How Does a Hedge Fund Work?

How do Hedge Fund Functions?

Hedge Fund Work is the process followed by a hedge fund in order to protect themselves against the movements of stocks or securities in the market and to make a profit on a very small working capital without risking the entire budget.

The hedge fund manager pools money from various investors and institutional investors and invests it in the aggressive portfolio, which is managed through such techniques that help to achieve the goal of the specified return which regardless of the change in the money market or fluctuations in share price that saves from any loss of investments.

hedge-fund-structure

What is a Hedge Fund?

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

  • The concept is pretty similar to a Mutual fund; however, hedge funds are comparatively less regulated, can make use of broad and aggressive strategies, and aim for large returns on the capital.
  • Hedge funds serve a small number of huge investors. These investors usually are very wealthy and tend to have a considerable appetite to absorb the loss on the entire capital. Most 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), over $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.

Useful Links on Hedge Funds

Top Hedge Funds 

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

source: Octafinance.com

Benefits of a Hedge Fund

Downside Protection

  • Hedge funds seek to protect the Profits and the Capital amount from declining hedging strategies.
  • They can take advantage of falling market prices: By ‘Short selling,’ whereby they shall sell the securities with a promise to repurchase them at a later date.
  • Make use of trading strategies that are suitable for the given type of market situation.
  • Reap the benefits of broader asset diversification and asset allocations.
  • Hence, e.g., if a portfolio has shares of Pharmaceutical companies and the Automobile sector and if the government offers some benefits to the Pharmaceutical industry 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 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 with 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 to manage the funds and are popularly referred to as the “Two and Twenty” rule. The ‘two’ component refers to charging a flat 2% management fee on the total assetTotal AssetTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more value. Management fees are paid to the fund manager irrespective of the funds’ performance and are required for the operational/regular functioning of the fund. 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 the Hedge Fund

Master – Feeder

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

how-does-hedge-fund-work

  • The most common form of a master-feeder structure involves One Master Fund with One onshore feeder and One Offshore feeder (Similar to the chart above).
  • The investor begins with the investor feeding capital into the feeder funds, which invests in the master fund similar to the purchase of 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, 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 U.S. 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 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 the Master Feeder Fund structure are given below:
  • It involves the consolidation of various portfolios into one, giving an advantage of diversification and standing larger chances of gaining even in volatile market conditions.
  • Consolidation generally leads to lower Operational and Transaction costs. E.g., only a single set of risk management reports and analyses must be undertaken at the master level.
  • A broad portfolio will have economies of scale and possess more favorable terms offered by Prime BrokersPrime BrokersPrime brokerage is the bunch of services offered by the financial institutions, especially the investment banks, to the hedge fund clients or other similar investors. These services include cash management, custodian services, lending securities, leveraged trade execution, etc.read more and other institutions.
  • Such structures can be extremely flexible. It can be employed equally for a single strategy fund (e.g., a fund will only consider earning by making investments in Equities) as well as umbrella structures using multiple investment strategies (a fund which will impact investment in Swaps aggressively, 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 to different classes of investors, which adopt other currency, subscription, and fee structures.
  • The primary drawback of this structure is that funds held offshore are typically subject to withholding tax on U.S. Dividends. Withholding tax is the tax imposed on interest or dividends from securities owned by a Nonresident or any other income paid to nonresidents of a country. The withholding tax in the U.S. is charged 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 and is set up for investors with a common approach. The structure can be shown with the help of a diagram:

hedge-fund-structure

  • As the name suggests, this is an individual fund set up catering to the needs of a particular category of customers.
  • For their tax purposes, Non- U.S. and Tax-exempt investors may want to invest in a structure which is “Opaque.” On the other hand, U.S. taxable investors may prefer a “transparent” system for the U.S. 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 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 various fund categories wrapped into a single fund.
  • Such characteristics attract small investors who want to get better exposure with fewer risks than directly investing in securities.
  • Investments in such funds give the investor Professional Financial Management services.
  • Most of these funds require formal due diligence procedures for their fund managers. Applying managers’ background is checked, which ensures the portfolio handler’s experience 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 a cost already included in the fees of the underlying funds.

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

After allocation of the money towards the fees and tax payments, the returns on the 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 pockets, 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 when this side pocket was established and not to the new investors. They have participated in the fund’s post. These side pockets were included.
  • Funds typically carry side pocket assets “at cost” (purchase price or standard valuation) to calculate management fees and report 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 at the time of redemption 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 refer 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. The more the liquidity of the underlying investments, the 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 application for one year. In some instances, 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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Comments

  1. AvatarPaul Barton says

    Well explained and I have to say this is a perfect guide on how hedge fund really works. Thanks. Can you tell me some common points between Hedge Funds and Mutual Funds? Are there any differences?

    • Dheeraj VaidyaDheeraj Vaidya says

      Hi Paul, thanks! Both mutual fund and Hedge fund are managed by portfolio managers. Hedge fund managers can take the bigger risk by aggressively investing in derivatives and take leveraged positions. However, Mutual funds are governed my set mandate and are not allowed to take higher risks/leveraged positions.

  2. AvatarIvan Stephens says

    Thank you so much for providing the depth knowledge about Hedge Funds. Very easily explained. Can you list me some important skills to become Hedge Fund Analyst?

    • Dheeraj VaidyaDheeraj Vaidya says

      My pleasure Ivan! There are also some mandatory skills of hedge fund analyst –
      1. Deep knowledge of Finance and financial instruments
      2. Strong Quantitative Background
      3. Fundamental understanding of Risk
      4. Ability to cope with stressful situations
      5. CFA, CAIA, or CHA will be helpful too.

      Hope this works for you.

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