To "hedge", according to Webster's dictionary, is "a means of protection or defense (as against financial loss), or to minimize the risk of a bet." The term "hedge fund" includes a multitude of skill-based investment strategies with a broad range of risk and return objectives. A common element is the use of investment and risk management skills to seek positive returns regardless of market direction.
A hedge fund is a private "pool" of capital for accredited investors only and organized using the limited partnership legal structure. The general partner is usually the money manager and is likely to have a very high percentage of his/her own net worth invested in the fund.
The fund has an offering memorandum, which is intended to provide much of the necessary information to support an investor's due diligence. Among several topics, the offering memorandum will specify the trading style, hedging strategies, and instruments to be employed by the fund at the discretion of the general partner (e.g., being long and /or short stock; use of puts, calls, and futures; use of OTC derivatives).
Hedge funds utilize alternative investment strategies for the purpose of achieving superior returns relative to risk (i.e., return vs. standard deviation). Performance objectives range from conservative to aggressive. The degree of hedging varies. In fact, some do not hedge at all while others simply use S&P put options and futures in lieu of shorting equities. Consequently, there is a broad spectrum of expected risk and return within the hedge fund universe.
Hedge Fund Strategies
Hedge funds can be classified in a variety of ways. Here is one way of classification (by investment strategy):
In terms of performance, hedge funds are generally viewed as having:
However, the performance data from hedge fund databases and indices suffer from serious biases such as self-selection bias, instant history bias and survivorship bias.
Hedge Fund Fees and Other Considerations
Hedge funds almost always have a fee structure that includes both a fixed fee and a management fee. The most common fee structure is "2 and 20", meaning 2% management fee and 20% incentive fee.
A fund of funds invests in a portfolio of hedge funds to provide access, diversification, risk management and due diligence benefits to investors. Such funds of funds generally charge a fee for their services. Recently funds of funds have been criticized for the significant incremental costs they impose.
Although some hedge funds don't use leverage at all, most of them do. Leverage in hedge funds often runs from 2:1 to 10:1, depending on the type of assets held and strategies used. High leverage is often part of the trading strategy and is an essential part of some strategies in which the arbitrage return is so small that leverage is needed to amplify the profit. As in any other investments, however, leverage also amplifies losses when the market direction turns out to be unfavorable.
Investor redemptions can also magnify losses for hedge funds.
Hedge Fund Valuation Issues
Questions to ask:
Generally, due diligence refers to the care a reasonable person should take before entering in an agreement or transaction with another party. The due diligence that has to be performed by an institutional investor when selecting a hedge fund is highly specialized and time consuming, given the secretive nature of hedge funds and their complex investment strategies.
The key factors to consider include investment strategy, investment process, competitive advantage, track record, size and longevity, management style, key-person risk, reputation, investor relations, plans for growth, and systems risk management.