A short explanatory video by Rich Bello defining hedge funds, clarifying misconceptions, and describing common hedge fund types and mechanics. It explains private offering status, investor qualifications, fee structures (management and incentive fees), use of shorting and leverage, risks of short selling, and overviews of fund types: long-short equity, macro, event-driven, multi-strategy, long-only, short-only, and fund-of-funds.
Chapters
So what is a hedge fund? Hedge funds are so broad in nature that it's difficult to find a concise definition. So the best way to view them is what they are and what they are not. They are offered privately, in other words, not to the general public. Only qualified investors can invest. Due to the risky and sometimes complex nature of these investment vehicles, they have an incentive fee structure which means the fees are charged on a portion of the returns and most importantly including unrealized returns of the fund. They also typically have a management fee charging the assets under management. They're allowed to short securities, which means they can profit profit on securities that actually lose value. They're allowed to finance or in other words, borrow against the assets under management. So they can invest more than two times and sometimes significantly more than two times the capital contributed by their investors. They are risky. Now, there's some misconceptions about hedge funds also. They're not always hedged. There's no requirement that they be hedged. In fact, long only funds are many times referred to as hedge funds. They're not safe investments. They're not for wealthy individuals only. There are many different types of hedge fund investors that we're going to discuss in a little bit. They are not evil. They have a very important role to play in the stability of our financials markets. For instance, one role of hedge funds is to uncover frauds in the marketplace. Now, the most popular and well known type of investing for hedge fund is shorting a security. And here's how that works. The PM of a hedge fund is a view based on research that the price of a security is going to go down and wants to profit. On that view, the PM borrows that security for a 2% fee from a lender and then sells the security at the current market price for 100 bucks. The PM has the proceeds of the sale in hand. Assuming that the PM was right, at some point she'll want to lock in the profits. At that point the security will be bought back at the lower price of 40 and the security will be returned to the lender. The profit is the initial proceeds of 100 plus the amount it cost to buy back the security 40 and also less the borrow fee of $2 for net profit of $58. Of course, it could also go the other way and the security could go up in price, theoretically to infinity. Then the fund would lose money. Since the increase in any given security price is unlimited, yet the decrease can only go to zero. The profit on the trade is limited, but the loss is unlimited. As such, short selling can be a very risky business if you don't keep your eyes wide open. And even if you do. Now, there are many different types of hedge fund and here are just a few more of the popular ones. There's long short equity hedge funds. These are what people typically think about when they refer to hedge funds. These funds generally buy long the stocks of public companies and hopefully the price goes up and sell short stocks of public companies hoping the price goes down. The short side is generally thought of as the hedge and the hedge fund. If the market goes up, you're going to make money on the long side and if the market goes down, you're going to make money on the short side. The idea is just do a little bit better on both. That's what the term alpha refers to. Julian Robertson used to say that it's a perfect business model. You just have to be right a little bit more than 50% of the time on both sides. With some leverage that's financing or borrowing, you can do really well. Macro funds. Macro funds don't invest in stocks. They invest on a more global basis such as industries, currencies, interest rates, commodities. Think about your macroeconomics courses. They can invest either long or short, but just not in stocks. Event driven funds seek out specific events such as mergers and acquisitions reorgs and look to take advantage of opportunities that present themselves when and if these events occur. Multi strats pursue different strategies in lieu of focusing on a particular investment. The strategies might be in house or allocated to sub managers outside of the firm. Long only funds are just what they sound like. It's a great business because if you have a hedge fund already, there's not much more work to do. You just buy more of your longs and b. Markets generally go up. Of course there's no hedge, so you can get killed in bear markets. Short only funds are a lot more difficult for just the opposite reason. And that's why there aren't many of them. Markets over time tend to go up. People or institutions still invest in them to hedge out the other investments though. Funded funds are basically funds that invest in other funds. The positive is that you can have somebody doing all the due diligence for you to safely go into hedge funds. But the downside is of course, a double layer of fees. Sam.
