A healthy scepticism is in order as these opaque vehicles become more widely marketed.
What are they?
A US investment manager named A W Jones is reputed to have been the first (in 1949) to set up an investment partnership with an investment strategy of hedging out the market risk (see shorting) by selling stocks as well as buying them. So he called it a hedge fund.
But you should forget about the word 'hedge'. Now, any enterprise that tries to profit from buying and selling financial instruments and investments (including derivatives) can be called a hedge fund. The defining feature of hedge funds is that they are unregulated. This arose, historically, from the fact that shorting was not allowed in a regulated fund sold to the general public.
The name may have stuck because so many of the trading strategies involve buying one thing and selling another. And perhaps a teensy-weensy bit because the word 'hedge' has a more comfortable feel than 'unregulated' or 'speculative' or even 'arbitrage'.
Now (2018) there is some $3.1trillion invested in hedge funds, earning perhaps $5billion in fees annually for their managers.
Types of fund
Some funds may operate in a way that is almost indistinguishable from unit trusts - just buying and selling stocks. Others may engage in the most complex trading strategies, using sophisticated derivatives to slice and dice their risk into the shape that they want, and then maybe using leverage to magnify the very small gains into much bigger ones.
A non-exhaustive list of hedge fund trading strategies :
Hedged Equity: Betting on stock price differences (like the GM/Ford example in shorting)
Convertible Arbitrage: Betting on the price difference between a convertible security and the underlying stock
Merger Arbitrage: Betting on the outcome of takeovers
Distressed Securities: Betting on recovery stocks
Event-driven: Betting on the occurrence of specific events
Long only: Just like unit trusts (therefore never the only strategy in a hedge fund)
Short only: Take short positions (betting on stocks falling)
Quantitative: Relying on computer models
Macro: Betting on movements in global economies, as reflected in interest and exchange rates and other macroeconomic derivatives
Fund of Funds: Investing in other hedge funds
It is usual, though not invariable, for the managers to have their own money in the fund. This is good, but don't forget they take their (risk-free) management fees first.
In a nutshell
If you invest in a hedge fund you are lending your capital to a team that aims to make money for you (and themselves) by living on their wits in the markets. It's a skill business, like currency trading, oil prospecting or poker.
Do they work?
Who knows? The actual running of any hedge fund is opaque. In an investment trust you can periodically scrutinise the investments of the trust and hear the excuses of management. In a hedge fund you'll hear what the management wants to tell you.
Data on the long-run returns of hedge funds is thin on the ground. To the extent that it is available at all, it will be biased by the standard techniques available to fund managers: selective nurturing, data biases and pick on performance?
The data will be particularly affected by the statistical bias of survivorship. There are probably now some 10,000 hedge funds worldwide. 10-20% of them close every year (to be replaced by others). So the turnover in this secretive and unregulated industry is high. Do you think the funds with good records close?
Any other snags?
- Fees: You will be charged a fixed % (maybe 1%, maybe as much as 4%) and a performance fee (maybe 20% of the profits). We have views on performance fees.
- Opacity: Secrecy is both endemic and necessary. If a trader spots a profitable market opportunity he cannot exploit it if it is common knowledge.
- Risk: Even if your fund claims to be following a low-risk trading strategy today, what about tomorrow? And how do you know it's low risk (when performance fees encourage a "double-or-quits" mentality)? And leverage can turn a small risk into a big risk.
- Most of these funds are unregulated. They need to be , because they use trading techniques proscribed for more conventional funds, and because they demand secrecy. 'Unregulated' does not mean 'crooked' or 'dodgy'. It just means what it says - the funds are set up to operate outside the regulatory regime designed to protect inexperienced savers.
- Tax. Can be tricky. Gains may be charged as income and losses may not be offsettable. Take advice.
- Liquidity. You can buy, but can you always sell?
- Valuation. Funds can invest in some pretty obscure stuff. Who is to say what it is worth if there is no quoted market for it? Could the manager be tempted to pump the valuations? This is one of the ways that Enron covered its tracks.
- This is a people business, but your investment is in the fund. What happens if the manager walks?
What do the managers do?
A few managers of private hedge funds (funds for small numbers of extremely rich clients) have become famous. George Soros is perhaps the best known. This has made them sexy. Sexiness, in investment as in life, is the enemy of good judgement.
The hedge fund premise is that skilled management can deliver exceptional returns - in good times as in bad. They put your money where their mouth is by charging high fees, often supposedly performance-related. These are an illusion (performance fees).The high transaction costs of active dealing add to this burden (costs unwrapped).
Are they risky?
Some are, some aren't. But if they aren't, how do you think they make any money? Risk Premiums
Hedge funds are particularly prone to the trap of the hidden rare event and the dangerous charms of leverage. Read the cautionary tale of Long Term Capital Management (which collapsed in 1998), most digestibly told by Roger Lowenstein in his book "When Genius Failed". Worth it just for his description of LTCM's trading methods: "picking up nickels in front of a bulldozer". LTCM was run by a 'dream team' led by two Nobel prizewinners. When it collapsed it had $5billion of equity supporting $125billion of debt and $1,250billion of risk exposure to derivatives not on its balance sheet.
Aren't they good for diversification?
Maybe. But the trouble with this argument is that it can be applied to any tatty old business that responds to economic drivers different from those of the market as a whole. Why not invest in insolvency practitioners or pawnshops?
You sometimes read "hedge funds can make money in both good markets and bad". This is true, but disingenuous. The profitability of hedge funds depends, instead, on market volatility. So you might say "equities can make money in periods of both high and low volatility". Which would be just as true and just as disingenuous.
Hedge funds are often described as a separate asset class. Good diversification means you should have a piece of all the major asset classes. Therefore you should should invest in hedge funds.
Nice try! But there is no fixed rule for defining asset classes. Why not currency trading or oil exploration as separate asset classes? After all, hedge funds are only 5% of the value of the businesses quoted on the world's stock markets. It is not actually helpful to call hedge funds an asset class. Their common feature is not what they do, but their ownership structure while doing it.
Just ask yourself: What economic service are they delivering? From who do they make money - if they are winning, who is losing? Is there a limit to the total size of the hedge fund cake (hedge fund profit worldwide) or is the cake unlimited? If the cake is limited, why do you think your position in the pecking order entitles you to a slice of it? Does the law of diminishing returns operate (so that each new dollar of hedge fund investment makes less money than the previous dollar)?
If you understand the risks; have read and understood the investment philosophy of the fund; believe in the market judgement and technical skills of the managers; and can logically justify their claim to make excess returns sufficient to cover their charges and still leave something for you.......... the best of luck to you.
For anyone else, keep clear.
This is not a game for the amateur.
We hope you are not thinking of a Fund of Hedge Funds. How on earth are the poor underlying funds going to generate enough profit to pay the extra layer of costs - sometimes with another performance fee thrown in? Understand Risk Premiums, look at How Much Return? and do the maths.