1 means the fund’s returns are expected to move in line with the market, while a beta greater than 1 indicates higher volatility than the market. A beta less than 1 suggests the fund is less volatile than the market.
4. Information Ratio: IR measures the fund manager’s ability to generate excess returns relative to a benchmark, adjusted for the risk (tracking error) taken to achieve those returns. A higher Information Ratio indicates higher excess returns with less risk.

Should You Consider Investing in Hedge Funds?

Hedge funds are not suitable for all investors, and those considering investing in them should conduct thorough due diligence, assess their risk tolerance, and consult with financial professionals. Hedge funds can be a powerful tool in a well-diversified investment portfolio, but they demand very high investment amounts. To learn more about the upcoming trends in the hedge fund industry in the next 10 years, read the article: The Evolution of Hedge Funds.