A Brief Overview on Hedge Funds

Hedge funds are different from mutual funds in that they are subject to very little regulation. This is because they accept funds only from financially sophisticated individuals and organisations. Examples of the regulations that affect mutual funds are the requirements that: Hedge funds are largely free from these regulations. This gives them a great deal of freedom to develop sophisticated, unconventional, and proprietary investment strategies. Hedge funds are sometimes referred to as alternative investments.

The first hedge fund, A.W. Jones & Co., was created by Alfred Winslow Jones in the United States in 1949. It was structured as a general partnership to avoid SEC regulations. Jones combined long positions in stocks considered to be undervalued with short positions in stocks considered to be overvalued. He used leverage to magnify returns. A performance fee equal to 20% of profits was charged to investors. The fund performed well and the term “hedge fund” was coined in a newspaper article written about A.W. Jones & Co., by Carol Loomis in 1966. The article showed that the fund’s performance after allowing for fees was better than the most successful mutual funds. Not surprisingly, the article led to a great deal of interest in hedge funds and their investment approach. Other hedge fund pioneers were George Soros, Walter J. Schloss, and Julian Robertson.

“Hedge fund” implies that risks are being hedged. The trading strategy of Jones did involve hedging. He had little exposure to the overall direction of the market because his long position (in stocks considered to be undervalued) at any given time was about the same size as his short position (in stocks considered to be overvalued). However, for some hedge funds, the word “hedge” is inappropriate because they take aggressive bets on the future direction of the market with no particular hedging policy.

Hedge funds have grown in popularity over the years, and it is estimated that more than $2 trillion was invested with them in 2004. However, as we will see later, hedge funds have performed less well than the S&P 500 between 2009 and 2013. Many hedge funds are registered in tax-favourable jurisdictions. For example, over 30% of hedge funds are domiciled in the Cayman Islands. Funds of funds have been set up to allocate funds to different hedge funds. Hedge funds are difficult to ignore. They account for a large part of the daily turnover on the New York and London stock exchanges. They are major players in the convertible bond, credit default swap, distressed debt, and non-investment-grade bond markets. They are also active participants in the ETF market, often taking short positions.

The famous investor, Warren Buffett, can also be considered to be a hedge fund pioneer. In 1956, he started Buffett Partnership LLP with seven limited partners and $100,100. Buffett charged his partners 25% of profits above a hurdle rate of 25%. He searched for unique situations, merger arbitrage, spin-offs, and distressed debt opportunities and earned an average of 29.5% per year. The partnership was disbanded in 1969 and Berkshire Hathaway (a holding company, not a hedge fund) was formed.


One characteristics of hedge funds that distinguishes them from mutual funds is that fees are higher and dependent on performance. An annual management fee that is usually between 1% and 3% of assets under management is charged. This is designed to meet operating costs - but there may be an additional fee for such things as audits, account administration, and trader bonuses. Moreover, an incentive fee that is usually between 15% and 30% of realised net profits (i.e. profits after management fees) is charged if the net profits are positive. This fee structure is designed to attract the most talented and sophisticated investment managers. Thus, a typical hedge fund fee schedule might be expressed as “2 plus 20%” indicating that the fund charges 2% per year of assets under management and 20% of net profits. On top of high fees there is usually a lock up period of at least one year during which invested funds cannot the withdrawn. Some hedge funds with good track records have sometimes charged much more than the average. An example is Jim Simons’s Renaissance Technologies Corp., which has charged as much as “5 plus 44%.” (Jim Simons is a former math professor whose wealth is estimated to exceed $10 billion).

The agreements offered by hedge funds may include clauses that make the incentive fees more palatable. For example: Some hedge fund managers have become very rich from the generous fee schedules. In 2013, hedge fund managers reported as earning over $1 billion were George Soros of Soros Fund Management LLC, David Tepper of Appaloosa Management, John Paulson of Paulson and Co., Carlcahn of Icahn Capital Management, Jim Simons of Renaissance Technologies, and Steve Cohen of SAC Capital. (SAC Capital no longer manages outside money. Eight of its employees, though not Cohen, and the firm itself had pleaded guilty or been convicted of insider trading in April 2014.)

If an investor has a portfolio of investments in hedge funds, the fees paid can be quite high. As a simple example, suppose that an investment is divided equally between two funds, A and B. Both funds charge 2 plus 20%. In the first year, Fund A earns 20% while Fund B earns -10%. The investor’s average return on investment before fees is (0.5% x 20%) + (0.5% x -10%) or 5%. The fees paid to Fund A are 2% + 0.2 (20 - 2)% or 5.6%. The fees paid to Fund B are 2%. The average fee paid on the investment in the hedge funds is therefore 3.8%. The investor is left with a 1.2% return. This is half what the investor would get if 2 plus 20% were applied to the overall 5% return.

When a fund of funds is involved, there is an extra layer of fees and the investor’s return after fees is even worse. A typical fee charged by a fund of hedge funds used to be 1% of assets under management plus 10% of the net (after management and incentive fees) profits of the hedge funds they invest in. These fees have gone down as a result of poor hedge fund performance. Suppose a fund of hedge funds divides its money equally between 10 hedge funds. All charge 2 plus 20% and the fund of hedge funds charges 1% plus 10%. It sounds as though the investor pays 3 plus 30% - but it can be much more than this. Suppose that five of the hedge funds lose 40% before fees and the other five make 40% before fees. An incentive fee of 20% of 38% or 7.6% has to be paid to each of the profitable hedge funds. The total incentive fee is therefore 3.8% of the funds invested. In addition there is a 2% annual fee paid to the hedge funds and 1% annual fee paid to the fund of funds. The investor’s net return is -6.8% of the amount invested. (This is 6.8% less than the return on the underlying assets before fees.)

Incentives of Hedge Fund Managers

The fee structure gives hedge fund managers an incentive to make a profit. But it also encourages them to take risks. The hedge fund manager has a call option on the assets of the fund. As is well known, the value of a call option increases as the volatility of the underlying assets increases. This means that the hedge fund manager can increase the value of the option by taking risks that increases the volatility of the fund’s assets. The fund manager has a particular incentive to do this when nearing the end of the period over which the incentive fee is calculated and the return to date is low or negative.

Suppose that a hedge fund manager is presented with an opportunity where there is a 0.4 probability of a 60% profit and a 0.6 probability of a 60% loss with the fees earned by the hedge fund manager being 2 plus 20%. The expected return of the investment is

0.4 x 60% + 0.6 x (-60%) = -12%

Even though this is a terrible expected return, the hedge fund manager might be tempted to accept the investment. If the investment produces a 60% profit, the hedge fund’s fee is 2 + 0.2 x 58% or 13.6%. If the investment produces a 60% loss, the hedge fund’s fee is 2%. The expected fee to the hedge fund is therefore

0.4 x 13.6 + 0.6 x 2 = 6.64%

of the funds under administration. The expected management fee is 2% and the expected incentive fee is 4.64%.

To the investor in the hedge fund, the expected return is

0.4 x (60 - (0.2 x 58 - 2)) + 0.6 x (-60 - 2) = - 18.64%.

The example is summarised in the table below. It shows that the fee structure of a hedge fund gives its managers an incentive to take high risks even when expected returns are negative. The incentives may be reduced by hurdle rates, high-water mark clauses, and clawback clauses. However, these clauses are not always as useful to investors as they sound. One reason is that investors have to continue to invest with the fund to take advantage of them. Another is that, as losses mount up for a hedge fund, the hedge fund managers have an incentive to windup the hedge fund and start a new one.

Return from high-risk investment where returns of + 60% and -60% have probabilities of 0.4% and 0.6%. Respectively, and the Hedge Fund charges 2 plus 20%.

Expected return to hedge fund 6.64%
Expected return to investors -18.64%
Overall expected return -12.00%

The incentives we are talking about here are real. Imagine how you would feel as an investor in the hedge fund, Amarnath. One of its traders, Brian Hunter, liked to make huge bets on the price of natural gas. Until 2006, his bets were large right and as a result he was regarded as a star trader. His remuneration including bonuses is reputed to have been close to $100 million in 2005. During 2006, his bets proved wrong and Amarnath, which had about $9 billion of assets under administration, lost a massive $6.5 billion. (This was even more than the loss of hedge fund Long-Term Capital Management in 1998). Brian Hunter did not have to return the bonuses he had previously earned. Instead, he left Amarnath and tried to start his own hedge fund.

It is interesting to note that, in theory, two individuals can create a money machine as follows. One starts a hedge fund with a certain high risk (and secret) investment strategy. The other starts a hedge fund with an investment strategy that is opposite of that followed by the first hedge fund. For example, if the first hedge fund decides to buy $1 million of silver, the second hedge fund shorts this amount of silver. At the time they start the funds, the two individuals enter into an agreement to share the incentive fees. One hedge fund (we do not know which one) is likely to do well and earn good incentive fees. Provided they can find investors for their funds, they have a money machine!.

Prime Brokers

Prime brokers are the banks that offer services to hedge funds. Typically a hedge fund, when it is first started, will choose a particular bank as its prime broker. This bank handles the hedge fund’s trades (which may be with the prime broker or with other institutions), carries out calculations each day to determine the collateral the hedge fund has to provide, borrows securities for the hedge fund when it wants to take short positions, provides cash management and portfolio reporting services, and makes loans to the hedge fund. In some cases, the prime broker provides risk management and consulting services and introduces the hedge fund to potential investors. The prime broker has a good understanding of the hedge fund’s portfolio and will typically carry out stress tests on the portfolio to decide how much leverage it is prepared to offer the fund.

Although hedge funds are not heavily regulated, they do have to answer to their prime brokers. The prime broker is the main source of borrowed funds for a hedge fund. The prime broker monitors the risks being taken by the hedge fund and determines how much the hedge fund is allowed to borrow. Typically, a hedge fund has to post securities with the prime broker as collateral for its loans. When it loses money, more collateral has to be posted. If it cannot post collateral, it has no choice but to close out its trades. One thing the hedge fund has to think about is the possibility that it will enter into a trade that is correct in the long term, but loses money in the short term. Consider a hedge fund that thinks credit spreads are too high. It might be tempted to take a highly leveraged position where BBB-rated bonds are bought and Treasury bonds are shorted. However, there is the danger that credit spreads will increase before they decrease. In this case, the hedge fund might run out of collateral and be forced to close out its position at a huge loss.

As a hedge fund gets larger, it is likely to use more than one prime broker. This means that no one bank sees all its trades and has a complete understanding of its portfolio. The opportunity of transacting business with more than one prime broker gives a hedge fund more negotiating clout to reduce the fees it pays. Goldman Sachs, Morgan Stanley, and many other large banks offer prime broker services to hedge funds and find them to be an important contributor of their profits.

Although a bank is taking some risks when it lends to a hedge fund, it is also true that a hedge fund is taking some risks when it chooses a prime broker. Many hedge funds that choose Lehman Brothers as their prime broker found that they could not access assets, which they had placed with Lehman Brothers as collateral, when the company went bankrupt in 2008.

Hedge Fund Strategies

The following are some of the strategies followed by hedge funds.

Long/Short Equity

The Long/Short equity strategies were used by hedge fund pioneer Alfred Winslow Jones. They continue to be among the most popular of hedge fund strategies. The hedge fund manager identifies a set of stocks that are considered to be undervalued by the market and a set that are considered to be overvalued. The manager takes a long position in the first set and a short position in the second set. Typically, the hedge fund has to pay the prime broker a fee (perhaps 1% per year) to rent the shares that are borrowed for the short position.

Long/short equity strategies are all about stock picking. If the overvalued and undervalued stocks have been picked well, the strategies should give good returns in both bull and bear markets. Hedge fund managers often concentrate on smaller stocks that are not well covered by analysts and research the stocks extensively using fundamental analysis, as pioneered by Benjamin Graham. The hedge fund manager may choose to maintain a net long bias where the shorts are of smaller magnitude than the longs or a net short bias where the reverse is true. Alfred Winslow Jones maintained a net long bias in his successful use of long/short equity strategies.

An equity-market-neutral fund is one where longs and shorts are matched in some way. A dollar-neutral fund is an equity-market-neutral fund where the dollar amount of the long position equals the dollar amount of the short position. A beta-neutral fund is a more sophisticated equity-market neutral fund where the weighted average beta of the shares in the long portfolio equals the weighted average beta of the shares in the short portfolio so that the overall beta of the portfolio is zero. If the capital asset pricing model is true, the beta-neutral fund should be totally insensitive to market movements. Long and short positions in index futures are sometimes used to maintain a beta-neutral position.

Sometimes equity market neutral funds go one step future. They maintain sector neutrality where long and short positions are balanced by industry sectors or factor neutrality where the exposure to factors such as the price of oil, level of interest rates, or the rate of inflation is neutralised.

Dedicated Short

Managers of dedicated short funds look exclusively for overvalued companies and sell them short. They are attempting to take advantage of the fact that brokers and analysts are reluctant to issue sell recommendations - even though one might reasonably expect the number of companies overvalued by the stock market to be approximately the same as the number of companies undervalued at any given time. Typically, the companies chooses are those with weak financials, those that change their auditors regularly, those that delay filing reports with the SEC, companies in industries with overcapacity, companies suing or attempting to silence their short sellers, and so on.

Distressed Securities

Bonds with credit ratings of BB or lower are known as “non-investment-grade” or “junk” bonds. Those with a credit rating of CCC are referred to as “distressed” and those with a credit rating of D are in default. Typically, distressed bonds sell at a big discount to their par value and provide a yield that is over 1,000 basis points (10%) more than the yield on Treasury bonds. Of course, an investor only earns this yield if the required interest and principal payments are actually made.

The managers of funds specialising in distressed securities carefully calculate a fair value for distressed securities by considering possible future scenarios and their probabilities. Distressed debt cannot be shorted and so they are searching for debt that is undervalued by the market. Bankruptcy proceedings usually lead to a reorganisation or liquidation of a company. The fund managers understand the legal system, know priorities in the event of liquidation, estimate recovery rates, consider actions likely to be taken by management, and so on.

Some hedge funds are passive investors. They buy distressed debt when the price is below its fair value and wait. Other hedge funds adopt an active approach. They might purchase a sufficiently large position in outstanding debt claims so that they have the right to influence a reorganisational proposal. In Chapter 11 reorganisations in the United States, each class of claims must approve a reorganisation proposal with a two-thirds majority. This means that one-third of an outstanding issue can be sufficient to stop a reorganisation proposed by management or other stakeholders. In a reorganisation of a company, the equity is often worthless and outstanding debt is converted into new equity. Sometimes, the goal of an active manager is to buy more than one-third of the debt, obtain control of a target company, and then find a way to extract wealth from it.

Merger Arbitrage

Merger arbitrage involves trading after a merger or acquisition is announced in the hope that the announced deal will take place. There are two main types of deals: cash deals and share-for-share exchanges.

Consider first cash deals. Suppose that Company A announces that it is prepared to acquire all the shares of Company B for $30 per share. Suppose the shares of Company B were trading at $20 prior to the announcement. Immediately after the announcement its share price might jump to $28. It does not jump immediately to $30 because (a) there is some chance that the deal will not go through and (b) it may take some time for the full impact of the deal to be reflected in market prices. Merger-arbitrage hedge funds buy the shares in Company B for $28 and wait. If the acquisition goes through at $30, the fund makes a profit of $2 per share. If it goes through at a higher price, the profit is higher. However, if for any reason the deal does not go through, the hedge fund will take a loss.

Consider next a share-for-share exchange. Suppose that Company a announces that it is willing to exchange one of its shares for for of Company B’s shares. Assume that Company B’s shares were trading at 15% of the price of Company A’s shares prior to the announcement. After this announcement, Company B’s share price might rise to 22% of Company A’s share price. A merger-arbitrage hedge fund would buy a certain amount of Company B’stock and at the same time short a quarter as much of Company A’s stock. This strategy generates a profit if the deal goes ahead at the announced share-for-share exchange ratio or one that is more favourable to Company B.

Merger-arbitrage hedge funds can generate steady, but not stellar, returns. It is important to distinguish merger arbitrage from the activities of Ivan Boersky and others who used inside information to trade before mergers became public knowledge. Trading on inside information is illegal. Ivan Boesky was sentenced to three years in prison and fined $100 million.

The Michael Douglas character of Gordon Gekko in the award-winning movie Wall Street was based on Ivan Boesky.

Convertible Arbitrage

Convertible bonds are bonds that can be converted into the equity of the bond issuer at certain specified future times with the number of shares received in exchange for a bond possibly depending on the time of the conversion. The issuer usually has the right to call the bond (i.e. buy it back for a pre-specified price) in certain circumstances. Usually, the issuer announces its intention to call the bond as a way of forcing the holder to convert the bond into equity immediately. (If the bond is not called, the holder is likely to postpone the decision to convert it into equity for as long as possible.)

A convertible arbitrage hedge fund has typically developed a sophisticated model for valuing convertible bonds. The convertible bond price depends in a complex way on the price of the underlying equity, its volatility, the level of interest rates, and the chance of the issuer defaulting.

Many convertible bonds trade at prices below their fair value. Hedge fund managers buy the bond and then hedge their risks by shorting the stock. This is an application of delta hedging. Interest rate risk and credit risk can be hedged by shorting nonconvertible bonds that are issued by the company that issued the convertible bond. Alternatively, the managers can take positions in interest rate futures contract, asset swaps, and credit default swaps to accomplish this hedging.

Fixed Income Arbitrage

The basic tool of fixed income trading is the zero coupon yield curve. One strategy followed by hedge fund managers that engage in fixed income arbitrage is a relative value strategy, where they buy bonds that the zero-coupon yield curve indicates are undervalued by the market and sell bonds that it indicates are overvalued. Market neutral strategies are similar to relative value strategies except that the hedge fund manager tries to ensure that the fund has no exposure to interest rate movements.

Some fixed-income hedge fund managers follow directional strategies where they take a position based on a belief that a certain spread between interest rates, or interest rates themselves, will move in a certain direction. Usually they have a lot of leverage and have to post collateral. They are therefore taking the risk that they are right in the long term, but that the market moves against them in the short term so that they cannot post collateral and are forced to close out positions at a loss. This is what happened to Long Term Capital Management.

Emerging Markets

Emerging market hedge funds specialise in investments associated with developing countries. Some of these funds focus on equity investments. They screen emerging market companies looking for shares that are overvalued or undervalued. They gather information by travelling, attending conferences, meeting with analysts, talking to management, and employing consultants. usually they invest in securities trading on the local exchange, but sometimes they use American Depository Receipts (ADRs). ADRs are certificates issued in the United States and traded on a U.S. exchange. They are backed by shares of a foreign company. ADRs may have better liquidity and lower transaction costs than the underlying foreign shares. Sometimes there are price discrepancies between ADRs and the underlying shares giving rise to arbitrage opportunities.

Another type of investment is debt issued by an emerging market country. Eurobonds are bonds issued by the country and denominated in a hard currency such as the U.S. dollar or the Euro. Local currency bonds are bonds denominated in the local currency. Hedge funds invest in both types of bonds. They can be risky: countries such as Russia, Argentina, Brazil and Venezuela have defaulted several times on their debt.

Global Macro

Global macro is the hedge fund strategy used by star managers such as George Soros and Julian Robertson. Global macro hedge fund managers carry out trades that reflect global macroeconomic trends. They look for situations where markets have, for whatever reason, moved away from equilibrium and place large bets that they will move back into equilibrium. Often the bets are on exchange rates and interest rates. A global macro strategy was used in 1992 when George Soros’s Quantum Fund gained $1 billion by betting that the British Pound would decrease in value. More recently, hedge funds have (with mixed results) placed bets that the huge U.S. balance of payments deficit would cause the value of the U.S. dollar to decline. The main problem for global macro funds is that they do not know when equilibrium will be restored. World markets can for various reasons be in disequilibrium for long periods of time.

Managed Futures

Hedge fund managers that use managed futures strategies attempt to predict future movements in commodity prices. Some rely on the manager’s judgement; others use computer programs to generate trades. Some managers base their trading on technical analysis, which analyses past price patterns to predict the future. Others use fundamental analysis, which involves calculating a fair value for the commodity from economic, political, and other relevant factors.

When technical analysis is used, trading rules are usually first tested on historical data. This is known as back-testing. If (as is often the case), a trading rule has come from an analysis of past data, trading rules should be tested out of sample (that is, on data that are different from the data used to generate the rules). Analysts should be aware of the perils of data mining. Suppose thousands of different trading rules are generated and then tested on historical data. Just by chance a few of the trading rules will perform very well - but this does not mean that they will perform well in the future.

Hedge Fund Performance

It is not easy to assess hedge fund performance as it is to assess mutual fund performance. There is no data set that records the returns of all hedge funds. For the Tass hedge funds database, which is available to researchers, participation by hedge funds is voluntary. Small hedge funds and those with poor track records often do not report their returns and are therefore not included in the data set. When returns are reported by a hedge fund, the database is usually backfilled with the fund’s previous returns. This creates a bias in the returns that are in the data set because, as just mentioned, the hedge funds that decide to start providing data are likely to be the ones doing well. When this bias is removed, some researchers have argued, hedge fund returns have historically been no better than mutual fund returns, particularly when fees are taken into account.

Arguably, hedge funds can improve the risk-return trade offs available to pension plans. This is because pension plans cannot (or choose not to) take short positions, obtain leverage, invest in derivatives, and engage in many of the complex trades that are favoured by hedge funds. Investing in a hedge fund is a simple way in which a pension fund can (for a fee) expand the scope of its investing. This may improve its efficient frontier.

It is not uncommon for hedge funds to report good returns for a few years and then “blow up”. Long-Term Capital Management reported returns (before fees) of 28%, 59%, 57% and 17% in 1994, 1995, 1996 and 1997, respectively. In 1998, it lost virtually all its capital. Some people have argued that hedge fund returns are like the returns from writing out-of-the-money options. Most of the time, the options cost nothing, but every so often they are very expensive.

This may be unfair. Advocates of hedge funds would argue that hedge fund managers search for profitable opportunities that other investors do not have the resources or expertise to find. They would point out that the top hedge fund managers have been very successful at finding these opportunities.

Prior to 2008, hedge funds performed quite well. In 2008, hedge funds on average lost money but provided a better performance than the S&P 500. During the years 2009 to 2013, the S&P 500 provided a much better return than the average hedge fund. The Credit Suisse hedge fund index is an asset-weighted index of hedge fund returns after fees (potentially having some of the biases mentioned earlier). The below table compares returns given by the index with total returns from the S&P 500.

Performance of Hedge Funds
Year Return on Hedge Fund Index (%) S&P 500 return including dividends (%)
2008 -15.66 -37.00
2009 18.57 26.46
2010 10.95 15.06
2011 -2.52 2.11
2012 7.67 16.00
2013 9.73 32.39


Updation History
First updated on 13th December 2019.