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What is a Hedge Fund: Part 2

This article further expands on the information discussed in What is a Hedge Fund Part 1 by examining various forms of classification for hedge funds as well as common hedge fund compensation schemes.

Hedge Funds Come In A Variety Of Different Flavours

There is an almost infinite variety of hedge fund types available to suitable investors. One common way to classify hedge funds is by strategy. Key differences between strategies include the level of systematic risk they assume; the asset classes in which they invest; their investment process; their leverage and their liquidity profile. Investors invest in hedge funds in order to create an intelligent exposure to a particular risk factor (or set of risk factors).

The following taxonomy is a general, non-comprehensive list of strategies seeking to distinguish fund types along these five dimensions. Naturally, individual funds may differ.

  • Long/Short funds exploit relative valuation differences within a single asset class
    • Systematic Risk: may be net long or net short
    • Systematic Risk: may be net long or net short
    • Asset Classes: equities or credit
    • Investment Process: fundamental, confined to one layer of the capital structure
    • Leverage: low
    • Liquidity: very liquid (potentially less liquid for long/short credit)
  • Market-neutral funds are a subset of long/short funds
    • Systematic Risk: in a tight tolerance band around net zero
    • Asset Classes: equities
    • Investment Process: fundamental, confined to the common equity
    • Leverage: low
    • Liquidity: very liquid (potentially less liquid for long/short credit)
    • Event-driven funds exploit pricing anomalies created by events, typically corporate events such as merger and acquisition activity, bankruptcy, financial distress, corporate reorganizations, corporate buybacks and investor activism, though this definition may be expanded more broadly to include any type of event, including sector-specific or macro investment themes
    • Systematic Risk: may be net long or net short
    • Asset Classes: equities and/or credit
    • Investment Process: fundamental
    • Leverage: medium
    • Liquidity: liquid
  • Capital Structure Arbitrage funds are also a type of long/short fund
    • Systematic Risk: may be net long or net short
    • Asset Classes: equities and credit
    • Investment Process: fundamental, across different layers of the capital structure
    • Leverage: medium
    • Liquidity: liquid, though may be less liquid than long/short equity
  • Convertible Arbitrage funds exploit pricing anomalies between convertible bonds and the underlying equity
    • Systematic Risk: may be net long or net short
    • Asset Classes: equities and credit
    • Investment Process: fundamental analysis combined with derivatives analysis
    • Leverage: medium
    • Liquidity: medium liquidity, depending on credit mix
  • Quantitative funds use systematic trading strategies to monetize market volatility
    • Systematic Risk: may be net long or net short (but typically very little)
    • Asset Classes: equities, credit, foreign exchange and/or commodities
    • Investment Process: quantitative
    • Leverage: high
    • Liquidity: very liquid
  • Relative Value funds exploit relative valuation differences within fixed income
    • Systematic Risk: may be net long or net short
    • Asset Classes: fixed income
    • Investment Process: anywhere along a spectrum from fundamental to quantitative
    • Leverage: high
    • Liquidity: mixed, depending on the individual positions
  • Structured Credit funds invest in products the complex design of which may obscure long-term value
    • Systematic Risk: may be net long or net short
    • Asset Classes: fixed income
    • Investment Process: anywhere along a spectrum from fundamental to quantitative
    • Leverage: high
    • Liquidity: mixed to poor
  • Commodities Trading Advisors trade commodities actively, principally using futures contracts
    • Systematic Risk: may be net long or net short
    • Asset Classes: futures (including commodities, equity, fixed income, foreign exchange)
    • Investment Process: principally quantitative, with some fundamental analysis
    • Leverage: very high Liquidity: liquid
  • Macro funds exploit mispricings in global macro markets, typically with a trend-following approach
    • Systematic Risk: may be net long or net short
    • Asset Classes: futures, over-the-counter derivatives
    • Investment Process: principally quantitative, with some fundamental analysis
    • Leverage: high to very high
    • Liquidity: liquid

Hedge Funds Have Different Compensation Schemes

Unlike traditional mutual funds which only charge a fee for managing the assets under management, a hedge fund typically charges both a management fee and an incentive fee (also known as a performance fee).

The benchmark management fee is 2% of the net asset value of assets under management, measured at a particular period of time. This may be roughly comparable to some of the more actively managed mutual funds available to investors. In practice, the 2% management fee has been whittled down by competition to anywhere from 1% to 2%.

The incentive fee is charged as a percentage of the profits of the fund less fund expenses and the management fee. Pre-2008, the typical starting point for a management fee was 20% of this amount. Now, it ranges from 10% to 20%.

The purpose of the management fee is to defray the ongoing expenses of the manager, other than those expenses that are specified as responsibilities of the fund itself. Fund expenses often include items such as Bloomberg terminals, Capital IQ subscriptions, trips to research conferences and the fees due to outsourced service providers. Expenses that are incurred by the management company are those pertaining to the ongoing operations of the manager’s business, including compensation, benefits and office rent.

The rationale and the importance of the incentive fee come from the competitive market for investment professionals. To the extent that proprietary trading desks at banks were willing to pay a percentage of the desk profits to the employee teams, hedge funds needed to compete by offering similar compensation structures. Now, with the advent of regulation designed to control the taking of proprietary risk by federally insured financial institutions, the incentive fee is driven by the need to attract talent in competition with other hedge funds.

Restrictions on when the manager can withdraw his incentive fee often mean practically that the manager re-invests much, if not all, of her incentive fee into the fund, increasing the alignment of her general partnership interests with those of the investor limited partners.

Hedge Funds Provide An Alternative To Conventional Investments For Suitable Investors
Hedge funds enable sophisticated investors who meet certain tests of suitability to obtain different exposures to market risk factors, managed by some of the most gifted and experienced investment talent in the world.

-Article by Chand Sooran, Point Frederick Capital Management, LLC. Disclaimer

3 years ago

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