How Does A Hedge Fund Work?

How Does A Hedge Fund Work – Investment Vehicles with a Twist”.  This Hedge Fund definition here is perfect. They are amazingly complicated!

Hedge funds are always in limelight due to innovative structures and hedge fund strategies and they constantly challenge the traditional investments channels.

In this article, we learn about how hedge funds work and their structure in depth.

What is a Hedge Fund?

A hedge fund is an alternative Private investment vehicle which utilizes pooled funds using Diverse and Aggressive Strategies in order to earn Active and Large returns for their investors.

  • The concept is pretty similar to a Mutual fund however, hedge funds are comparatively less regulated, can make use of wide and aggressive strategies and aim for large returns on the Capital.
  • Hedge funds serve a small number of very large investors. These investors are normally very wealthy and tend to have a very large appetite to absorb the loss on entire capital. Most of the hedge funds also hold criteria to allow only investors ready to invest a minimum of $10 million of Investment.
  • The fund is managed by a Hedge Fund Manager who is responsible for the investment decisions and operations of the fund. The unique feature is that this manager must be one of the large investors in the fund which will make them cautious while making relevant investment decisions.
  • Funds with regulatory Assets Under Management (AUM) in excess of $100 million are required to be registered with the U.S. Securities and Exchange Commission. Furthermore, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934.

Top Hedge Funds 

Some of the Top Hedge funds are given below with their Assets Under Management (Q1’16):top-hedge-funds-aum


Benefits of a Hedge Fund

Downside Protection

  • Hedge funds seek to protect the Profits and the Capital amount from declining markets by using various hedging strategies.
  • They can take advantage of falling market prices: By using techniques such as ‘Short selling’ whereby they shall sell the securities with a promise to buy them back at a later date
  • Make use of trading strategies which are suitable for given type of market situation
  • Reap the benefits of wider asset diversification and asset allocations.
  • Hence, for e.g. if a portfolio has shares of Pharmaceutical companies and of the Automobile sector and if the government offers some benefits to the Pharmaceutical sector but poses additional charge on the automobile sector, then in such cases the benefits can outshine the possible declines in the automobile sector.

Performance Consistency

  • Generally, Managers do not have any restrictions in their choice of investment strategies and possess the ability to invest in any asset class or instrument.
  • The role of the fund manager is to maximize the capital as much as possible and not beat a particular level of benchmark and be content.
  • Their individual funds are also involved which should act as a booster in this case.

Low Correlation:

  • The ability to make profits in volatile market conditions equips them to generate returns that have little correlation to traditional investments.
  • Hence, it is not essential that if the market is going in a downward direction the portfolio would be making a loss and vice versa.

Management Fee & Performance Fee of Hedge Funds

These fees are compensation given to hedge fund managers for management of the funds and is popularly referred as “Two and Twenty” rule. The ‘two’ component refers to charging a flat 2% Management fees on the total asset value. This Management fees is paid to the fund manager irrespective of the funds’ performance and is required for the operational/regular functioning of the fund. For e.g. a manager with $1 billion of Assets under Management earns $20 million as Management fees. If the performance of the fund is not satisfactory this can drop to 1.5% or 1.75%.

The 20% Performance fee is paid once the fund reaches a certain level of performance generating positive returns. This fee is generally calculated as a Percentage of Investment profits often both realized and unrealized.

Say an investor subscribes for shares worth $10 million in a hedge fund and let’s assume that over the next year the NAV (Net Asset Value) of the fund increases by 10% taking the investors shares to $11 million. In this increase of $1million a 20% Performance fee ($20,000) will be paid to the Investment fund manager, thereby reducing the NAV of the fund by that amount, leaving the investor with shares worth $10.8 million giving a return of 8% before any further deduction of expenses.

Structure of Hedge Fund

Master – Feeder

The structure of a hedge fund shows the way it operates. The most popular structure is a Master-Feeder one which is commonly used to accumulate funds raised from both US taxable, US Tax-exempt (Gratuity funds, Pension funds) and Non – US investors into one central vehicle. This can be shown with the help of a diagram:


  • The most common form of a master feeder structure involves One Master Fund with One onshore feeder and One Offshore feeder (Similar to diagram above).
  • The investor begins with the investor feeding capital into the feeder funds which in turn invests in the master fund similar to purchase of a security since it will purchase the “shares” of the master fund which in turn conducts all the trading activities.
  • This master company is generally incorporated in a tax neutral offshore jurisdiction such as the Cayman Islands or Bermuda. Through the investments in the master fund, the feeder funds participate in the profits on a pro rata basis depending on the proportionate investment made.
  • For instance, if Feeder fund A’s contribution is $500 and Feeder Fund B’s contribution is $1,000 towards the total master fund investment then fund A would receive one third of the master fund profits, while fund B would receive two thirds.
  • U.S. taxable investors take advantage of making investments in a US Limited partnership feeder fund, which through certain elections made at the time of incorporation is tax effective for such investors.
  • Non U.S. and U.S. tax exempt investors subscribe via a separate offshore feeder company so as to avoid coming directly within the U.S. tax regulatory net applicable to the U.S tax investors. Management Fee and Performance Fee are charged at the level of the Feeder funds.
Features of Master Feeder Fund structure are given below:
  • It involves consolidation of various portfolios into one giving advantage of diversification and standing larger chances of gaining even in volatile market conditions.
  • Consolidation generally leads to lower Operational and Transactions cost. For e.g. only a single set of risk management reports and analysis needs to be undertaken at the master level.
  • A large portfolio will have economies of scale and would also possess more favorable terms offered by Prime Brokers and other institutions.
  • Such structures can be extremely flexible. It can be employed equally for a single strategy fund (for e.g. a fund will only consider earning by making investments in Equities) as well as umbrella structures employing multiple investment strategies (a fund which will aggressively investment in Swaps, Derivatives or even Private placements)
  • Flexibility is also maximized at the investor level since multiple feeder arrangements can be introduced into the master fund catering for different classes of investors, which adopt different currency, subscription and fee structures.
  • The primary drawback of this structure is that funds held offshore are typically subject to with- holding tax on U.S. Dividends. With-holding tax is the tax imposed on interest or dividends from securities owned by a Non-resident or any other income paid to nonresidents of a country. The withholding tax varies from one country to another. in US it is imposed at a rate of 30% or lesser depending on treaties with other countries, whereas in Canada it is imposed at a flat rate of 25%.

Standalone Fund

Such a fund is an individual structure in itself and is set up for investors with a common approach. The structure can be shown with the help of a diagram:


  • As the name suggests, this is an individual fund set up catering to the needs of an individual category of customers.
  • For their own tax purposes, Non- US and Tax exempt investors may want to invest in a structure which is “Opaque” and on the other hand US taxable investors may have a preference for a “transparent” structure for US Income tax purposes, typically limited partnership.
  • Hence, such structures will either be set up individually, or in Parallel depending on the skills of the hedge fund manager.
  • The benefits or drawbacks of the funds are borne by all the investors and not spread out in this case.
  • The accounting methodology is also simple in this case since all the accounting will be done at the standalone level itself.

Fund of Funds

A fund of funds (F-O-F) also known as Multi-manager investment is an investment strategy in which an individual fund invests in other types of hedge funds.

  • It aims to achieve appropriate asset allocation and broad diversification with investments in a wide variety of fund categories wrapped into a single fund.
  • Such characteristics attract small investors who want to get better exposure with fewer risks compared to directly investing in securities.
  • Investments in such funds give the investor Professional Financial Management services.
  • Most of these funds require formal due diligence procedure for their fund managers. Applying mangers’ background are checked which in turn ensures the portfolio handler’s background and credentials in the securities industry.
  • Such funds offer the investors a testing ground in professionally managed funds before they take on the challenge of going for Individual fund investing.
  • The drawback of this structure is that it carries an operating expense which indicates that investors are paying double for an expense which is already included in the fees of the underlying funds.

Though Fund of Funds provide diversification and less exposure in market volatility in exchange for average returns, such returns may get impacted by investment fees which are typically higher in comparison to traditional investment funds.

After allocation of the money towards the fees and tax payments, the returns on fund of funds investments may generally be lower as compared to the profits that a single fund manager can provide.

Side Pockets

A side-pocket fund is a mechanism within a hedge fund whereby certain assets are compartmentalized from all the regular assets of the fund which are relatively illiquid or difficult to value directly.

  • When an investment is considered to be included for side pocket, its value is computed in isolation as compared to the main portfolio of the fund.
  • Since side-pockets are used to hold illiquid or less liquid investments, investors do not possess regular rights of redeeming them and this can only be done in certain unforeseen circumstances with the consent of the investors to whom the side pocket is applicable.
  • Profits or Losses from the investment are allocated on a pro-rata basis only to those investors at the time this side pocket was established and not to the new investors who have participated in the funds post these side pockets were included.
  • Funds typically carry side pocket assets “at cost” (purchase price or standard valuation) for purpose of calculating management fees and reporting the NAV. This will allow the fund manager to avoid attempting vague valuations of these underlying instruments as the value of these securities may not necessarily be available. In most of the cases such side-pockets are private placements.
  • Such side – pockets can be useful the time of redemption of when immediate liquidity is required.

Subscriptions, Redemptions & Lock-ups in Hedge Funds

Subscriptions refer to the entry of Capital into the fund by the Investors and Redemptions refers to the Exit of capital from the fund by the investors. Hedge funds do not have daily liquidity since the minimum requirement of investment is relatively large and hence such subscriptions and redemptions can either be monthly or quarterly. The term of the fund has to be consistent with the strategy adopted by the fund manager. More the liquidity of the underlying investments, more frequent the subscription/redemption shall be. The number of days shall also be specified which ranges from 15 to 180 days.

“Lock Up” is an arrangement whereby a time commitment is stated within which the investor cannot remove his capital. Some funds require up to a two-year lock in commitment but the most common lock up is one applicable for one year. In certain cases, this could be a “hard lock” preventing the investor from withdrawing the funds for the full time period while in other cases the investor can redeem his funds upon payment of a Penalty which can range from 2%-10%.

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