Monday, February 18, 2008

What is a hedge fund?

The conversation usually starts like this.
"Hi. I am so and so, nice to meet you Armchair. So Armchair what do you do for a living?"
"I work at a hedge fund."
Blank stare...
Then the question.
"What's a hedge fund?"

I probably give a different five minute answer every time I have to answer the question, so I figured I would put it down in writing so I can give the same consistent answer every time I get the question from now on.

What is a hedge fund?
A hedge fund is typically a limited partnership that is put together with the goal of generating investment returns. These partnerships are very loosely regulated by the government (in certain instances they must register as investment advisers and file 13Fs). They are typically run by a "general partner" who is either an individual or investment team. The general partner makes all the investment decisions, while the "limited partners" contribute their capital to a common pool and share in the gains or losses incurred by the general partner. The limited partners typically pay a fixed management fee of 1-2% of assets annually, plus an incentive fee equal to 20% of any profits that are generated.

For example if a $100 mil fund is up 20% in a year the fund will take a 2% management fee of $2 million and 20% of the $20 mil in return they generated as an incentive fee- in this case $4 million. The investors will be left with $114 mil or a 14% "net of fees" return. Many funds have a high water mark meaning investors do not pay incentive fees again until the fund recoups any losses it incurs. Management and incentive fees can vary widely among different funds.

Hedge funds are generally limited to 100 limited partners and are only available to accredited investors which are defined as individuals with $300k in annual income or $1 million net worth (excluding the value of the individuals home). Hedge funds are not allowed to advertise publicly like mutual funds which helps contribute to their aura of secrecy and mystique. Typical clients of hedge funds include: wealthy individuals, pension funds, endowments, and other hedge funds (often referred to as "funds of funds"). Hedge funds generally employ or are allowed to employ leverage (i.e. borrow money) to enhance their returns.

Hedge funds are also known for their ability to short sell. When a fund shorts a security, it sells a security that is borrowed from their broker right now. The fund hopes to close the position (referred to as covering the short) by buying that same security back at a lower price and giving it back to their broker. The firm captures the difference between the price they sold it at and the price they buy to cover at as a profit. So if a fund shorts 100 shares of CSCO at $30 and buys CSCO to cover at $25 a week later they book a $500 ($5 x 100 shares) profit. Shorting is considered risky because the potential losses can technically be infinite while the potential gains are finite.

The underlying concept of hedge funds (and the reason people invest in them) is that they are supposed to generate good investment returns with much lower volatility than traditional long-only equity funds because they can "hedge" their bets. They are also typically not supposed to be directly correlated with the individual bond or equity markets.

A little like the many ways there are to lose money at a casino (blackjack, poker, roulette, craps, slots, etc.) there are many different strategies that hedge funds employ to generate their returns. I have listed a few of them and a layman's explanation of what they mean below:

  1. Long/Short Equity -- These funds typically make long and short equity bets. They may be net long the market, or net short, or anywhere in between.
  2. Short Equity -- These funds are only short equities.
  3. Market Neutral Equity -- These funds balance long and short positions equally. Returns are generated only by a manager's skill and not by broad market movements.
  4. Merger Arbitrage -- These funds typically try to profit from differences in pricing between acquirers and acquirees.
  5. Convertible Arbitrage -- These funds typically try to profit from discrepancies between the price of a companies equity and its convertible debt. Usually these funds short the equity and own the convertible debt.
  6. Fixed Income Arbitrage-- These strategies try to capture returns by taking advantage of the discrepencies in the pricing of very similar bonds.
  7. Global Macro-- These funds basically try to profit from macro analysis. They use foreign currency, equity, bonds, swaps, etc. to express their macro view and try to profit from it.
  8. Funds of Funds -- These funds own several different hedge funds. They are meant to diversify risk as any one individual fund or strategy might be quite risky. However, investors pay dearly for the diversification as they are often charged a double incentive fee structure (i.e. they pay incentive fees on the individual funds and the fund of funds).

Famous Funds

Quantum Fund -- Probably the most famous of them all, this was George Soros's global macro hedge fund. He put hedge funds on the map when he "broke the Bank of England."

Tiger -- Run by Julian Robertson and spawned a bunch of other famous funds including Maverick and Lone Pine.

Citadel -- Started by Ken Griffin shortly after his stint as a hedge fund manager in is Harvard dorm-room. The first major multi-strategy hedge fund.

Renaissance -- King of the Quants. Fund founded by James Simons. Known for stellar returns and eye-popping fees (5% management fee, 44% incentive fee).

Centaurus Energy -- Run by former Enron energy trader John Arnold (age 33). Took the other side of the Amaranth trade and landed on the Forbes 400.

Infamous Funds

Long-Term Capital -- Fund blew up in 1998 (lost $4.6 billion) and had so much leverage the Federal Reserve had to negotiate the bail-out with the counterparties.

Amaranth -- Energy fund that had an epic implosion in September 2006. Rumored to be down 65% on their $9 billion fund.

Sowood -- Fund that blew up $1.5 billion in July 2007; Cidatel bought their positions for pennies on the dollar.

Other Reading

New York Magazine has a great if somewhat dramatized series of articles all about hedge funds and the personalities in the business.
Barton Biggs's Hedge Hogging is a great read about hedge funds and the personalities that run them.
Steven Drobny's Inside the House of Money is a good read about some famous hedge fund managers and their strategies.

1 comment:

Anonymous said...

Great post!