What Are Hedge Funds And How Do They Work?

How do hedge funds work?

Hedge funds work by identifying and capitalising on investment opportunities resulting from financial asset mis-pricings, expected market trends, corporate transactional events like mergers and acquisitions, and events that impact certain macroeconomic variables.

To profit from the latter, hedge funds employ a range of trading strategies and leveraged derivatives unavailable to traditional pooled-fund vehicles.

Because several hedge fund strategies rely on the fund taking advantage of opportunities before a competitor – called ‘first mover advantage’ – they are often tight-lipped and secretive, even with investors. This has been interpreted as hedge funds wanting to keep unethical dealings away from public scrutiny – a charge that may be unwarranted.

What is a hedge fund manager?

A hedge fund manager directs investment strategy at a hedge fund. They are tasked with protecting and augmenting the wealth of the fund’s investors by achieving results that, over a period of several years, outperform traditional funds and competing alternative investments.

Managers typically invest alongside other investors, and are sometimes required to reinvest a large portion of their performance fee back into the fund. If the fund is set up as a limited partnership, the hedge fund manager is the general partner.

Well-known hedge fund managers include:

• John Meriwether (Long-Term Capital Management)
• Ray Dalio (Bridgewater Associates)
• Jim Simons (Renaissance Technologies)
• Paul Tudor Jones (Tudor Investment Corporation)
• George Soros (Quantum Group of Funds)
• Bill Ackman (Pershing Square Capital Management LP)
• John Paulson (Paulson & Co.)
• Steve Cohen (Point72 Asset Management)
• David Tepper (Appaloosa Management)
• Daniel Och (Och-Ziff Capital Management Group)

How do hedge funds make money?

Hedge funds make money by charging management and performance fees. The funds are usually divided into two components – the pooled-fund component and the company that manages the fund. In the case of a limited partnership, the general partner may charge a management fee of 1% to 2% of the total assets under management (AUM). Performance fees of 20% to 30% are added above this amount.

Many hedge funds use the ‘2 and 20’ structure also common in venture capital and private equity. This is a 2% management fee and a 20% performance incentive. As noted, hedge fund managers are usually required to invest in the fund, and are often mandated to reinvest up to 50% of their performance fees to ensure that their interests align with those of their clients.

Several additional measures to protect the interests of clients are employed. A ‘hurdle rate’ is a return that must be reached before any performance fee can be charged, and a ‘high watermark’ is a benchmark high that, if the fund falls, must be reached again before which no performance fees may be charged.

Example of a hedge fund’s fee schedule

To illustrate a ‘2 and 20’ fee schedule in an example of a modestly sized hedge fund of £100 million, let’s assume that:

• The fund has a £105 million hurdle
• It increases to £130 million after year one
• Falls to £110 million in year two
• And then reaches £145 million in year three

The fee structure would be as follows:

• Year one: (2% x £130 million) + (20% x £25 million profit) = £7.6 million
• Year two: (2% x £110 million) + (0) = £2.2 million
• Year three: (2% x £145 million) + (20% of £15 million profit above previous high watermark) = £5.9 million
• Total fees: £15.7 million
• Return to investors: £129.3 million