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Hedge Fund Strategies

Step-by-Step Guide to Understanding Hedge Fund Strategies

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What is Hedge Fund?

A Hedge Fund is a pooled investment vehicle that uses specialized hedging strategies across various asset classes to generate positive returns uncorrelated with the broader market.

Hedge funds, stated in simple terms, are actively managed investment vehicles that specialize in various strategies and hedging techniques across a broad range of asset classes to generate strong, risk-adjusted returns on behalf of their investor base, or limited partners (LPs).

Hedge Fund Strategies

  • A hedge fund is an actively managed investment vehicle that raises capital from accredited investors to allocate the funds into a wide array of alternative securities.
  • Hedge funds rely on riskier strategies and techniques to construct a beta neutral portfolio, where returns are uncorrected with the broader market and unaffected by price fluctuations.
  • The main function of a hedge fund is to generate positive returns consistently on behalf of its limited partners (LPs), irrespective of the prevailing market conditions.
  • A hedge fund is expected to periodically deliver outsized returns, but with measures in place to reduce market risk and volatility via hedging techniques and portfolio diversification.
  • The different types of hedge fund investment strategies include long-short equity (L/S), relative value arbitrage, event-driven, multi-strategy, short-only, and activist investing.
  • The traditional fee structure inherent to the hedge fund industry is termed the “2 and 20” model, which entails a 2% management fee coupled with a 20% performance fee.

How Does a Hedge Fund Work?

Originally, the formation of the hedge fund industry came to fruition from the objective of hedging the portfolio risk stemming from long positions.

Offsetting long positions with short positions can reduce portfolio risk and lead to stable, risk-adjusted returns, which reflects the classic “long-short equity” strategy still employed as of the present date.

Hedge funds are investment vehicles designed to generate stable, non-volatile returns, independent of prevailing market conditions.

The strategic portfolio construction of a hedge fund is intended to reduce the correlation between the returns of the fund and pricing fluctuations in the broader market, with the underlying aim to achieve a zero-beta portfolio.

The priority of hedge fund managers is the consistent generation of risk-adjusted returns on their portfolio uncorrelated with the broader market, albeit certain firms have deviated far from the industry’s origins.

The modern hedge fund business model, however, nowadays operates as firms with far more discretion and optionality in terms of the types of investment strategies utilized, including the asset classes to which to allocate capital.

Why? The consistent generation of alpha in public equities investing has become increasingly difficult, as the information asymmetry between institutional investors and retail investors continues to wane, and there are substantially more investment managers and participants in the public markets compared to the 1980s.

What are Hedge Funds?

“What are Hedge Funds?” (Source: SEC.gov )

What are the Origins of the Hedge Fund Industry?

Hedge funds are a form of active management, where various investment strategies are utilized to generate positive risk-adjusted returns uncorrelated with the broader market.

Formerly, most hedge funds strived to profit regardless of the market direction – i.e. in a bull market or bear market – with their priority on minimizing correlation to the public markets, rather than out-performance of the market overall.

The origins of the hedge fund industry are rooted in market neutrality, but many funds nowadays attempt to outperform the market (i.e. “beat the market”), or at least are pressured to do so.

The objective of the hedge fund business model remains the generation of long-term positive returns driven by alpha, rather than market beta .

  • Alpha (α) → The term “alpha” in finance refers to the excess returns generated by a portfolio of investments relative to the benchmark return, which is most often the S&P 500. If a fund strategy achieved positive alpha over a specified period, then the manager effectively “beat the market” given the abnormal returns compared to the broader market.
  • Beta ( β) → By definition, the beta of the broader market is 1.0, so a beta >1.0 implies greater volatility risk, and vice versa for a beta <1. While there is much criticism of the validity of beta as a risk measure, the historical price movement is still widely used to estimate the risk profile of securities, which directly influences the return expected by investors.

However, the modern hedge fund industry has gradually developed into encompassing a vast assortment of investment strategies.

Because of that structural shift in the industry, hedge fund managers nowadays seek to profit from more speculative, riskier strategies, such as using leverage to amplify returns, i.e. borrowed funds.

Nevertheless, most hedge funds still have measures in place for portfolio diversification and risk mitigation (e.g. avoidance of over-concentration in a single investment), but there has certainly been a widespread shift towards becoming more returns-oriented.

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What is the Structure of a Hedge Fund?

The general partner (GP) and the team of investment professionals regularly track fund performance and adjust the portfolio accordingly, on behalf of the fund’s limited partners (LPs).

Investment decisions are grounded in detailed analysis, research, and forecast models, which all contribute to formulating a more logical judgment on whether to buy, sell, or hold an asset.

Furthermore, hedge funds are often open-ended, pooled vehicles structured in the form of either:

  • Limited Partnership (LP)
  • Limited Liability Company (LLC)

What are the Top 10 Hedge Funds?

The following chart ranks the top ten largest hedge funds in terms of assets under management (AUM) .

Largest Hedge Funds in 2022 (Source: Pensions & Investments )

Largest Hedge Funds List Ranked by AUM (2024)

Interested in accessing our comprehensive database of 400 hedge funds and investment firms in the public equities market?

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What is the criteria to invest in a hedge fund.

For an individual to qualify as a limited partner at a hedge fund, one of the listed criteria must be met:

  • Personal Income of $200,000+ Per Year
  • Combined Income with Spouse of $300,000+ Per Year
  • Personal Net Worth of $1+ Million

Documented proof that the current income level can be maintained for at least two more years must also be supplied.

The investors, or limited partners (LPs), of hedge funds are generally individual and institutional investors seeking to diversify their portfolios, while still retaining the potential to earn outsized returns.

  • Institutional Investors → The institutional investor categorization refers to organizations with substantial amounts of capital to allocate across different asset classes. Common examples include pension funds, university endowments, insurance companies, sovereign wealth funds, and certain firms in the banking sector.
  • High Net-Worth Individuals → High net-worth individuals are non-institutional, individual investors with significant personal wealth. In the U.S., the criteria to qualify as an “accredited investor”, one must have a net worth that exceeds $1 million, excluding the value of their primary residence, or have an income of $200,000+ each year for the past two years (or $300,000 combined income if married).
  • Family Offices → Family offices are essentially private wealth management firms that serve ultra-high-net-worth investors. Unlike traditional wealth management firms, in which the offers are available to any qualified investor, financial and investment management specifically serves an affluent individual (or family), as implied by the name.
  • Funds of Funds (FOF) → The fund of funds investment structure invests in other types of funds, including hedge funds. The FOF strategy is oriented around allocating capital across different funds, rather than selecting the equity or debt investments themselves.

The decision to invest in a hedge fund carries substantial risk, and the illiquid nature of the investment, as well as the higher fee structure (“2 and 20”), are drawbacks compared to mutual funds and ETFs.

The higher barrier for investors to qualify to invest in hedge funds is to limit access to more sophisticated investors.

Why? The investors that meet the criteria to become an investor at a hedge fund are assumed to understand the risks presented by the return strategies and tactics, with a higher tolerance for risk.

Learn More → Hedge Funds SEC Investor Bulletin (Source: SEC.gov)

What is the Fee Structure of Hedge Funds?

So, how do hedge funds make money?

Historically, the standard fee structure in the hedge fund industry was the classic “2 and 20” arrangement.

  • 2% Management Fee → The 2% management fee is typically charged based on the net asset value (NAV) of each LP’s investment contribution, and is used to cover the costs of operating the hedge fund (and employee compensation).
  • 20% Performance Fee → The 20% performance fee (or “carried interest”) is an incentive for hedge fund managers to achieve strong returns, i.e. “beat the market”.

Once the GP has caught up and earned the 20% carry, all fund profits are split 20% to the GP and 80% to the LP.

Following years of underperformance since the 2008 recession, however, the fees charged in the hedge fund industry have declined.

Over the past decade, there has been a notable marginal decline in management fees and performance fees across the industry, particularly for the larger-sized, more institutionalized hedge funds:

  • Management Fee → 2.0% to 1.5%
  • Performance Fee → 20.0% to 15.0%

To ensure no preemptive performance fees are obtained, the limited partners (LPs) of a hedge fund can negotiate certain provisions:

  • Claw-Back Provision → The LP can retrieve fees previously paid for the original percentage agreement to be met, which implies losses were incurred by the fund in subsequent periods.
  • Hurdle Rate → A minimum rate of return can be established, which must be surpassed before any performance fees can be collected. Sometimes, once the threshold is met, there is a “catch-up” clause for the GPs to receive 100% of the distributions once the agreed-upon split is met.
  • High-Water Mark → The highest peak the value of the fund reached – in such a provision, only capital gains in excess of the high-water mark are subject to the performance-based fee.

What are the Different Types of Hedge Fund Strategies?

Before delving in, the following list outlines the most common hedge fund investment strategies.

  • Long-Short Equity Strategy (L/S)
  • Market Neutral Strategy, i.e. Equity Market Neutral (EMN)
  • Short-Selling Strategy (Short-Only Funds)
  • Event-Driven Investing Strategy (Special Situations)
  • Relative Value Strategy (Arbitrage Fund)
  • Activist Investor Strategy (Shareholder Activism Funds)
  • Global Macro Strategy
  • Quantitive Funds (Systematic Trading)
  • Distressed Debt Investing Strategy
  • Multi-Strategy Funds (Multi-Strat)
  • Credit Fund Strategy (Fixed Income)

1. Long-Short Equity Strategy (L/S)

Alfred Winslow Jones is often cited as the pioneer of the long-short fund strategy in the mid-1940s.

The market-neutral portfolio of Jones distinguished between two different types of risk:

  • Market Risk (Non-Diversifiable)
  • Company-Specific Risk (Diversifiable)

Based upon the understanding of systematic vs. unsystematic risk , the long-short equity strategy (L/S) was derived, wherein an investor strives to profit from the upside and downside movements in stock prices.

Therefore, the long/short fund strategy is taking “long” positions on equities perceived as underpriced, while hedging the downside risk via “shorting” stocks deemed overpriced.

In effect, the long-short strategy is designed to accurately predict upward price movement on its long positions, while limiting potential losses on its short positions, i.e. the short-selling component can partially offset the losses (or in entirety).

  • Long Positions → Undervalued Stocks (i.e. Intrinsic Value > Market Price)
  • Short Positions → Overvalued Stocks (i.e. Intrinsic Value < Market Price)

Unlike long-only portfolios that can incur steep losses from market volatility, long/short hedge funds often profit from sudden dislocations in the financial markets, i.e. the hedging strategies offset their long positions.

Generally, most long/short equity funds hold a “long” market bias, so the long positions constitute a greater proportion of their total portfolio.

Learn More → Long-Short Equity (L/S)

2. Market-Neutral Strategy (EMN Fund)

The market-neutral strategy seeks to exploit market mispricings of securities by pairing long and short positions in securities in the same or adjacent industry.

Simply put, the market-neutral fund strategy tries to exploit and profit from temporary dislocations in share prices by taking both long and short positions in equivalent amounts in closely related stocks with similar characteristics (e.g. industry, sector).

Put together, the paired long and short positions balance the portfolio’s long positions with their short positions, with the core objective of achieving a net portfolio exposure of zero, i.e. a portfolio beta of zero.

In theory, the market-neutral fund strategy should exhibit returns with minimal correlation to the broad asset classes (e.g. equity, bond, credit).

That said, the returns on a market-neutral fund are structured to be independent of movements of the broader market, with less volatility risk.

However, the trade-off here is that the reduction in market sensitivity causes the upside potential in returns to also decline, even more so than long-short funds (L/S).

The objective of a market-neutral fund is to achieve a portfolio beta as close to zero as possible by pairing long and short trades to mitigate market risk.

The expected portfolio return of a market-neutral fund is the sum of the risk-free rate and the alpha generated by the fund’s portfolio.

Learn More → Market Neutral Fund Strategy

3. Short-Selling Strategy (Short-Only Fund)

Short-selling funds are specialists in the art of short selling, which is called “short-only”, or net short – i.e. the short positions outweigh long positions in the portfolio.

Short selling is not just intended to reduce risk and capital losses amid periods of declines in market prices but also to capitalize on and profit from such scenarios.

The short positions are intended to produce alpha, rather than serve as a portfolio hedge.

Kynikos Short Fund Business Model “Kynikos has sometimes been called a “hedge fund,” but it is not a hedge fund following the classic model first established by A.W.Jones & Co. We operate a short fund. With the proliferation of private investment funds, however, the term “hedge fund” is now used so broadly in some quarters to refer to any private investment fund that I do not believe that it accurately describes Kynikos’ business model accurately.” – Jim Chanos, Kynikos Associates

For that reason, short specialists tend to make fewer investments and are willing to hold onto capital for longer periods to capitalize on opportunities such as fraudulent behavior related to accounting fraud, malfeasance, and more.

Enron Short Selling Example

The collapse of Enron Corporation was a major financial scandal that unfolded in the early 2000s and has become a symbol of corporate fraud and the necessity of independent auditors.

Enron, one of the top energy companies in the U.S. at that time, engaged in fraudulent behavior where management identified loopholes in the system and used special purpose entities to conceal their debt burden while inflating their reported profits.

The scheme, once uncovered, led to the bankruptcy of Enron, the criminal indictment of former Enron executives – most notably, Jeffrey Skilling – and the conviction of former “Big 5” accounting firm Arthur Andersen for their complicity in the fraud.

The conviction of Andersen was later reversed by the Court, yet the reputational damage and pile of lawsuits was enough to put the firm out of business.

The scandal led to the enactment of the Sarbanes-Oxley Act of 2002 to further protect the interests of investors, but also brought Jim Chanos, a short seller and the founder of Kynikos Associates, into the spotlight.

Chanos was one of the earlier skeptics of Enron and publicly questioned the opaque financial statements of Enron. Despite the negative connotation attributed to short sellers, Enron’s downfall is a historical precedent, reflecting the need for research-based short-selling and skeptics in the market.

Short Selling Hedge Fund Example

“Hedge Fund Strategies and Market Participation” (Source: SEC )

Learn More → Short-Selling

4. Event-Driven Investing Strategy (Special Situations)

Event-driven hedge funds invest in the securities issued by companies anticipated to undergo significant changes.

The event-driven investing strategy is oriented around timing an investment around “special situations”, wherein a catalyst can soon affect the valuation (and stock price) of the underlying issuer.

The fund attempts to capitalize on a particular event, which can range from regulatory changes to operational turnarounds.

Common examples of catalyst events – often referred to as “special situations” – include the following.

  • Mergers and Acquisitions (M&A)
  • Tender Offers
  • Corporate Spin-Offs
  • Rights Offerings
  • Corporate Bankruptcies
  • Operational Restructuring
  • Divestitures
  • Financial Distress, i.e. Insolvency Risk
  • Recapitalization
  • Stock Buybacks
Joel Greenblatt Quote on Special Situations “Something out of the ordinary course of business is taking place that creates an investment opportunity. The list of corporate events that can result in big profits for you runs the gamut—spinoffs, mergers, restructurings, rights offerings, bankruptcies, liquidations, asset sales, distributions.” ― Joel Greenblatt

Learn More → Event-Driven Investing

5. Relative Value Fund Strategy (Arbitrage Strategies)

A relative-value hedge fund uses arbitrage investment strategies and actively pursues temporary mispricing opportunities to exploit and capitalize on.

The price discrepancies, or “spread inconsistencies”, represent opportunities to profit once stock prices revert to trading at their fair value.

The relative value arbitrage investment strategy starts with identifying pricing differentials between closely-related securities, by simultaneously purchasing and selling different financial instruments based on speculations of near-term price movements.

For instance, the merger arbitrage strategy – a blend of relative-value arbitrage and event-driven investing – entails a hedge fund taking offsetting positions in two companies involved in a pending merger to profit from the pricing inefficiencies that occur before and after the transaction.

Following the announcement of a proposed merger, the stock price of the acquisition target often rises, whereas the stock price of the acquirer can decline.

The merger arbitrage strategy involves the concurrent purchase and sale of the stocks of two companies on the verge of a potential merger (or acquisition).

Oftentimes, M&A transactions fall apart from unexpected events or regulations, such as anti-trust concerns, which represent opportunities to profit and “capture the spread” between the:

  • Current Market Share Price (Normalized Basis)
  • Proposed Offer Price per Share

Amid periods characterized by widespread uncertainty surrounding the outcome of a merger or acquisition, the fund exploits and profits from the pricing inefficiencies reflected in the market.

MSFT and ATVI Merger Arbitrage Example

For a real-world example, Microsoft (MSFT) announced its intention to acquire Activision Blizzard (ATVI) around mid-January 2022 for $95.00 per share ( Schedule 14-A )

The announcement was swiftly met with regulatory scrutiny not only from the Federal Trade Commission (FTC) in the US, but also from the UK’s Competition and Markets Authority (CMA) .

ATVI’s shares rose around 25% on the date of announcement – narrowing the difference between the market price and offer price per share – but in the coming months soon shed a sizable percentage of the gains from the potential acquisition as the regulatory hurdles on the horizon became more apparent.

The share price of ATVI continued to remain mostly around the ~$70 to $80 range until an unexpected decision by the EU’s European Commission to approve the deal in May 2023.

Yet, the optimism in the market soon left right after UK’s CMA restated its unchanged intent to prevent the acquisition on the grounds of anti-trust concerns in cloud gaming.

MSFT must therefore overcome the regulatory hurdle set by the CMA, as well as the FTC.

The uncertainty in the closure of the acquisition is priced into the market’s valuation of ATVI’s equity – which as of the present date – is trading at a hefty discount relative to the offer price per share, reflecting a lucrative (and highly risky) opportunity for investors.

Merger Arbitage Strategy Example (MSFT, ATVI)

MSFT and ATVI Stock Price Percent Trendline (Source: CapIQ)

Learn More → Merger Arbitrage

6. Activist Investor Fund Strategy (Shareholder Activism)

The activist fund strategy aims to influence corporate decisions by vocally exerting their shareholder rights (i.e. direct management on how to increase the value of their investment).

  • Friendly Engagement → Often, the activist investor is the “catalyst” that brings positive changes to how the company is managed, which usually coincides with obtaining a seat on the board to work with the management team on good terms.
  • Hostile Engagement → In other cases, activist funds can be hostile to public criticism of the company to turn market sentiment (and existing shareholders) against the existing management team – often to start a proxy fight to obtain enough votes to force certain actions.

Underperforming companies are ordinarily targeted by activist funds, as it tends to be easier to advocate for changes in such companies or even replace the management team.

The news alone of an investment by an activist investor could cause a company’s share price to increase because investors now expect tangible changes to soon be implemented.

Activist Hedge Fund Criteria

“Do Activist Investors Boost Shareholder Returns?” (Source: Goldman Sachs Research )

Learn More → Activist Investor

7. Global Macro Fund Strategy

The strategy of global macro hedge funds is based on investment decisions based on the broader economic themes and political landscape.

Macro fund managers closely monitor economic variables and indicators to form a thesis on the outlook of macro conditions, e.g. the Federal Reserve, inflation rates, and international developments with implications on global trade.

The range of holdings by global macro funds tends to be diverse, including equity indices, fixed income, currencies, commodities, and derivatives (e.g. futures , forwards, swaps).

The strategy of these funds shifts continuously and is contingent on recent developments in economic policies, global events, regulatory policies, and foreign policies, i.e. “directional analysis”.

8. Quantitative Investing Strategy (Systematic Trading)

Quantitative funds rely on systematic software programs to guide investment decisions, as opposed to fundamental analysis (i.e. automated decisions to remove human emotion and bias).

The investing strategy is built on proprietary algorithms, with significant emphasis on compiling historical market data for in-depth analysis, as well as back-testing models (i.e. running simulations)

Systematic trading strategies rely on computerized trading systems and complex mathematical models based on either technical or fundamental factors to identify patterns or trends to capitalize on within the global financial markets.

The systematic aspect of the investment strategy enables such firms to quickly identify investment opportunities and profit from temporary price patterns across different countries, contrary to fundamental investors.

9. Distressed Debt Fund Investment Strategy

The securities of distressed companies often trade at steeply discounted valuations, creating a risky yet lucrative opportunity for the investment firm.

The distressed fund strategy is a riskier form of investing that specializes in purchasing the mispriced securities of a troubled company (the “debtor”) that has filed for bankruptcy protection or is on the verge of doing so in the near future due to a sudden deterioration in its financial state.

Often, an investment in distressed securities can become a complex, long-winded process, since most corporate bankruptcies are in-court restructuring , rather than out-of-court.

Therefore, the time frame for the debtor and the creditors – contingent on the severity of the debtor’s financial state (and the incentives of the creditors) – can require significant time before an amicable solution is reached and approved by the Court.

  • Chapter 11 Reorganization → The debtor cannot reorganize without the formal approval from the Court of its plan of reorganization (POR), i.e. the document negotiated with creditors that outlines the debtor’s plans moving forward post-emergence from bankruptcy and an attempt to return to operating on a “going concern” basis.
  • Chapter 7 Liquidation → If the Court rules that the debtor’s value after the reorganization does not exceed its liquidation value, the assets belonging to the debtor are liquidated and distributed to its creditors by the absolute priority rule (APR), which dictates the order at which claims are repaid in full.

Distressed debt funds purchase debt trading at steep discounts because of the uncertainty around the outcome of the bankruptcy, i.e. Chapter 7 liquidation or Chapter 11 reorganization .

In the latter scenario, the reorganization and emergence post-bankruptcy presents the distressed fund with the opportunity to obtain a sizable stake in the new entity’s equity to generate a strong return, assuming a successful turnaround.

For instance, a distressed fund could invest in the debt of a corporate undergoing a reorganization , where the debt will soon be converted into equity in the new entity (i.e. debt to equity swap) amid the attempt to return to a “ going concern .”

Learn More → Distressed Debt Investing Primer

10. Multi-Strategy Fund (Multi-Strat Investing)

The investment strategy used by multi-strategy funds is at their discretion, as such firms tend to prioritize capital preservation with a lower appetite for risk.

Multi-strategy funds are seldom risk-averse from the start, but rather prioritize risk management because of the expansion of their assets under management (AUM).

The higher the assets under management (AUM) of an investment firm, the more risk-averse the investor must become, since there is now more capital at risk.

Therefore, multi-strategy firms strive to achieve stable, positive returns regardless of market performance, like most hedge funds, but there is far more capital at stake.

In general, portfolio diversification is the main appeal to multi-strategy investors, where risk is allocated across different investment strategies, asset classes, and geographical locations.

That said, the risk profile attributable to the “multi-strat” fund strategy is on the lower end (and less risk coincides with lower potential returns, per usual).

11. Credit Fund Strategies (Fixed Income Investing)

Credit funds utilize strategies that allocate capital predominately to debt securities, which can range widely in terms of risk-reward profile.

Credit funds strive to exploit opportunities in corporate debt issuances, government bonds, and other types of financial securities.

The following list contains examples of fixed-income securities:

  • Corporate Bonds
  • Treasury Bills (T-Bills)
  • Treasury Notes (T-Notes)
  • Treasury Bonds  (T-Bonds)
  • Municipal Bonds (“Munis”)
  • Certificates of Deposit (CDs)

Credit hedge funds can use various strategies to achieve their target returns, such as long/short credit, distressed debt, arbitrage strategies, such as convertible arbitrage (i.e. purchase convertible bonds and short the issuer’s stock to hedge risk), and structured credit (CDOs, CLOs).

Fixed-income credit fund strategies consist of investing in long-term government bonds, corporate bonds with high credit ratings, annuities , and preferred stock , all securities that pay a fixed rate of interest to the bondholder until maturity.

Credit fund managers must have a strong grasp of analyzing the risk profile of a given lending scenario, such as performing diligence on the implied default risk, credit spread risk, and illiquidity risk, to identify and profit from inefficiencies.

Opportunities to profit and the upside potential in monetary gains decline for debt securities higher in the capital structure (and vice versa).

Often, the only method for a credit fund to achieve equity-like returns is to engage in riskier strategies, such as leverage, convertible bond arbitrage, and distressed credit.

Learn More → Fixed Income Securities

Convertible Bond Arbitrage Example

The convertible bond arbitrage strategy is a mixture of credit investing and relative value arbitrage investing.

For instance, a credit fund could take opposing positions in a convertible bond and the underlying stock in the convertible bond arbitrage strategy, i.e. long and short positions in related financial securities.

The credit fund seeks to profit from movements in either direction by setting a contrasting hedge between the long and short positions, in which the two bets reduce portfolio risk.

  • Share Price Decline → If the share price declines, the investor can benefit from the short position taken, and thus there’ll be more downside protection.
  • Share Price Increase → If the share price increases, the investor can convert the bond into shares and then sell, earning enough to cover the short position (and again minimize the downside).

Hedge Fund vs. Mutual Fund: What is the Difference?

Hedge funds and mutual funds are distinct investment vehicles, with significant differences regarding the fund structure, investor qualifications, risk-reward profiles, investing strategies, and regulatory risks.

Learn More → Hedge Fund vs. Mutual Fund

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hedge fund business model definition

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Table of Contents

What is a hedge fund?

Key hedge fund characteristics, hedge funds by type or strategy, who invests in hedge funds, requirements and costs of investing in hedge funds, comparing hedge funds with other funds, advantages of investing in hedge funds, risks and drawbacks of investing in hedge funds, the bottom line, hedge funds: definition, examples, and how they work.

Jun 21, 2022

Hedge funds are for the wealthy and big institutions, and getting into them requires more money, tolerance for risk, and patience than most investors have.

hedge fund business model definition

Anyone who watches Axe go all-in on Billions or reads financial news is probably familiar with hedge funds. They have taken on an aura of greatness, with supposedly genius investment returns that beat market averages. 

That said, such funds have had a mixed record in the past several decades. From 1980 through 2008, hedge fund returns were less than half the 12.5% annual average of the stock market benchmark, the Standard & Poor’s 500 Index. And from 2009 to 2019, hedge funds outperformed in one year, and that was only by losing less than the index. Here is a primer on hedge funds for the average investor.

A hedge fund is a private pool of money collected from an assortment of wealthy individuals and institutions such as trusts, college endowments, and pension funds. The pool is managed by a financial professional who invests the money in a variety of securities and financial contracts.

“They’re basically ways for very wealthy people and pools of capital to get wealthier,’’ says Titan analyst Vincent Ning.

“The idea behind it was: If you are clever in how you position your portfolio with your main assets and your hedges, you should have a portfolio that makes money whether the market goes up or down,” Ning explains.

Jones also used borrowed money (leverage) to try to boost the fund’s returns and established the now-common practice in which managers receive 20% of the investment gains above a minimum threshold.

Among the most prominent hedge funds in the last few decades are:  

  • Bridgewater Associates, founded by Ray Dalio
  • AQR Capital Management, founded by Clifford Asness
  • Renaissance Technologies, founded by James Simons

Hedge funds can specialize in different approaches and strategies. Some can be so-called quants: funds that use complex mathematical analysis in making buy and sell decisions. AQR and Renaissance are most notable for their data-driven investment strategy.

Other funds may have an activist approach, focusing on undervalued companies in which the fund manager wants to take an active role through representation on the board, campaigning for new management, or possibly a sale of the company. Bill Ackman at Pershing Square Capital Management is a notable activist investor, as is Carl Icahn.

Hedge funds tend to have specific characteristics and features.

Hedge funds typically require an investor to have a liquid net worth (excluding a primary home) of at least $1 million, or annual income of more than $200,000 for the two most recent years. Some funds may set higher thresholds.

This is known as leverage, and it can magnify a fund’s returns if the investment turns out right. On the other hand, leverage magnifies losses if the investment is wrong.

For example, a hedge fund could invest in derivatives, commodities, real estate—even art and antiques. It may also engage in short sales—profiting when an asset loses value—to hedge its long investment positions.

The typical compensation for a hedge fund manager is known as the 2/20 package: The manager is paid 2% of the fund’s asset value, plus an incentive fee of 20% of any profits above an agreed minimum, known as the hurdle rate. So if the fund manages $1 billion and it generates a 25% return ($250 million), the manager is paid 2% of $1 billion ($20 million), plus 20% of the returns exceeding a 5% hurdle, or $40 million. This is how successful managers of big hedge funds become billionaires.

Hedge funds fall into several broad categories based largely on how they invest:

With this approach, the manager looks to buy stocks with long-term growth potential while short-selling stocks that may be overvalued and poised for a decline. The strategy is meant to profit in good or bad markets, or at least not to lose in bad markets.

Similar to long-short equity as a good times/bad times strategy, equity market-neutral tries to profit from pairs trading—buying an amount in one company and selling short an equal amount in a related company. For example, the fund manager might buy $1 million of shares in ABC Pharmaceuticals Inc. because it’s the leader in the industry while shorting XYZ Pharma Orp. because it’s a laggard.

This focuses on pending mergers and takeovers. The fund manager typically will buy shares of the company being acquired and simultaneously short the shares of the acquiring company. The hedge fund is gambling on how long the merger will take to be completed and on any change in price between announcement and completion.

As the name implies, this strategy looks to bet on macroeconomic shifts, such as changes in interest rates set by central banks, trade balances between countries, or currency exchange rates. Global-macro strategies often use large amounts of leverage, which can result in spectacular gains or huge losses.

This approach tries to capture gains from the difference in expected price volatility of a financial asset and the implied volatility of options on that asset. Stocks are the asset of choice for such a strategy.

Some companies issue bonds that give the holder, at certain times, the option to convert the bond’s face value into a number of company shares. The hedge fund manager tries to profit from temporary pricing discrepancies in the convertible bond relative to the underlying stock.

Hedge funds tend to seek out so-called accredited or sophisticated investors, meaning those who:

  • Have the wealth and income required to participate
  • Fully understand the risks as well as potential rewards
  • Don’t require the protection of securities regulations
  • Can commit to leaving their money in the fund for a certain period of time without needing to withdraw

Hedge funds are usually formed as limited partnerships, and each investor is a limited partner. Minimum investments can vary among hedge funds—as little as $25,000 or as much as $1 million. Investors also must commit to leaving their money with the hedge fund for a certain amount of time, known as the lockup. Lockups usually are at least one year, sometimes several years.

and exchange-traded funds (ETFs) are similar to hedge funds in theory because they are investment pools managed for the benefit of the investors. However, they differ in their investments—mutual funds are more conservative and generally stick to stocks and bonds. They may do some limited short sales. ETFs are often designed to track stock market indexes .  

Hedge fund managers can be more aggressive in their investment strategies than mutual fund managers. Also, hedge funds are lightly regulated , whereas mutual funds and ETFs operate under US securities regulations.

Hedge funds can invest in a wider array of assets, including derivatives, real estate, natural resources, venture capital—even exotic things such as royalty income from copyrighted music or films. And they can be more aggressive in their efforts to produce returns that exceed market averages—for instance, beating the benchmark Standard & Poor’s 500 Index .

Depending on the hedge fund and an investor’s financial plan, there are advantages to keep in mind:

  • Hedge funds use strategies to try to profit whether stock and bond markets are rising or falling.
  • They strive for returns above market averages.
  • They seek to reduce risk and volatility in their mix of investments.
  • They can employ a variety of investment styles for the investing partners, tailoring specific strategies for them.
  • Hedge funds have attracted some of the most talented and successful managers, some of whom have produced incredible gains.

Hedge funds come with some drawbacks to consider, including the following:

  • Hedge-fund investors surrender control of their money during the lockup. They must be patient and trust the fund manager.
  • Hedge funds are much less liquid than mutual funds and ETFs, which can be bought or sold daily.
  • They make big bets on relatively few things, so if any of the bets fails, hedge funds can face very large losses. In this respect, hedge funds belie their name, as such concentrated bets could be seen as speculation rather than hedging .
  • Hedge funds’ use of leverage is a double-edge sword; it can magnify losses as well as gains.  

Hedge funds are for the wealthy and big institutions, and getting into them requires more money, tolerance for risk , and patience than most investors have. They tend to do best for investors during fluctuating or declining markets, by avoiding or minimizing losses. During long bull markets, they have done worse than market averages, sometimes by significant margins.

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  • What is a hedge fund? 
  • Understanding how hedge funds work 

Hedge funds vs. the S&P 500

Hedge funds pay structure.

  • A history of hedge funds
  • Are hedge funds regulated? 

The bottom line

What is a hedge fund and how does it work.

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  • Hedge funds are pooled investment funds that aim to maximize returns and protect against market losses by investing in a wider array of assets.
  • Hedge funds charge higher fees and have fewer regulations, which can make them riskier.
  • Individuals, large companies, and pension funds may invest in hedge funds as long as they meet asset requirements.

Insider Today

A hedge fund is a type of investment that's open to accredited investors . The goal is for participants to come out ahead no matter how the overall market is performing, which may help protect and grow your portfolio over time. But hedge funds come with some risks, which you'll need to consider before diving in.

What is a hedge fund? 

A hedge fund is a private investment that pools money from several high-net-worth investors and large companies with the goal of maximizing returns and reducing risk. To protect against market uncertainty, the fund might make two investments that respond in opposite ways. If one investment does well, then the other loses money — theoretically reducing the overall risk to investors. This is actually where the term "hedge" comes from, since using various market strategies can help offset risk, or "hedge" the fund against large market downturns.

Understanding how hedge funds work 

Hedge funds have a lot of leeway in how they earn money. They can invest both domestically and around the world and use just about any investment strategy to make active returns. For instance, the fund may borrow money to grow returns — known as leveraging — make highly concentrated bets, or take aggressive short positions. 

But that flexibility also makes these investment vehicles risky, despite being called "hedge" funds. "There's no transparency in hedge funds, and most of the time, managers can do whatever they want inside of the fund," says Meghan Railey, a certified financial planner and co-founder/chief financial officer of Optas Capital. "So they can make big bets on where the market's going, and they could be very wrong."

The elevated risk is why only accredited investors — those deemed sophisticated enough to handle potential risks — can invest in this type of fund. To be considered an accredited investor, you'll need to earn at least $200,000 in each of the last two years ($300,000 for married couples) or have a net worth of more than $1 million. 

hedge fund business model definition

It's tough to compare hedge funds to the S&P 500 because there are so many different types of hedge funds, and the markets they invest in might be global-oriented, says Chris Berkel, investment adviser and founder of AXIS Financial. "However, we can say that a broad index of hedge funds underperformed the S&P 500 over the last 10 to 15 years," Berkel says. 

Berkel points to data compiled by the American Enterprise Institute (AEI) from both the S&P 500 and the average hedge fund from 2011 to 2020. The data shows that S&P 500 index outperformed a sample of hedge funds in each of the 10 years from 2011 to 2020:

"The S&P 500 is a systematic risk, which cannot be diversified away," Berkel says. A hedge fund may provide some safeguards to your portfolio, which you won't get with the S&P 500.

Investors earn money from the gains generated on hedge funds, but they pay higher fees compared to other investments such as mutual funds. "The management fee is charged every year, regardless of performance, and the incentive fee is charged if the manager performs in excess of a specific threshold, typically its high-water mark," Berkel says.

The fee is typically structured as "2% and 20%." So in this example, participants pay an annual fee of 2% of their investment in the fund and a 20% cut of any gains. But recently, many hedge funds have reduced their fees to "1.5% and 15%," says Evan Katz, managing director of Crawford Ventures Inc. 

Once you put money into the fund, you'll also have to follow rules on when you can withdraw your money. "During market turmoil, most hedge funds reserve the right to 'gate,' or block, investors from redeeming their shares," Berkel says. "The rationale is that it protects other investors and helps the fund manager maintain the integrity of their strategy."

Outside of these lockup periods, you can usually withdraw money at certain intervals such as quarterly or annually.

Are hedge funds regulated? 

Hedge funds are regulated, but to a lesser degree than other investments such as mutual funds . Most hedge funds aren't required to register with the Securities and Exchange Commission (SEC), so they lack some of the rules and disclosure requirements that are designed to protect investors. This can make it difficult to research and verify a hedge fund before investing in this type of product. However, hedge fund investors are still protected against fraud, and fund managers still have a fiduciary duty to the funds they manage. 

Investing in hedge funds could help your portfolio grow, but you wouldn't want to concentrate your entire nest egg here. Hedge funds are illiquid, require higher minimum investments, are only open to accredited investors, and have fewer regulations than other types of investments, making them a risky endeavor. 

"Start by consulting a financial professional who's not incentivized to sell you a hedge fund," Railey says. "Read the offering memorandum, ask some critical questions about past performance, and ask what their strategy is going forward." Then, she suggests, allocate no more than 5% to 10% of your overall investable assets into a hedge fund.

If you're not an accredited investor or you'd rather look at different investments, you still have options outside of your retirement accounts. For instance, you might decide to open an online brokerage account. Keeping your money in the market over time — instead of trying to buy and sell based on market conditions — can be a good strategy, Railey says. "Just start simple, stay simple, and add on complexity as time goes and you have more experience to be able to understand the difference."

hedge fund business model definition

  • Main content

Hedge Fund Definition

Table of Contents

What Is a Hedge Fund?

How do you join a hedge fund, who can invest in hedge funds.

A hedge fund is a partnership of investors who pool their assets together in pursuit of big returns that are often in exclusive assets uncorrelated to typical mainstream investments.

The unfortunate reality is that most investors can't invest in a hedge fund. Hedge funds are elite investment vehicles that sometimes bring in participants by invitation only and frequently have minimum buy-ins of more than $1 million.

There are "smaller" funds that allow access with only a few hundred thousand dollars, but even so, almost all hedge funds prohibit you from redeeming your money until several years after that initial investment.

Unless you have a huge chunk of change that you can say goodbye to for nearly a decade, you simply aren't hedge fund material.

The short answer is that only the very wealthiest investors and institutions use this strategy.

And that's not just because the hedge funds themselves set high bars for entry. Under the Dodd-Frank Act, the U.S. Securities and Exchange Commission set new standards on what kinds of investors are appropriate for these vehicles. You must have a net worth of at least $1 million, excluding the value of your home, to qualify as an accredited investor . Individual investors looking to meet the "qualified purchaser" standards of the most elite hedge funds have to hold $5 million or more in investments, while institutions must have $25 million to even qualify.

How Do Hedge Funds Make Money?

Unlike traditional mutual funds or other investment vehicles, hedge funds use every tool possible on Wall Street in the pursuit of big gains. A few of these sophisticated techniques include direct investment in private companies, "short" positions that bet against an asset and convertible bonds , where the upfront cash starts as a loan but can be converted to ownership stakes.

Furthermore, hedge funds frequently use leverage to supercharge these bets. Borrowing on margin is risky because it increases the potential for gains but also increases the potential for losses. If your goal is outperformance and you think your investment is a good one, however, leverage can turn a modest profit into a mammoth one.

Do Hedge Funds Outperform the Market?

Sometimes some hedge funds do outperform. And in some years, hedge funds as a group do post better returns than typical investments. But it is anything but a sure thing.

The plain truth is that hedge funds routinely underperform the market after fees. This group has trailed the S&P 500 for at least seven straight years, and in 2021, distressed investing hedge funds delivered just less than 15%, for instance, and long/short equity funds delivered just more than 13%. The same year, the S&P 500 returned about 27%.

There is no shortage of research out there that says active management typically underperforms a passive, long-term approach . Though hedge funds are exclusive and sophisticated, they tend to follow the same path to underperformance.

What Is the Fee Structure for Hedge Funds?

The costs of hedge funds vary, but a common standard for fees is "2 and 20" – meaning the hedge fund charges 2% on the assets you invest and then an additional 20% of the profits after a predefined goal.

To do the math, let's say you have $1 million to invest in a fund that will deliver 50% gains. On paper, that works out to $500,000 in profits, right? However, if you're charged 2% upfront and then forfeit 20% of your investment gains back to the hedge fund in fees, you only bag about $400,000 in net profits when all is said and done.

These massive fees can indeed be justified if significant profits materialize to cover the costs. But a steep fee structure that eats into profits can often be one of the main reasons hedge fund investors often don't fare much better than the rest of us in conventional but much cheaper asset classes.

Why You Need to Know About Hedge Funds

There is a school of thought on Wall Street that says it often pays to know what the "smart money" is doing and then follow suit. If you subscribe to this notion, then understanding hedge fund behavior can sometimes give you an early read on what's going on in the stock market and the broader economy.

If you care about wealth inequality, it may be worth watching what hedge funds are doing – and who is a part of them – as a proxy for where the world's super-rich are putting their capital right now.

Hedge funds involve risk and, like all assets, sometimes don't work out for their investors. But they are legitimate investment vehicles, subject to federal regulations and investor protections. Yes, a few infamous hedge fund managers such as Bernie Madoff have made big headlines over the years by defrauding investors. But these are outliers and do not represent the vast majority of hedge fund leadership on Wall Street.

It depends on what period you're considering, but some of the best-known and most successful hedge fund managers in history are George Soros with his eponymous Soros Fund, Ken Griffin of Citadel and renowned activist investor Carl Icahn, to name a few.

Some firms have multiple, distinct hedge funds operating at one time – and collectively, the assets under that umbrella can be staggering in size. Investment powerhouse Bridgewater Associates is the leader with more than $100 billion in assets under management. Man Group, Millennium Management and Renaissance Technologies are some other large hedge funds.

Some of the offers on this site are from companies who are advertising clients of U.S. News. Advertising considerations may impact where and in what order offers appear on the site but do not affect any editorial decisions, such as which financial institutions we write about and how we evaluate them.

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Understanding How a Hedge Fund Makes Money

How a Hedge Fund Makes Money

Hedge funds are investment vehicles that allow investors to pool their money to purchase various assets, including stocks, bonds, commodities, and currencies. There are many different types of hedge funds, but all share one common goal: to make money for their investors.

The Hedge Fund Business Model

A hedge fund typically charges two types of fees: management fees and performance fees.

Management fees are a percentage of the total assets in the fund and are paid to the fund’s managers for their work in selecting and monitoring investments. 

Performance fees are based on the profits generated by the fund and are usually paid only when the hedge fund outperforms a predetermined benchmark, such as the S&P 500.

Management Fees

Hedge fund management fees are a percentage of the total assets in the fund. This fee is paid to the fund’s managers for their work selecting and monitoring investments.

You can expect to receive a management fee of 1% to 2% of the assets in your hedge fund. So, for example, if you have $100 million invested in your hedge fund with a 1% management fee, you would receive $1 million annually.

Performance Fees

A performance fee is a fee that a hedge fund manager charges when the fund outperforms a predetermined benchmark, such as the S&P 500.

You can expect to pay a performance fee of 10% to 20% of the profits generated by your hedge fund. So, for example, if your hedge fund earned $100,000 in profits last year and had a 20% performance fee, you would owe the fund’s managers $20,000.

The Two Types of Hedge Funds

There are two types of hedge funds: long/short funds and absolute return funds. Long/short funds bet on the direction of the markets, while absolute return funds aim to make money regardless of how the markets move.

Long/Short Funds

A long/short fund is a type of hedge fund that bets on the direction of the markets. These funds take both long and short positions in various assets, including stocks, bonds, commodities, and currencies.

The goal of a long/short fund is to make money when the markets move up or down. These funds try to minimize losses when the markets are falling and maximize gains when the markets are rising.

Absolute Return Funds

An absolute return fund is a type of hedge fund that aims to make money regardless of how the markets move. These funds take both long and short positions in a variety of assets, including stocks, bonds, commodities, and currencies.

The goal of an absolute return fund is to make money in all market conditions. These funds try to minimize losses in falling markets and make gains in rising markets.

The Bottom Line

Hedge funds are investment vehicles that allow investors to pool their money and purchase a variety of assets, including stocks, bonds, commodities, and currencies. Hedge funds charge management fees and performance fees. Long/short funds bet on the direction of the markets, while absolute return funds aim to make money regardless of how the markets move.

Fee Structure

Hedge funds typically charge two types of fees: management fees and performance fees. Management fees are a percentage of the total assets in the fund and are paid to the fund’s managers for their work in selecting and monitoring investments. Performance fees are based on the profits generated by the fund and are usually paid only when the hedge fund outperforms a predetermined benchmark, such as the S&P 500.

You can expect to pay a management fee of 1% to 2% of the assets in your hedge fund. For example, if you have $1 million invested in a hedge fund with a 1% management fee, you would pay the fund’s managers $10,000 per year.

Investment Strategy

Hedge funds use a variety of investment strategies, including long/short investing and absolute return investing. Long/short funds bet on the direction of the markets, while absolute return funds aim to make money regardless of how the markets move.

Risk Management

Hedge funds are required to maintain a certain level of capital, which provides a buffer against losses. In addition, hedge fund managers use a variety of tools to manage risk, including stop-loss orders and position limits.

Return On Investment (ROI)

Hedge funds typically aim for a return of 20% or more. However, hedge fund returns can be volatile, and investors should be prepared for both positive and negative outcomes.

Developing Your Fee Structure

As a new hedge fund manager, you will need to decide how to structure your fees. The most common fee structure is a combination of management fees and performance fees.

This fee structure allows you to charge a percentage of the assets under management (management fees) as well as a performance fee. The performance fee is usually a percentage of the profits generated by the fund.

For example, if your hedge fund earned $100,000 in profits last year and had a 20% performance fee, you would owe the fund’s investors $20,000.

When structuring your fees, it is important to align your interests with those of your investors. For example, if you charge a performance fee, you will only make money if the fund performs well. This aligns your interests with those of your investors and gives you an incentive to generate strong returns.

Hedge funds make money by charging management fees and performance fees. They use a variety of investment strategies, including long/short investing and absolute return investing. Hedge funds are risky investments, but they can offer high returns. 

When choosing a hedge fund, it is important to align your interests with those of the fund manager by selecting a fee structure that gives the manager an incentive to generate strong returns.


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An investment vehicle wherein an investment pool is created

Patrick Curtis

Prior to becoming our CEO & Founder at Wall Street Oasis, Patrick spent three years as a Private Equity  Associate for Tailwind Capital  in New York and two years as an Investment Banking Analyst at Rothschild.

Patrick has an  MBA  in Entrepreneurial Management from The Wharton School and a BA in Economics from Williams College.

David Bickerton

Previously a Portfolio Manager for MDH Investment Management, David has been with the firm for nearly a decade, serving as President since 2015. He has extensive experience in wealth management,  investments and portfolio management .

David holds a  BS  from Miami University in Finance.

  • What Is A Hedge Fund?
  • Understanding How Hedge Funds Work
  • Types Of Hedge Funds
  • Fee Structure Of Hedge Funds
  • Who Can Invest In A Hedge Fund?

What Is a Hedge Fund?

Hedge funds  (HFs) are an investment vehicle wherein an investment pool is created consisting of various institutional and accredited investors having large sums of money to deploy. These funds are mostly not open to retail investors as it involves a high degree of risk.

Examples of institutional and accredited investors are - Banks, Financial Institutions, Pension Funds, Endowment Funds, HNI, etc.

 Hedge fund managers often use unconventional investment strategies to generate above-average returns for their clients, and these include techniques like - using leverage (borrowed money) to take positions in the market and trading in specialized assets/markets. 

These funds are also allowed to hold multiple long and short positions in the derivatives market, and this is because they are less strictly regulated by the Securities and Exchanges Commission ( SEC ) as compared to other funds/investment vehicles.

Taking a long position in the market means betting that an asset/security will appreciate at a price. This is because investors buy at lower levels and square off their positions when the prices shoot up.

Short positions are exactly the opposite; in this strategy, the trader/investor believes that the asset will see a drop in its price. Therefore the trader sells the asset at higher prices only to square it off (buy the asset back) at a lower price.  

The term 'hedge' means taking a bet or a trade in the opposite direction of one's focus. This is done to protect a portfolio of assets from severe depreciation and offset any losses.

For instance - If Fund A has a long position on Amazon 's stock and they realize that the stock may fall, they have the option to take a short position on Amazon, which offsets losses made by the long position taken earlier. This is a simple example of hedging ; however, hedging is highly complex and involves different strategies.

Key Takeaways

Hedge funds are a specialized form of investment where a group of wealthy and professional investors pool their money together. These funds are often not accessible to regular investors due to the high risks involved.

Hedge fund managers use unique strategies, like borrowing money to make big investments and trading in specialized assets, to aim for above-average returns.

Unlike other investment vehicles, hedge funds have fewer regulations from the SEC and can take both long and short positions in the derivatives market.

Hedge funds have distinct characteristics, including leverage, exclusivity to certain investors, limited liquidity, flexible investment strategies, and unconventional fee structures.

Most HFs usually focus on generating returns even in market downturns (bear markets) rather than beating market returns in a normal scenario, and this is because the main purpose of these funds is to act as a hedge rather than a wealth creator.

Understanding how Hedge Funds work

These funds can park investor money anywhere in the market and use almost any strategy, making a "typical" hedge fund challenging to characterize.

The majority of them, however, have a preference for liquid financial instruments (as opposed to illiquid private equity investments) and an inclination to use unorthodox trading strategies such as derivatives or short selling .

Their usual fundamental structure is an investment or partnership pool in which a fund manager invests in various asset classes, geographies, and stocks that correspond to the fund's objectives. 

Fund managers pitch several plans to clients, and those who buy into the fund expect the management to follow it and generate maximum returns. 

There are several types of funds present in the market; some of these include - a fund that is long or short on all of its stocks or a fund that specializes in a certain form of investment, such as common stock or patents.

Key Features

These funds have certain characteristics which separate them from other types of investment vehicles; let us list down some of these important features below:

1. Use of leverage:  

The use of leverage or borrowed money is a common characteristic among all such funds, and leverage is used so that these funds can maximize the returns for their clients. 

This borrowed money can be acquired through various means, and some funds prefer trading on margin , i.e., using their broker’s money to take bigger positions in the market, while some funds prefer to trade on a credit line provided by a financial institution, in the hope of getting returns which surpass the interest costs.

2. Open to limited investors:

The Securities and Exchange Commission (SEC)  and most other market regulators worldwide only allow accredited/qualified investors to deploy their money in such high-risk funds, as it is believed that these investors have an adequate risk appetite for these funds.

Also, institutional investors and HNI’s (High net-worth individuals) usually have a large portfolio. Therefore, they often need to diversify their investments across various asset classes and geographies. These services are provided to them by specific funds.

3. Low liquidity:

These funds usually provide lower liquidity to investors than other traditional investment vehicles. Fund managers usually lock up the investments for two years or more.

This is because these funds use a high degree of leverage along with complex trading strategies that do not allow them to withdraw money or liquidate their positions easily.

4. Lesser regulatory oversight:

The SEC and other market regulators worldwide usually do not strictly regulate this industry.  

In the United States, the SEC does not require these funds to register with the Commission. Their fund managers are also exempted from registering themselves with the Financial Industry Regulatory Authority or the Commodity Futures Trading Commission.

However, many funds register themselves with the concerned authorities as it gives their investors peace of mind and provides these funds the necessary protection under various laws/acts.

5. Flexibility in investments:

Since this industry is not very strictly regulated, it has the flexibility and option to invest in various asset classes and geographies to maximize returns. This is a feature that is missing in other investment vehicles.

For instance - If the team of analysts at Fund X concludes that there is a good investment opportunity in the real estate sector of China, then Fund X has the option to invest their client’s money in the opportunity, unlike other investment opportunities which limit themselves to a specific asset class or geography.  

6. Unconventional fee structures:

Traditional investment schemes like mutual funds usually charge a fixed commission from the investors, known as the expense ratio . However, the fee structures of such funds are complicated and unconventional.

We will cover the fee structure of these funds in detail later in this article.       

7. High degree of risk:

Because of the above-mentioned reasons such as - less regulatory oversight, use of high leverage, investments in unconventional assets, etc. Such funds are risky bets and are, therefore, only open to qualified investors.

Since the majority of retail investors have a comparatively smaller portfolio or capital size, they might panic seeing the extreme volatility and riskiness of this industry. Therefore, the SEC only allows big investors to deploy funds in such schemes.

Types of Hedge Funds

There are various types that are present in the market. Investors carefully examine their investment goals and select a fund that fulfills those goals.

Let us look at the types of such funds:

1. Domestic Funds:   

Domestic funds are those funds that are set up in a particular country or geography and are open to investors who belong to that specific geography.

For instance - Fund X is set up in the United States and operates within the specified geography. Therefore, the fund offering of Fund X will only be available to eligible investors from the United States of America, and clients belonging to other countries will not be able to invest in Fund X.

2. Off-shore funds  : These are hedge funds that are established and operate outside one's own country, and these funds usually prefer low-tax geographies to maximize their post-tax returns.

However, there are certain risks associated with investing in such off-shore funds:

Movement in currency value can significantly affect the value of one's investments.

The off-shore country might come up with new laws and rules, or there might be geopolitical tensions that can impact the returns of such funds.

3. Fund of Funds (FOFs)  : These are funds that invest in the investment schemes of other funds. This is a strategy that helps these funds to diversify their investor's portfolios.

Some of these funds are owned by bigger financial institutions, and in those cases, they invest in the funds of their parent company .

For instance - Fund X invests a large part of its client's money in Fund Y's investment vehicles, and this allows Fund X's clients to firstly diversify their portfolios. Secondly, it acts as a hedge against Fund X not being able to generate enough returns.

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Fee Structure of Hedge Funds

Before we understand the exact fee structure of these funds, it is important to be aware of certain terminologies, and these will help us when we finally move on to understanding the fee structures :

1. Net Asset Value ( NAV ):

The  NAV  is defined as the net value of a business or fund. It is calculated as the business's assets minus the total liabilities.

In the context of a mutual fund, hedge fund, or ETF , it simply represents the unit price of a fund on a particular date, and investors can use the NAV to find out the number of units that they would be allotted corresponding to their total investment. This further helps them while redeeming or withdrawing their money from funds.

2. Hurdle Rate:

It is defined as the minimum rate of return that a fund (usually HFs) has to achieve before it can start charging a performance fee.

This hurdle rate can be either fixed, variable, or even linked to benchmark rates such as LIBOR , equity index, bond index, etc. For instance - if the hurdle rate of a fund is 10%, then until the fund's returns exceed 10%, they cannot charge performance fees from their clients.

3. High-Water Mark: 

This refers to the highest value (NAV) a fund has ever reached. Some funds use this mechanism to pay fees only when the current NAV exceeds the high-water mark. 

This is done to ensure that investors pay performance fees only on the new profits made by the fund manager, and incentives are not given on profits that are used to offset losses.

Fee Structure

Such funds, which hedge their client’s portfolio, usually operate on a 2/20 fee structure. Let us see the various components of this fee structure:

1. Management Fees:

This can be defined as the fees paid by investors for having their money professionally managed by fund managers. Management fees are paid annually regardless of a fund’s performance.

The usual fee is around 2%, which means clients will have to pay management fees equal to 2% of the fund’s NAV every year.

For instance - A fund managing $1 billion in AUM (Assets under Management) will receive $20 million as management fees every year.

2. Performance Fees: 

This is the fee paid by clients to incentivize fund managers to generate excess returns. The performance fee is only paid when the fund’s returns exceed the hurdle rate set. The performance fee is usually set at 20% for most hedge funds.

Who can invest in a Hedge Fund?

Investing in hedge funds carries a high amount of risk along with lots of volatility in the value of investments. Therefore, regulatory authorities worldwide have imposed certain restrictions on investors who can deploy their money in such funds.

The majority of market regulators do not allow retail investors to invest in such funds due to the high-risk factor. These funds are usually only open to accredited and qualified investors. In the context of the United States, the Securities and Exchanges Commission ( SEC ) defines qualified investors as the following:

1. Institutional Investors  - Banks, Insurance companies, Pension funds, Endowment funds, Mutual funds, etc. are examples of institutional investors. They are categorized as investors who possess large sums of money to deploy in the markets on behalf of an institution or company.

2. Accredited Investors  - Accredited investors are defined as individuals having a net worth of a minimum of $1 million, excluding the value of their primary residence. They are also sometimes categorized as investors having an income of above $200,000 or $300,000 if the individual is married.

Apart from these two criteria, certain funds have their eligibility criteria which govern the nature of their investors. Anybody who does not fall into those categories is not allowed to invest in such funds.

This is the reason only a small fraction of the entire population invests in such types of funds. However, these funds still remain very profitable as their fee structure often supports their financial feasibility.

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Multi-Strategy Hedge Funds Explained

  • Top-performing hedge fund strategies for the year ending Aug 31, 2021
  • Multi-strategy hedge funds vs. fund of funds
  • Potential risks and limitations of the strategy
  • Multi-strategy hedge funds are reportedly gaining interest in 2021

Gain exposure to institutional multi-strategy hedge funds that may minimize risk for your clients' portfolios.

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Global hedge fund assets hit roughly $4 trillion as of June 30, 2021, up more than 4% from the previous three months, according to HFR Inc.

Rising interest in hedge funds follows the recent returns witnessed in the asset class. For the year ended Aug. 31, 2021, the HFRI Event-Driven and HFRI Multi-Strategy indexes were reportedly among the top-performing strategies, both returning 25% on a one-year basis.

Hedge fund index returns

Multi-Strategy Hedge Funds Explained: Hedge Fund Index Performance

Source: Pensions & Investments, September 2021. “Hedge Funds Build Momentum.”

Unpacking Multi-Strategy Hedge Funds

Multi-Strategy hedge funds combine a variety of different investment strategies that are generally uncorrelated, with the goal of delivering a less volatile return stream to investors. Each investment strategy is typically executed by a portfolio manager (PM) who is dedicated to their respective strategy. These strategies can span the full spectrum of markets, including but not limited to equities, credit, and derivatives. Additionally, these strategies can either be specific and narrowly defined (i.e., trading precious metals) or broader in nature (i.e., trading all commodities), depending on the individual manager.

Multi-strategy funds can operate under either a single manager model or a multi-manager model. Under both models, the fund managers’ leadership will have broad discretion over which strategies or sectors capital is allocated to. The key differentiator is how involved the firm’s management is once the allocation has been made to the dedicated teams. In the single-manager model, the firm’s management will be more involved in individual security selection. In the multi-manager model, once an allocation has been made to a strategy or sector, the PM will typically have total discretion within their defined investment universe. Under both models, capital can be dynamically allocated depending on the shifting opportunity set.

The Fund’s objective will help shape which strategies capital is allocated to. For example, a multi-strategy hedge fund may have an objective to provide returns with a low correlation to traditional risk assets. This objective will likely lead the fund manager to find low-beta strategies to help support the objective.

A multi-strategy hedge fund helps provide investors with diversification since the fund houses different strategies. However, as mentioned above, these strategies are often dictated by the fund's objective, meaning that the type of strategies employed will depend on what the fund is designed to do.

Multi-Strategy Hedge Funds vs. Fund of Funds

A common analogy is to think of a multi-strategy fund as similar to a Fund of Funds (FoF) because both structures employ different portfolio managers under a single fund structure. For fund of funds, one fund invests in multiple hedge funds to diversify its hedge fund portfolio. Conversely, with multi-strategy funds, one fund employs different portfolio management teams, but each team is housed within the single fund structure. This subtle difference plays out into varying advantages and drawbacks within each structure.

Multi-Strategy Hedge Funds Explained: Difference Between Multi Strategy Hedge Funds And Fund Of Funds

Capital Allocation

For a fund of funds, the fund manager selects hedge funds to include in their overall portfolio. While this allows the fund of fund manager diversification, one of the challenges for fund of fund managers is that these decisions need to coincide with the underlying hedge fund's subscription and redemption cycle, which may delay the process of implementing changes to the portfolio. For example, if a prospective underlying hedge fund accepts new subscriptions monthly and offers redemptions every three months, then the FoF manager is only able to add new capital at the end of the month and redeem every quarter. As such, this mismatch results in a FoF manager needing extra time to make portfolio changes and lessening their ability to be dynamic during changing market conditions. Conversely, since multi-strategy managers work within the same fund, the manager can be more dynamic with their allocations and respond quicker to market dislocations.

Lessons Learned: 2008

The GFC in 2008 provided a lesson to fund of fund managers on liquidity management. As mentioned above, FoF managers need to consider the liquidity terms of the underlying funds when managing their portfolios. However, most funds have “gates”, which limits the amount of redemptions to a percentage of a fund. For example, if a fund offers quarterly liquidity with a 10% gate, the fund will allow investors to redeem every quarter, if redemptions remain under 10% of the fund. Once redemptions exceed 10%, per the example, the fund will limit or suspend redemptions. The gates help to preserve the portfolio from being fully liquidated if redemptions exceed what is needed to maintain the portfolio.

Gates are usually hit in extreme market conditions when redemptions are higher than normal. In 2008, as investors were pulling out of the market to preserve their capital, some hedge funds were forced to implement these gates, which proved to be challenging for fund of fund managers.

With a fund of funds, investors will have two layers of fees, one layer from the underlying hedge fund and the other layer from the fund of fund manager choosing the underlying hedge fund managers. For multi-strategy hedge funds, investors receive one fee from the fund since the underlying PMs fall within the same fund. The compensation of the underlying PMs gets rolled up into the multi-strategy hedge fund fees.

There is a key differentiator between single manager and multi-manager funds with regard to performance fees. Many multi-manager funds have what is called a pass-through fee model. This means that PM expenses, including performance fees, are passed through to the end investor. This ensures that winning PMs will be paid even if the overall fund is flat or even loses money. This is important because it helps ensure that the fund manager can retain its top-performing investment talent in all environments. This is referred to as netting-risk. In fund of funds and multi-manager funds, it is typically the end investor who takes on the netting-risk. In a single manager fund, the firm’s manager will be responsible for compensating top-performing talent during a flat or down period of performance or risk the talent departing for another firm. In this scenario, it is the Fund manager who is assuming the netting-risk.

Obstacles and Potential Risks for Multi-Strategy Hedge Funds

Potential allocators to multi-strategy hedge funds should pay particular attention to the risk management and service providers in place to assess whether the fund is equipped to manage the portfolio.

Risk Management

A drawback to multi-strategy hedge funds is the complexity in managing the risk of the fund's overall portfolio. While employing various PM teams offers diversification in the portfolio, the teams are often siloed to their respective strategy, making it difficult to attribute each portfolio team’s impact on the overall portfolio and potential overlap. This is where the multi-strategy manager steps in with a risk management team to monitor the correlation of the underlying portfolio and review whether the portfolio is in line with the fund's objective. The multi-strategy manager will often work with the risk management team to establish parameters for each PM team to follow. As a result, each manager, in theory, has provided a unique set of guidelines and portfolio constraints. This structure may also reduce the level of transparency an investor can experience given the difficulty of aggregating individual portfolio level exposures.

Manager Diversification

The shared resources across the multi-strategy fund can pose a business risk for investors. Under multi-strategy hedge funds, each team shares the resources of the fund and is reliant on the functioning capabilities of the firm to execute its strategy. If the multi-strategy firm falls deficient in its infrastructure, an investor is wholly exposed to that risk, whereas in a fund of fund structure, the business risk is diversified across a series of funds. Within a fund of fund structure, investors diversify away their exposure from a single manager.

Multi-Strategy Hedge Funds are Reportedly Gaining Interest in 2021

About 31% of investors planned to increase their multi-strategy allocation in the second half of 2021, up 25% from the first half of 2021, favoring the multi-strategy hedge funds’ versatility in the expected market environment.

Proportion of investors planning to increase their allocation to top-level hedge fund strategies in H2 vs. H1 2021

https://web.cdn.crystalfunds.com/public-web/the-ones/20190301/images/2021/10-october/multi-strategy-hedge-funds-explained/multi-strategy-hedge-funds-explained-: Investor Preferences H2 Vs. H1 2021

Fixed income allocators seem to be hedging against today's low-rate environment eroding value in fixed income, especially with the recent inflationary pressures plaguing the market. This has prompted a net 27% of investors planning to move out of fixed income. According to the recent study by AIMA, allocators have been increasingly looking at hedge funds with net neutral equity plans as a risk-adjusted alternative, as evidenced in the year-to-date flows through May 2021 of $8.8bn to these multi-strategy hedge funds.

Hedge fund asset flows ($Bn) through May 2021 by investment strategy

https://web.cdn.crystalfunds.com/public-web/the-ones/20190301/images/2021/10-october/multi-strategy-hedge-funds-explained/multi-strategy-hedge-funds-explained-: Hedge Fund Asset Flows

Source: AIMA, July 2021. "Investor Intentions H2 2021."

In taking a deeper dive into multi-strategy hedge funds, we have noted that these funds can operate with a variety of trading teams employing different strategies to serve the overall portfolio objective dictated by the multi-strategy manager. Multi-strategy hedge funds can offer an opportunity to achieve lower correlated returns through the diversity of PM teams and a diverse set of trading strategies within one fund. However, monitoring the risk and performance of the overall portfolio can prove to be challenging for a fund manager. Multi-strategy hedge funds require proper risk management protocols and infrastructure to obtain the requisite insight into the overall portfolio.

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Hedge Fund Analysis: 4 Performance Metrics to Consider

Hedge fund managers analyze trends

  • 21 Sep 2021

According to data by research firm Preqin, hedge funds surpassed $4 trillion in assets under management at the end of March 2021. This high-risk, high-reward asset class is a notoriously esoteric investment option limited to high-net-worth individuals and institutional investors. Hedge funds use a wide variety of sophisticated strategies, but they don’t have to be confusing.

Whether you’re an aspiring hedge fund manager, an accredited investor looking to get started in the space, or a curious professional hoping to understand hedge fund analysis, gaining a foundation in the basics of hedge funds and the metrics most commonly used to measure their performance is a great place to start.

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What Are Hedge Funds?

Hedge funds are a type of alternative investment that use pooled funds and various investment strategies to earn returns for limited partners. Hedge funds’ investment strategies can include virtually any investment type, ranging from traditional assets, such as stocks and bonds, to other types of alternatives, like private companies or real estate . The primary goal of hedge funds is to realize a return on investment no matter the market’s state.

Two key hedge fund strategies to know are:

  • Diversification , which requires building portfolios that contain a variety of asset types and risk profiles as a way to spread out risk and maximize potential returns.
  • Hedging , which aims to limit risk by offsetting one security’s risk with another. For example, to offset the risk caused by an asset’s seasonal fluctuation, you could invest in an asset with the opposite seasonality. In this simplified example, the risk of these two assets together is effectively zero.

Hedge funds require investors to be accredited, which is defined by the United States Securities and Exchange Commission (SEC) as having a net worth of at least $1 million or having had an annual income of $200,000 or more ($300,000 or more with a spouse) for the past two years with a reasonable expectation that it will extend to the current year.

If you’re an accredited investor, you need a network of connections in the field to get individually involved in hedge fund investing.

Related: 3 Essential Skills for Success in the Alternative Investments Industry

Foundations for Hedge Fund Analysis

Before learning about metrics for measuring hedge fund performance, there’s necessary groundwork to lay. It can be tempting to assume that if Portfolio A has a higher return on investment than Portfolio B, Portfolio A was a more successful investment. Yet, this doesn’t consider each portfolio’s risk profile.

A decent return on a high-risk investment can be considered more successful than a high return on a low-risk investment. This is especially relevant when analyzing hedge funds because this investment field is all about offsetting risk and outperforming the market based on well-managed securities combinations.

Basic statistical knowledge can be a helpful precursor to hedge fund analysis, as performance is often measured using averages, standard deviations, or ratios that are calculated using statistical formulas.

Additionally, hedge fund analysis relies heavily on benchmarking . Because the goal is to outperform the market, your analysis needs a point of reference, or benchmark. The metrics for measuring hedge fund performance are based on various factors—including risk and return—that are benchmarked against the S&P 500 or other investment indices.

Related: The Future of the Alternative Investments Industry

4 Performance Metrics for Hedge Fund Analysis

To get involved in hedge funds, you need to understand the ways you can measure their performance. Here’s a primer on four of the most common performance measures for hedge fund analysis.

Beta (β) is the measure of an asset or portfolio’s risk compared to the market’s risk. If an asset has a beta of one, its risk profile is the same as the market’s. There’s no “good” or “bad” beta—it’s all about you or your client’s risk preference. If you prefer safer investments, a portfolio with a beta of 0.3—30 percent of the market’s risk—could be a good choice. If you feel comfortable with a higher level of risk, a portfolio with a beta of 1.3—130 percent of the market’s risk—might be more attractive.

One way to obtain your desired beta level is to invest in the market as a whole, giving equal weight to riskier and safer investment options, then invest a percentage of your capital to match your desired beta.

For instance, it’s explained in the online course Alternative Investments that if you want a beta of 0.8, you could simply invest 80 percent of your investment capital in the market and keep the other 20 percent as cash, or invest it in a risk-free asset, such as treasury bills. This ensures that 80 percent of your investment will have the same beta as the market, and the other 20 percent will have a beta of zero.

The example also illustrates how you might obtain a beta of 1.3: Invest all of your capital in the market (100 percent) and then borrow the equivalent of 30 percent of your initial investment and invest that in the market, too. Your risk would then be equal to 130 percent of the market’s risk.

Although it may seem backward, beta sets the stage for alpha. Alpha ( α) is the difference between an asset or portfolio’s return and a benchmark’s return, relative to the amount of risk taken (beta). Essentially, alpha is the extra return your asset or portfolio gains above and beyond the market’s return.

Alpha is an important metric because it provides context. It answers the question, “If the beta were equal to one, how much better or worse did this asset perform than the market?” Alpha accounts for risk, allowing you to directly compare your asset’s returns with the market’s returns.

To calculate alpha, use this formula, where “A” refers to your asset or portfolio:

α A = (Actual Excess Return) A – β A × (Actual Return on Market)

Calculating alpha requires knowing the average market risk premium and the returns on a riskless asset (beta of zero). These figures allow you to calculate how much above or below the expected amount the asset or portfolio returned. Those numbers can then be used to calculate alpha.

3. Sharpe Ratio

The Sharpe ratio —coined by William Sharpe, winner of the Nobel Prize in Economics—is the return percentage per unit of risk. The Sharpe ratio is useful for directly comparing the performance of two assets or portfolios with different levels of risk.

Like alpha, the Sharpe ratio measures performance in relation to risk, but instead of comparing the asset to the market, it compares multiple assets to each other.

To calculate the Sharpe of a pair of assets, use this formula:

Sharpe Ratio = (Return of Asset – Risk-Free Return) / Standard Deviation of Asset’s Rate of Return

To use this formula, you need to know the return of your asset, the rate of return on a risk-free asset, and the standard deviation of your asset’s rate of return. Standard deviation , one way to measure risk, is the dispersion of a dataset based on its average. This basic statistical concept can explain the range of possibilities in both directions of the average. The larger the standard deviation, the more risk involved.

An example of the Sharpe ratio in action can be found in Alternative Investments, where two risky assets are described: Investment A returns eight percent with a 20 percent standard deviation, and Investment B returns nine percent with the same standard deviation. In this scenario, it’s clear which asset you’d prefer: Investment B, because it returns more than Investment A with the same level of risk.

Things get trickier when assets’ risk levels are different. Imagine now that Investment A returns eight percent with a 10 percent standard deviation instead of 20 percent. Is Investment B still the better performing asset? For this example, assume the risk-free rate of return is two percent.

Calculation for Investment A:

Sharpe ratio = (0.08 - 0.02) / 0.1

Sharpe ratio = 0.06 / 0.1

Sharpe ratio = 0.6

Calculation for Investment B:

Sharpe ratio = (0.09 – 0.02) / 0.2

Sharpe ratio = 0.07 / 0.2

Sharpe ratio = 0.35

After calculating the Sharpe ratio of the two assets, it’s clear that Investment A is the better performing investment.

4. Information Ratio

The information ratio is the excess return of an asset or portfolio divided by its “tracking error,” which is the standard deviation of the fund’s excess returns (or alpha). Similar to the Sharpe ratio, the information ratio measures return per unit of risk but focuses on excess returns instead of total returns.

To calculate the information ratio, use this formula:

Information Ratio = (Asset Rate of Return – Benchmark Rate of Return) / Alpha

The information ratio can be used to tell if the risk of trying to outperform the market is worth it. If your information ratio is high, your strategies are more likely to pay off.

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Building on Foundational Analysis Skills

These foundational concepts and metrics are just the tip of the hedge fund iceberg. If you’re interested in investing in hedge funds or becoming a portfolio manager, starting with the basics can provide a strong foundation on which to build your knowledge. It’s important to remember that each metric considers how an asset or portfolio relates to its benchmark and weighs the risk involved, but each provides a unique perspective on performance.

To learn more about hedge fund performance metrics, how they influence each other, and how to build a diversified portfolio, consider taking an online course, such as Alternative Investments .

Are you interested in expanding your knowledge of hedge funds and other alternative investments? Explore our five-week online course Alternative Investments and other finance and accounting courses .

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The New Business Model

Investing in the green space, peter c fusaro, global change associates, originally published in the april 2007 issue.

Emerging markets for environmental financial investment and trading continue to attract significant global investment interest. Traditionally, private investment has come from the venture capital world, which typically has the requisite patience to invest in many projects for as long as the ten-year life of venture capital funds. More recently, this area of investment has attracted hedge funds. Hedge funds don’t have that much patience and usually look for more immediate arbitrage opportunities.

As markets change, so do investment models. The new business model that has emerged for investment in alternative energy and clean technology is a hybrid business model of venture capital and hedge funds. Investment is locked up for shorter periods of time from two to four years rather than with traditional venture capital time periods of up to ten years. Coupled with the project orientation of the investment, there is a dimension of credit trading for emissions, carbon and renewable energy included in this investment strategy. The blurring of the lines between hedge funds and venture capital is also being exacerbated by significant private equity participation in environmental finance. This new hybrid financial green investment model will be discussed and analyzed in this article.

The new market drivers

The three global market drivers – sustained high energy prices, accelerated technology shift and increased environmental concerns – form the perfect storm for clean technology investment. Falling renewable energy costs are also increasing investment opportunities in this sector. To put this clean technology market in some perspective, we must look at its origin, what is driving it and where it is headed in the foreseeable future. Today, clean technology investment is the fifth largest share of early stage venture capital in North America at 10 per cent of market share and rising. US$8.2 billion was invested by venture capitalists in this sector from 1999 through 2005 according to the Cleantech Venture Network. It is now very conservatively estimated that US$8.5 billion more will be invested in this sector from 2007 through 2010.

In addition to early stage venture capital, both private equity and hedge funds will supply additional billions more as new technology is rapidly commercialized and deployed globally. The need is that great. Demand pull of global financial markets is accelerating. We will enter the world of Kyoto Protocol implementation in 2008 and that has already impacted environmental project finance. It is accelerating. Some of that anticipated investment in all stages of development is estimated in Fig.1. Global growing pains in this sector are seen in the shortage of wind turbines, polysilica for solar power, and even geothermal parts. The whole world is moving rapidly toward cleaner energy sources at the same time. Rising environmental imperatives will accelerate much of this energy market transformation into a cleaner energy world.

Clean technology investment is accelerating

The opportunities are immense. World demand is accelerating. Renewable energy mandates are proliferating in the United States, the European Union, China and India. The ‘Kyoto Factor’ arriving in 2008 and the need for carbon credits for the industrialized world are accelerating, as well as the need for less carbon-intensive technology. Also, this is much more market driven than regulatory driven as before. While there continues to be a focus on the regulatory regime, greater energy demand is pushing out products faster. Biological and materials sciences are also contributing to this effort on a new level in the form of both biofuels and nanotechnology. There is a higher use of IT than ever before. This tweaks many efficiency gains that make projects fly, particularly in advanced metering and remote sensing. Higher sustained energy prices are setting up the price floor to push it faster than ever before. Technology is also becoming more cost effective.

What the new business model looks like

It may be helpful to review recent developments in ‘clean technology,’ also called ‘cleantech.’ When mainstream press – Business Week, the Financial Times, Forbes and the Economist – all start covering this sector, they herald the news that the time has arrived for greener and cleaner technology. Good venture projects for the clean technology space need three elements to be successful. These are defined as: revenue stream, a seasoned management team to grow the business, and a defined exit strategy (usually by an initial public offering or roll up).

Building a business to scale and commercialization is very different than funding research and development efforts that are really science projects. In fact, some of the currently funded technologies are so debt ridden that they will never be commercially viable. Moreover, their cost structure will require an ability to significantly reduce costs in order to become commercialized. They cannot depend on the ‘environmental kicker’ of emissions reductions (called offsets) making a project economically viable. These are additional benefits for a business, but are not the reason for that business to exist.

What may be more interesting are the second stage investments in clean technology and alternative energy that do have revenue and can make money for investors. Several venture funds are focused on these later stage investments, and the investment space is beginning to get crowded. There is a great need for viable later stage companies. Angel investing, on the other hand, will fund start-ups in the green space, and consequently take on more risk. While the outcome is still uncertain, the timing is right. Higher energy prices are now sustainable due to unprecedented global demand coupled with under-investment in the global energy business for two decades. The real metric is that US$40 oil makes a floor for all these new technologies to take off. Higher global energy demand growth will continue to drive return on investment (ROI) higher in the cleantech space.

But what about the trading markets and the reduction of project costs? The new model that has emerged is a hybrid somewhere between venture capital and hedge funds. They require a capital commitment from investors for two to four years (i.e a lock-up) and a capability to trade the renewable energy credits (Recs) and emissions reductions (sulphur dioxide SO2, nitrous oxides NOX and carbon dioxide CO2). These green streams of revenue or ‘green finance’ make the cost of capital cheaper, but also bring much needed liquidity to emerging environmental financial markets. They cannot fund projects entirely unless they are a pure speculative play.

There is now increasing interest by investors in how SO2, NOX, CO2 and Recs are related to clean technology projects. It seems obvious to most cleantech investors that we are entering a carbon-constrained world and that their venture capital investments in clean technology will have an environmental kicker at some juncture in the US and from 2008 in the Kyoto world. The question then becomes how this is related to carbon finance and carbon offsets and more importantly investment in the realm of clean energy and cleaner technology. This hybrid business model of figuring out of the best business structure to participate – not only in investment in equities and commodities but also in clean technology tied to carbon reductions – is actually becoming quite important for new project development in the area of carbon offsets. The entire concept of ‘green trading’ is focused on the inter-relationship of emissions reductions, renewable energy credits and energy efficiency.

Investment interest is now more focused on how to invest in new technologies and gain investment streams that encompass two or three of these environmental benefits and should benefit from multiple credit streams. Of course, there are those who believe that ‘double counting’ of credits for renewable energy and carbon reductions is a bad thing, but I think that in the beginning of a market shift these multiple environmental credit streams actually enhance project creditworthiness. They also get us beyond the myopia of subsidizing technologies and push cleaner technologies to more market-centric sustainability. This is a better economic model for the future since it seems inevitable that technology cycles are accelerating and the need to invest in better technologies that are more energy efficient as well as cleaner will deliver better financial results.

Climate change as the new driver

The impending climate change regime in the United States will add an extra dimension to the drive for greater energy efficiency and reduction of emissions footprint for carbon. There is clear movement of capital into ‘carbon finance’ but this is not very well followed in the United States. This extra dimension of monetization of carbon credits for green project finance will increase ROI for many projects. More energy efficiency and renewable projects will take root as technology continues to shift, and the regulatory scheme for a less carbon-intensive world takes hold. It also seems reasonable that more rapid deployment of these cleantech investments will be needed to meet the rising environmental and energy needs both in the United States and around the world. It is no accident that there is a shortage of most renewable energy equipment today. A flattened world levels the playing field for new technology and also creates more market opportunities.

Everyone has misjudged the scale of the cleantech revolution. The short-term focus on ethanol and solar companies which receive most press and investment attention is only the initial stage of this change over to clean energy. It is a growing global phenomenon that will be rising in developing countries in coming years. The market demand is there in both the developing and developed world. One is leapfrogging technology and one is replacing antiquated infrastructure. Green is the new gold, and now is the time to watch it accelerate.

Several funds have invested and made money on the ethanol and solar price moves ofthe last year within existing funds and are now launching alternative energy specific funds. There are carbon funds in Europe that are oversubscribed and many in the US are growing their asset base. There are alternative energy/cleantech funds in Europe with multi hundred million dollar backing. There are cleantech funds on both sides of the ocean. There seems to be a realization that this market move is sustainable. What is really lacking is in-depth knowledge of the sector. The sector is not as widely followed by Wall Street and City of London investment analysts today. It would take mainstream investors at least 12-24 months to get up to speed in the cleantech/alternative energy sector. Some investors had allocated into several commodity trading green hedge funds (those that trade Recs and Greenhouse Gases [GHG]) but felt that the capacity was limited in those existing structures. This time lag of knowledge is significant as it focuses much of today’s investment attention on the narrow band of biofuel and solar projects and gives short shrift to the broader dimensions of the opportunity.

The green revenue stream

The ability to trade both emissions and renewable energy credits creates another revenue stream. Green trading is an encompassing term. we define green trading as the triple convergence of emissions reductions, renewable energy and energy efficiency. This triple convergence of carbon emissions, renewables and energy efficiency offers multiple risk arbitrage opportunities as well as many revenue streams. They are obviously interrelated in their use of more efficient technology, which reduces the emissions footprint. Similarly, using renewable energy can reduce the carbon footprint of power stations for example.

Green trading is a term coined several years ago to capture the value of the convergence of the capital markets and the environment. It encompasses all forms of environmental financial trading including carbon dioxide and other GHG reductions, sulphur dioxide (acid rain) and nitrous oxide (ozone), renewable energy credits and negawatt (value of energy efficiency). All of these emerging and established environmental financial markets have one thing in common: making the environment cleaner by either reducing emissions, using clean technology or not using energy through the use of financial markets. Sometimes, both can be accomplished as in reducing emissions and energy usage by moving to cleaner technology. Green trading is one mechanism to accelerate this change.

The trading markets determine the financial value of environmental benefits. The quaint notion that we are ‘trading pollution’ is an oversimplification of the need for markets to create financial incentives to reduce pollution and accelerate more efficient and environmentally benign technology transfer. This is not an academic exercise but an exercise of rational economic behavior.

BOX 2: SULPHUR DIOXIDE AND NITROUS OXIDE MARKETS IN THE US For example, in the well established US sulphur dioxide (SO2) and nitrous oxides (NOX)markets established in 1995 and 1999 respectively, we have seen a sea change in the past two years in US environmental financial markets. As coal burning increased, due to rising electricity demand and decreasing supply of natural gas, the emissions trading markets responded in kind. The price of emissions allowances rose to a peak of US$1,630 per ton for sulphur dioxide in December 2005 and US$40,000 for nitrous oxide during the past year in the US. Sulphur dioxide credits in the 11-year-old markets had never before risen above US$225 per ton. Prices have levelled off to the US$500 to US$600 range during most of 2006.

The financial penalty for emitting more emissions accelerated the emergence of new technology into the coal burning power generation space that was previously uneconomical. In the past year, at least 20 newly planned coal gasification facilities have either been announced or are on the permitting cycle for siting. Two years ago there were none. The benefits of gasification technology are that they not only reduce the previously mentioned SO2 and NOX emissions but also reduce carbon dioxide emissions. They also increase efficiency of coal burning from 30 per cent to the 50-70 per cent range, which means that less coal will need to be burned to produce the same amount of electric power in the future. This additional efficiency benefit is often overlooked by environmentalists, economists and policy makers who tend to view the energy supply picture as static with ever increasing energy demand.

Basically, we will be using less energy and it will be cleaner forms of energy in the future due to market-based incentives coupled with financial penalties for noncompliance. These are not voluntary markets but government mandated markets. Proved to work and are cost effective, they are essentially the templates for the Kyoto Protocol.

For carbon dioxide and GHG markets, 2005 was a watershed year. In February 2005, the Kyoto Protocol entered into force more than seven years after it was established. with Russia’s ratification in November 2004, countries that represent over 60 per cent of the total 1990 carbon dioxide emissions have now ratified the Protocol. They include the European Union, Japan, New Zealand, Canada, Russia and most of the countries known as the economies in transition (the countries that were ‘behind the iron curtain’ in the decades leading up to 1990). The United States and Australia have not ratified the Protocol, but are nonetheless pursuing programs to reduce GHG emissions on a voluntary basis – hence their prices for carbon credits are less than in the EU.

BOX 3: KYOTO PROTOCOL IN THE GLOBAL ARENA Under the Kyoto Protocol, countries can use emissions trading to lower the overall cost of reducing GHGs to meet the protocol targets. The protocol provides three flexible mechanisms for trading among countries: (1) An international emissions trading regime. This cap-and-trade program will allow industrialized countries to trade carbon permits in the international market. (2) Joint Implementation (JI) permits trading among industrialized countries and the economies in transition, and (3) the Clean development Mechanism (CdM) permits developing countries that are not parties to the Protocol to sell emission reductions to Annex 1 countries. By far, the CdM market has been the most developed with over 700 projects globally.

A marked shift in the market began in 2004 as the EU countries prepared to implement the EU Emissions Trading Scheme (ETS), a program adopted to reduce the cost of Kyoto Protocol compliance, permits trading of carbon dioxide. The EU emissions Trading Scheme officially started on 1 January 2005, and is now trading hundreds of millions of tons per year.

It is estimated that €25 to €30 billion will trade in 2006. Trades on the european market have continued to increase on a year to year basis. The European Commission estimated that adopting the EU-wide trading scheme would reduce the costs of attaining its emission target by at least 20 per cent if it covered the energy supply sector.

BOX 4: EMISSIONS TRADING SCHEME IN THE EUROPEAN UNION 12,000 facilities in europe fall under the purview of the EU Emissions Trading Scheme from 2005 to 2007. In 2008, the Kyoto Protocol takes effect and the program globalizes for the over 160 Kyoto signatory countries.

Carbon prices fluctuate: In the EU ETS, the price is €12.58 (September 29, 2006) On the Chicago Climate Exchange, the price is US$3.90 (29 September 2006)

Another venue for green trading has been in the renewable energy area. Wind, solar and biomass markets are accelerating commercially, due to the monetization of ‘renewable energy credits’ as they are called in the US. Today, 22 states have, or are developing, a Renewable Portfolio Standard (RPS) that is jump-starting markets in Texas, California and the Northeastern States to take advantage of ‘green power’ programs that are now popular with consumers. In America today there are over 600 green power programs where consumers willingly pay more for green power. The renewable energy projects in these states are able to bank-finance their development and create a revenue stream of green credits that reduce the cost of capital, in effect creating ‘green finance.’ Green trading is the mechanism to create market-based incentives. Their application is global. Not only are the US, EU and Japan moving forward, but so are developing economies such as China, India and Russia, on both emissions trading initiatives and clean technology applications.

As fossil fuel prices remain high throughout this decade and as demand continues to increase, clean technology will become a more attractive economic choice for deployment in global markets. Energy and environment issues continue to be more interconnected. Rising demand is accelerating the need to move faster to clean technology solutions. Green trading is the financial mechanism that allows markets to meet that goal of global deployment of new, cleaner technology to meet rising demand for electricity, transportation, heating and cooling applications. What used to be expensive and uncommercial is rapidly changing to economic solutions to global environmental problems.

The new wall of money

This investment sector is getting started. There is pent up demand for renewable and clean technology. There is global demand due to rising Asian economies. The green investment sector is about to really blossom. Wall Street and City of London analysts are gearing up to speed and to start following those companies that can scale. A new asset class has emerged and it is called ‘green.’ The implications of this new wall of money are hard to predict at the present time. The hype of markets for ethanol and solar power overshadow many other investment opportunities. However, we are starting to see private equity funds dedicated to infrastructure investment beyond clean technology raise capital in the multi-billion scale.

The rapidly evolving renewable energy and clean technology industry offer attractive investment opportunities. while some funds focus on early stage investment, many funds are focused on mid/later stage development and want to provide developmental capital to fund expansion and scale of operations. There are opportunities across the value energy and environmental chain. Renewable opportunities include wind, biomass, geothermal, solar, landfill gas, waste-to-energy, hydro, ocean/wave, biodiesel and ethanol. Some funds are offering the traditional private equity project finance component and are extremely well capitalized. For example, Carlyle’s Riverstone fund and ARC Light fund is now close to US$3 billion. Others are just ramping up and are in the process of raising US$100 to US$400 million in their first financing. Still others have become standalone investment vehicles as part of larger hedge funds where ethanol and solar projects over the 2005-2006 have paid off handsomely. These fund managers now wish to take the deeper dive by building a wider renewable energy portfolio. Some funds are seeking to secure a portfolio of projects with different locations so that they can get into the game faster. Others are either looking for co-investment opportunities or partnerships with developers. Law firms have become extremely entrepreneurial and take equity stakes in projects in lieu of fees, as Boston Consulting Group, Bain and McKinsey have all done.

The sector is changing rapidly since the need has become global. It is not surprising to see the emergence of India’s Suzlon and the rapid growth of China’s Suntech, with global projects in 2006. But what is under-estimated is the second wave of new technology companies that will also come from those and other developing countries.

Finding the good green projects globally

The Holy Grail of clean energy investment is finding the outstanding technology projects that can be scaled into a robust enterprise. Market opportunities for wind, biofuels, photo-voltaics, and fuel cells are expected to increase fourfold in the next ten years, growing from US$40 billion in global revenues in 2005 to US$167 billion by 2012 according to Clean Edge, Inc.’s ‘Clean energy Trends 2006.’ According to the Cleantech Venture Network, investments increased to US$513 million in the first quarter 2006 – the largest recorded since Q1 2000 representing a 2.3 per cent increase from the US$502 million recorded in the previous quarter. As in all boom times, there will be a short-term bust, and this most likely will be in the ethanol sector sometime in 2007, but the need for global investment is so great and the technology is shifting so fast that the momentum will carry clean energy as well as clean water initiatives for the next two decades. Climate change risk will be increasingly mitigated by the movement and rapid deployment of clean energy projects on a global scale which has never before been anticipated nor appreciated.

The skills shortage of the oil and gas industry will spill over into the clean tech sector. Building out infrastructure will take time. This presents many opportunities for smaller scale technologies in distributed generation and distributed water solutions to take root. Both small and big projects will be built out, licensed and distributed on a global scale following a new manufacturing model of global outsourcing and distribution. It is possible this model may be crimped by supply chain management, too.


  • Create a professional, concise business plan with clear business objectives.
  • Have a seasoned management team in place to grow the business and allow experienced external help to assist in global company growth.
  • Look for scalable green technologies that have global applications.
  • Have strategic investors from the targeted market segment.
  • Create attainable financial milestones.
  • Don’t underestimate the environmental externalities that can be monetized such as carbon credits, renewable energy credits, and other emissions reductions.
  • Offer shared saving opportunities so that risk is also shared.
  • Be willing to be flexible in management control and providing equity opportunities for investors.
  • Look well beyond ethanol and solar for next generation market opportunities.
  • Use the knowledge and expertise of the advisory board to leverage global projects.

This is the end of the beginning

Higher energy prices, national security concerns over oil, global warming, implementation of Kyoto Protocol, modernization of Asian economies, particularly China and India, and a growing movement of multinational corporations to go green and adopt clean technologies have pushed the energy and environmental dynamic faster than anyone imagined five years ago. The need to improve operational efficiency, reduce costs, eliminate waste and pollution have all coalesced to form a new market. It is not hindered by misconceptions that it is a bubble or dotcom boomlet. The energy value chain is now overlaid with an environmental value chain. The clean energy market is large, growing and global with higher rates of market acceptance than anyone anticipated. There are now over 600 green power programs in the US alone where consumer preference is for green energy. This trend is growing.

The competitive landscape has shifted. Government initiatives are helpful but the global capital markets are driving this boom. There will be high-profile market failures during this transition to cleaner technology and cleaner use of energy. The era of coal and oil is plateauing, and not in the production sense. These dirtier, carbon-intensive fuels are being replaced by renewables, cleaner technology, and higher efficiencies. By 2020, oil and coal will plateau in global usage. For example, as clean coal technology takes root withgasification of coal, there is not only an emissions reduction but also a higher efficiency gain from 30 per cent for conventional coal-fired plants to a higher range of 50 – 70 per cent. The same is true of hybridization of the transportation fleet featuring greater fuel economy and reduced tailpipe emissions. If we apply this business model to how cleantech permeates the entire energy value chain, it stands to reason that all applications – to be financially viable – will have to reduce energy consumption and be cleaner. This dual benefit is lost by many observers in the mainstream media. Using renewables to replace fossil fuels brings with it a third layer of benefit by offsetting carbon.

The new green business model is blurring the lines between hedge funds, private equity and venture capital. The arbitrage opportunities combined with the building out of new projects will lead to more incentives to invest in clean energy and clean technology. However, this is a transition that defies a quick fix. It will take decades to remediate the environmental damage done and shift to the more environmentally benign technologies of tomorrow. But the good news is that global investors are now focused on this sector!

An extract from ‘Cut Carbon, Grow Profits’ edited by Kenny Tang and Ruth Yeoh, published by Middlesex University Press and available from www.mupress.co.uk

Peter Fusaro is Chairman of Global Change Associates and co-founder of the Energy Hedge Fund Center LLC (www.enegyhedgefunds.com).

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Hedge Funds: Purpose, Business Model, and Strategies

  • Post author By Zuhair Imaduddin
  • Post date November 11, 2023
  • No Comments on Hedge Funds: Purpose, Business Model, and Strategies

hedge fund business model definition

Hedge funds have long been shrouded in mystery, earning a reputation as lucrative yet elusive vehicles within the financial landscape.

Hedge funds have gained increased attention over the years, with their involvement in financial markets drawing interest from investors, media, and the general public. However, many people still struggle to grasp what exactly hedge funds are and how they operate.

In this article, we will start to unravel the mysteries surrounding hedge funds, exploring their nature, workings, and the strategies they employ to generate profits.

Their Purpose

A hedge fund is privately managed investment fund that employs various investment strategies with the aim of generating superior returns, striving to deliver positive returns even in adverse market conditions.

Generally structured as limited partnerships or limited liability companies (LLCs), hedge funds are subject to less regulatory oversight compared to mutual funds. This relative lack of regulation allows hedge fund managers to implement complex investment strategies and respond quickly to market opportunities.

The Hedge Fund Business Model 

Hedge funds obtain investment funds from accredited investors . This may include individuals with a high income (usually over $200,000 annually) or a high net-worth (over $1 million), or large institutions such as banks, insurance companies, and investment funds.

Accredited investors are permitted to invest in hedge funds because they are considered to be sophisticated and able to bear the risks associated with these less regulated investment vehicles.

Hedge funds generate revenue from two main sources:

  • Management fees – investors pay a percentage of assets under management each year to cover operational expenses.
  • Performance fees – investors pay a percentage of profits generated as a reward for superior performance.

Investment Strategies

Hedge funds operate under the supervision of fund managers, who make investment decisions on behalf of the fund’s investors. These managers possess extensive financial expertise and employ a wide range of investment strategies to maximise returns while managing risk.

Hedge funds typically invest in traditional financial assets, stocks and bonds, as well as alternative instruments like options and futures contracts.

Investment strategies can be broadly categorised into directional and non-directional approaches.

1. Directional Strategies

1.1 Long/Short Equity

Long/short equity funds take long and short positions in stocks, aiming to profit from both rising and falling prices. By selecting undervalued stocks and simultaneously shorting overvalued stocks, hedge funds seek to generate positive returns regardless of the market’s overall direction.

Greenlight Capital, founded by David Einhorn , is known for its long/short equity strategy, and most notable for its short selling of Lehman Brothers  prior to the bank’s collapse in 2008.

1.2 Global Macro

Global macro funds analyse macroeconomic trends and geopolitical events to identify opportunities across multiple asset classes, such as currencies, commodities, and equities. They take positions based on their predictions of broad economic shifts, including interest rate changes, political developments, or currency fluctuations.

George Soros ‘s Quantum Fund is famous for its global macro strategy. In 1992, Soros famously shorted the British Pound and profited handsomely from the currency’s collapse. The UK had been part of the European Exchange Rate Mechanism, a system that aimed to maintain stable exchange rates in Europe. However, the British economy was in a recession, and Soros correctly bet that the Pound would have to be devalued.

1.3 Event-Driven

Event-driven funds focus on specific corporate events, such as mergers, acquisitions, bankruptcies, or restructuring, to profit from price discrepancies. By anticipating the impact of these events on stock prices, hedge funds aim to capture potential arbitrage opportunities.

Bill Ackman ’s hedge fund Pershing Square is famous for its event-driven strategy. For example, in 2004 Ackman took a large stake in Wendys, the fast-food chain, and successfully pressured management to spin off its Tim Hortons brand. This allowed Ackman to exit the trade with a substantial profit.

2. Non-Directional Strategies

2.1 Arbitrage

Arbitrage funds exploit price differentials between related assets, such as convertible bonds and their underlying stocks, to generate profits. By simultaneously buying and selling related instruments, they seek to capture the price discrepancy while minimising exposure to market movements.

Long Term Capital Management famously specialised in fixed income arbitrage, aiming to exploit price differences in the bond market. They would look for small price differences between similar bonds, and then buy the undervalued bond and short sell the overvalued bond, expecting the price of the bonds to converge over time. Since the price differences were tiny, and believing their strategy to be essentially risk free, LTCM used massive amounts of financial leverage to increase their expected returns. Unfortunately for them, LTCM was heavily exposed to the Russian bond market. When the 1998 Russian financial crisis caused bond price differences to widen rather than converge as expected, LTCM suffered huge losses, and required a multi-billion dollar bailout before ceasing operations.

2.2 Distressed Securities

Distressed asset or distressed debt funds invest in distressed companies or debt instruments that are trading below intrinsic value, with the potential for significant upside upon recovery. They conduct in-depth analysis to identify undervalued securities and aim to profit from their eventual price appreciation.

Oaktree Capital Management , co-founded by Howard Marks , is well known for its distressed debt investment strategy, often investing in companies undergoing bankruptcy or financial restructuring. For instance, in 2007 OCM invested in debt securities issued by Pierre Foods , a company in distress. During the restructuring process, OCM was able to convert the debt into a controlling equity stake in the company.

2.3 Quantitative

Quant funds employ mathematical models and statistical analysis to identify patterns and execute trades, often relying on computer algorithms for decision-making. These systematic strategies rely on quantitative models to identify market inefficiencies and generate trading signals.

Jim Simons ‘ Medallion Fund  is well-known for its quantitative investment strategy, and is reputedly one of the most successful hedge funds in history with an average annual return exceeding 35% since 1988. Unfortunately, the fund has been closed to outside investors since 2005, and is focused on building wealth for its current partners and employees.

2.4 Relative Value

Relative value funds seek to profit from pricing discrepancies between related securities, such as bonds and their derivatives, by taking advantage of market mispricing. They identify and exploit relative price disparities to generate returns.

Risk Management Strategies

Hedge funds employ risk management strategies to mitigate potential losses. They often use leverage to enhance returns but must carefully manage the associated risks. Risk management techniques may include:

  • Diversification: Spreading investments to reduce vulnerability to a single investment. Funds could diversify in various ways, such as across asset classes, industries, regions, currencies, or management styles.
  • Stop-losses: Predetermined points to sell an asset, preventing further loss.
  • Hedging: Using derivative instruments to offset potential losses in other investments.
  • Position Monitoring: Regularly reviewing and adjusting investment positions to manage the amount of capital at risk in any given investment.

Additionally, hedge funds typically have risk management teams that assess and analyse the risk exposures of the fund’s portfolio, implementing controls to limit downside risk.

The Bottom Line

Hedge funds serve as alternative investment vehicles that aim to generate superior returns for accredited investors. They typically do this by employing a combination of extensive financial expertise, a diverse range of investment strategies, the ability to adapt quickly in changing markets, and significant amounts of financial leverage.

Zuhair Imaduddin is an Innovation Development Analyst at JPMorgan Chase. He studied Industrial and Labor Relations at Cornell University. Zuhair is interested in leveraging technology to solve problems.

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hedge fund business model definition

SEC’s Dealer Crackdown Wins in Court, Alarming Investment Firms

By Matthew Bultman

Matthew Bultman

The Securities and Exchange Commission is on a winning streak after cracking down on “toxic” lending using a relatively novel legal theory—one that has spooked investment firms leery of being tagged as a securities dealer.

The SEC in recent years has sued numerous people who got shares in penny stock companies at a discount by lending them money. District courts in places like New Jersey, Minnesota, and Florida have sided with the agency and found the lenders illegally acted as unregistered securities dealers.

The SEC’s latest win came last week when the US Court of Appeals for the Eleventh Circuit held Ibrahim Almagarby, a Florida man whose business model was predicated on quickly flipping the stocks, met the definition of a “dealer.”

The Feb. 14 ruling is the first endorsement from an appeals court in the SEC’s crackdown, with additional cases on the horizon, including in the pivotal Second Circuit covering New York.

But some investment firms worry the decision creates confusion about who counts as a securities dealer. The label can bring steep compliance costs for firms that have to register with the SEC and more oversight from the industry-backed Financial Industry Regulatory Authority.

“What we know in terms of where the line is, is that it’s not where we thought the line was 10 years ago,” said Marc Indeglia, president of the Small Public Company Coalition, which represents investors in the small and microcap markets. “There are a lot of people who may need to reconsider whether or not what they’re doing requires a license.”

‘Toxic’ Lending

The SEC’s cases have focused on lenders who obtain a type of convertible debt—or debt that can be exchanged for stock—known as “market adjustable securities” from penny stock companies.

Unlike other convertible debt, attorneys say market adjustable securities allow lenders to change the debt into stock at a percentage discount from the market price.

Some of Almagarby’s debt, for example, was convertible at a 50% discount from the market price, according to the Eleventh Circuit. Brenda Hamilton, a securities lawyer at Hamilton & Associates Law Group, P.A. in Boca Raton, Fla., said she’s seen discounts as high as 70%.

Investment firms and other lenders say they are providing much-needed capital to risky companies that can’t obtain financing from traditional sources, and that the discounts are a hedge.

But critics call the loans “toxic.” Once the debt is converted to shares, the lender can quickly sell the shares into the public market, which can cause share prices to plummet and send penny stock companies into a “death spiral,” critics say.

The loans, which have been around since at least the late 1990s, started to become more prevalent in the early 2010s, securities lawyers said.

The SEC sued Almagarby in late 2017 under the theory he violated federal securities law because he didn’t register as a securities dealer. The SEC said Almagarby, who started his business in 2013 as a 29-year-old college student, acquired and sold billions of shares of penny stocks, netting close to $900,000 in profits. A wave of similar cases followed.

They were “the Hiroshima bomb” on so-called toxic lenders, Mark Basile of the Basile Law Firm P.C. said.

Basile’s firm has represented companies suing their lenders for violations of state usury law, among other things. The theory that lenders violated federal securities laws was “another avenue to attack these guys,” he said.

The SEC’s “dealer” theory is gaining traction in court.

Of the more than dozen civil cases the agency has brought alleging convertible note lenders acted as unregistered dealers, the SEC has won judgments in at least four, according to Bloomberg Law’s review. Several others have survived a motion to dismiss or settled.

Almagarby argued at the Eleventh Circuit that he didn’t have fair notice of the SEC’s “novel theory.” He also maintained he was a trader, exempt from dealer registration. The appeals court rejected both arguments.

The SEC’s cases are against “individuals who are selling billions of shares of stock of penny stock companies, usually in short periods of time,” Hamilton, the Boca Raton securities lawyer, said. “It’s different than the trader.”

But the agency’s arguments in such cases have raised concerns for investment advisers and private fund managers.

Industry groups including the Alternative Investment Management Association and Trading and Markets Project told the Eleventh Circuit they’re worried the SEC’s interpretation of a “dealer” could sweep in all sorts of financial firms. MFA, formerly known as the Managed Funds Association, filed a brief in another Eleventh Circuit case, arguing only people who execute orders for customers are dealers.

Private funds and proprietary trading firms are already grappling with rules the SEC adopted this month that could force dozens to register as dealers.

The Eleventh Circuit in Almagarby’s case took pains to differentiate his firm from institutional asset managers, saying the latter group doesn’t rely on the “rapid resale” of microcap shares for their income or use networks of finders to solicit microcap debtholders.

Still, the Eleventh Circuit acknowledged that drawing a line between dealers and traders was difficult. The decision creates “a significant amount of uncertainty” for small investors, hedge funds, and venture capital funds, Indeglia said, warning small businesses could lose access to a source of capital.

“If you don’t explain where the line is, how are people supposed to understand whether they’re breaking the law or not?” he said.

Bigger Targets

Almagarby was ordered by the appeals court to disgorge over $885,000 in profits, although it lifted the lower court’s penny-stock ban against him, in part because there was no fraud, the Eleventh Circuit said. Other defendants are at risk of losing much more financially.

Justin Keener, who is set to argue his case at the Eleventh Circuit in May, was alleged to have made $7.7 million in profits from an unregistered dealer business. In Chicago, the SEC is pursuing a case against John Fife and five of his companies, which are alleged to have made $61 million in profits.

Fife has argued in court filings the case against him is based on a “government bait-and-switch,” with a “new, made-for-litigation view” of what a dealer is. The district court denied his motion to dismiss in late 2021.

The SEC’s lawsuits to date have largely involved people and firms selling penny stocks traded in over-the-counter markets. Basile said he expects the SEC will next turn its attention to larger debt arrangements with small-cap companies listed on a major stock exchange.

“It’s just a matter of time and who they target,” Basile said.

Defendants’ legal arguments could be narrowing. The Eleventh Circuit’s decision in Almagarby, together with some previous, but related, cases in other circuit courts, have addressed the “arguments that the funders have been using to try to defeat these claims,” Basile said.

An open question is how the Second Circuit will address the “dealer” theory in these types of cases. The circuit court’s jurisdiction includes New York, where various lawsuits have been brought by the SEC and by companies.

“Once the Second Circuit decides this, it will shut the door completely on all these arguments,” Basile said.

The Almagarby case SEC v. Almagarby , 11th Cir., No. 21-13755.

To contact the reporter on this story: Matthew Bultman in New York at [email protected]

To contact the editor responsible for this story: Michael Smallberg at [email protected] ; Maria Chutchian at [email protected]

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U.S. regulator wins key appeal challenging definition of securities ‘dealers’

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hedge fund business model definition

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Alison Frankel has covered high-stakes commercial litigation as a columnist for Reuters since 2011. A Dartmouth college graduate, she has worked as a journalist in New York covering the legal industry and the law for more than three decades. Before joining Reuters, she was a writer and editor at The American Lawyer. Frankel is the author of Double Eagle: The Epic Story of the World’s Most Valuable Coin.

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What Is a Hedge?

  • How It Works

Hedging With Derivatives

  • Example With a Put Option

Hedging Through Diversification

Spread hedging, hedging and the everyday investor, the bottom line.

  • Trading Strategies
  • Advanced Strategies & Instruments

Hedge Definition: What It Is and How It Works in Investing

hedge fund business model definition

Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).

hedge fund business model definition

Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

hedge fund business model definition

To hedge, in finance, is to take an offsetting position in an asset or investment that reduces the price risk of an existing position. A hedge is therefore a trade that is made with the purpose of reducing the risk of adverse price movements in another asset. Normally, a hedge consists of taking the opposite position in a related security or in a derivative security based on the asset to be hedged.

Derivatives can be effective hedges against their underlying assets because the relationship between the two is more or less clearly defined. Derivatives are securities that move in correspondence to one or more underlying assets. They include options, swaps, futures, and forward contracts. The underlying assets can be stocks, bonds, commodities, currencies, indexes, or interest rates. It’s possible to use derivatives to set up a trading strategy in which a loss for one investment is mitigated or offset by a gain in a comparable derivative.

Key Takeaways

  • A hedge is a strategy that seeks to limit risk exposures in financial assets.
  • Popular hedging techniques involve taking offsetting positions in derivatives that correspond to an existing position.
  • Other types of hedges can be constructed via other means like diversification . An example could be investing in both cyclical and countercyclical stocks.
  • Besides protecting an investor from various types of risk, it is believed that hedging makes the market run more efficiently.

Investopedia / Madelyn Goodnight

How a Hedge Works

Using a hedge is somewhat analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding—to hedge it, in other words—by taking out flood insurance. In this example, you cannot prevent a flood, but you can plan ahead of time to mitigate the dangers in the event that a flood occurs.

There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk , it also chips away at potential gains. Put simply, hedging isn’t free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policyholder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their heads.

In the investment world, hedging works in the same way. Investors and money managers use hedging practices to reduce and control their exposure to risks. To appropriately hedge in the investment world, one must use various instruments in a strategic fashion to offset the risk of adverse price movements in the market. The best way to do this is to make another investment in a targeted and controlled way. Of course, the parallels with the insurance example above are limited: In the case of flood insurance, the policyholder would be completely compensated for her loss, perhaps less a deductible. In the investment space, hedging is both more complex and an imperfect science.

A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100%  inversely correlated to the vulnerable asset. This is more an ideal than a reality on the ground, and even the hypothetical perfect hedge is not without cost. Basis risk refers to the risk that an asset and a hedge will not move in opposite directions as expected. “Basis” refers to the discrepancy.

Derivatives are financial contracts whose price depends on the value of some underlying security. Futures, forwards, and options contracts are common types of derivatives contracts.

The effectiveness of a derivative hedge is expressed in terms of its delta , sometimes called the hedge ratio. Delta is the amount that the price of a derivative moves per $1 movement in the price of the underlying asset.

The specific hedging strategy , as well as the pricing of hedging instruments, is likely to depend upon the downside risk of the underlying security against which the investor would like to hedge. Generally, the greater the downside risk, the greater the cost of the hedge. Downside risk tends to increase with higher levels of volatility and over time; an option that expires after a longer period and is linked to a more volatile security and thus will be more expensive as a means of hedging.

In the STOCK example above, the higher the strike price, the more expensive the put option will be, but the more price protection it will offer as well. These variables can be adjusted to create a less expensive option that offers less protection, or a more expensive one that provides greater protection. Still, at a certain point, it becomes inadvisable to purchase additional price protection from the perspective of cost-effectiveness.

Various kinds of options and futures contracts allow investors to hedge against adverse price movements in almost any investment, including stocks, bonds, interest rates, currencies, commodities, and more.

Example of Hedging With a Put Option

A common way of hedging in the investment world is through put options. Puts give the holder the right, but not the obligation, to sell the underlying security at a pre-set price on or before the date it expires.

For example, if Morty buys 100 shares of Stock PLC (STOCK) at $10 per share, he might hedge his investment by buying a put option with a strike price of $8 expiring in one year. This option gives Morty the right to sell 100 shares of STOCK for $8 anytime in the next year.

Let’s assume he pays $1 for the option, or $100 in premium. If STOCK is trading at $12 one year later, Morty will not exercise the option and will be out $100. He’s unlikely to fret, though, because his unrealized gain is $100 ($100 including the price of the put). If STOCK is trading at $0, on the other hand, Morty will exercise the option and sell his shares for $8, for a loss of $300 ($300 including the price of the put). Without the option, he stood to lose his entire investment.

Using derivatives to hedge an investment enables precise calculations of risk, but it requires a measure of sophistication and often quite a bit of capital. However, derivatives are not the only way to hedge. Strategically diversifying a portfolio to reduce certain risks can also be considered a hedge, albeit a somewhat crude one. For example, Rachel might invest in a luxury goods company with rising margins. She might worry, though, that a recession could wipe out the market for conspicuous consumption. One way to combat that would be to buy tobacco stocks or utilities, which tend to weather recessions well and pay hefty dividends.

This strategy has its tradeoffs: If wages are high and jobs are plentiful, the luxury goods maker might thrive, but few investors would be attracted to boring countercyclical stocks, which might fall as capital flows to more exciting places. It also has its risks: There is no guarantee that the luxury goods stock and the hedge will move in opposite directions. They could both drop due to one catastrophic event, as happened during the financial crisis, or for two unrelated reasons.

In the index space, moderate price declines are quite common and highly unpredictable. Investors focusing on this area may be more concerned with moderate declines than with more severe ones. In these cases, a bear put spread is a common hedging strategy.

In this type of spread, the index investor buys a put that has a higher strike price. Next, she sells a put with a lower strike price but the same expiration date. Depending on how the index behaves, the investor thus has a degree of price protection equal to the difference between the two strike prices (minus the cost). While this is likely to be a moderate amount of protection, it is often sufficient to cover a brief downturn in the index.

Risks of Hedging

Hedging is a technique used to reduce risk, but it’s important to keep in mind that nearly every hedging practice will have its own downsides. First, as indicated above, hedging is imperfect and is not a guarantee of future success, nor does it ensure that any losses will be mitigated. Rather, investors should think of hedging in terms of pros and cons.

Do the gains of a hedging strategy outweigh the added expense it requires? It’s worth remembering that a successful hedge is often designed only to prevents losses, so gains alone may not be sufficient measure of benefit. While many hedge funds do make money, hedging strategies are usually employed in combination with primary investing strategies.

For most investors, hedging will never come into play in their financial activities. Many investors are unlikely to trade a derivative contract at any point. Part of the reason for this is that investors with a long-term strategy, such as individuals saving for retirement, tend to ignore the day-to-day fluctuations of a given security. In these cases, short-term fluctuations are not critical because an investment will likely grow with the overall market.

For investors who fall into the buy-and-hold category, there may seem to be little to no reason to learn about hedging at all. Still, because large companies and investment funds tend to engage in hedging practices on a regular basis, and because these investors might follow or even be involved with these larger financial entities, it’s useful to understand what hedging entails to better be able to track and comprehend the actions of these larger players.

What Is Hedging Against Risk?

Hedging is a strategy that tries to limit risks in financial assets. It uses financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.

What Are Some Examples of Hedging?

Purchasing insurance against property losses, using derivatives such as options or futures to offset losses in underlying investment assets, or opening new foreign exchange positions to limit losses from fluctuations in existing currency holdings while retaining some upside potential are all examples of hedging. 

Is Hedging an Imperfect Science?

In investing, hedging is complex and thought of as an imperfect science. A perfect hedge is one that eliminates all risk in a position or portfolio. In other words, the hedge is 100% inversely correlated to the vulnerable asset. But even the hypothetical perfect hedge is not without cost.

Hedging is an important financial concept that allows investors and traders to minimize various risk exposures that they face. A hedge is effectively an offsetting or opposite position taken that will gain (lose) in value as the primary position loses (gains) value. A hedge can therefore be thought of as buying a sort of insurance policy on an investment or portfolio. These offsetting positions can be achieved using closely-related assets or through diversification. The most common and effective hedge, however, is often the use of a derivative such as a futures, forward. or options contract.

hedge fund business model definition

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The 10 stocks most popular with hedge funds right now, according to Goldman Sachs

  • The quarterly 13F filings with the SEC reveal exactly what hedge funds on Wall Street own.
  • Goldman Sachs has compiled the data and highlighted the most common themes across hedge funds.
  • Listed below are the top 10 most commonly held stocks by hedge funds, according to Goldman Sachs.

Insider Today

Hedge funds on Wall Street manage trillions of dollars of assets, so it pays to pay attention to exactly what they are buying and selling — especially when their top holdings are beating the market.

Quarterly 13F filings made with the SEC reveal exactly what hedge funds on Wall Street own, and Goldman Sachs has compiled and tallied the data, highlighting the most common themes across 722 hedge funds that have $2.6 trillion of gross equity positions.

So far this year, hedge funds are having a great stretch of performance. Goldman's hedge fund "VIP" list, known as "very important positions", tracks the 50 stocks that matter most to hedge funds. These are the stocks that most frequently appear among the ten largest holdings of hedge funds.

The VIP hedge fund basket is up 8.7% year-to-date, outpacing the S&P 500's return of about 5.1% over the same time period.

"The Hedge Fund VIP basket has outperformed the S&P 500 year-to-date and has outperformed the S&P 500 in 59% of quarters since 2001. The basket has been a strong historical performer at the cost of high volatility," Goldman said in a note on Tuesday.

These are the top ten most commonly held stocks by Wall Street hedge funds, according to Goldman Sachs. 

Ticker: VISA YTD Performance: 8% Hedge funds with stock as top 10 holding: 23

9. Salesforce

Ticker: CRM YTD Performance: 11% Hedge funds with stock as top 10 holding: 25

8. Pioneer Natural Resources

Ticker: PXD YTD Performance: 3% Hedge funds with stock as top 10 holding: 27

Ticker: AAPL YTD Performance: -4% Hedge funds with stock as top 10 holding: 29

6. Uber Technologies

Ticker: UBER YTD Performance: 32% Hedge funds with stock as top 10 holding: 32

Ticker: NVDA YTD Performance: 47% Hedge funds with stock as top 10 holding: 51

4. Alphabet

Ticker: GOOGL YTD Performance: 2% Hedge funds with stock as top 10 holding: 53

3. Meta Platforms

Ticker: META YTD Performance: 37% Hedge funds with stock as top 10 holding: 87

2. Microsoft

Ticker: MSFT YTD Performance: 8% Hedge funds with stock as top 10 holding: 96

Ticker: AMZN YTD Performance: 12% Hedge funds with stock as top 10 holding: 98

hedge fund business model definition

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  1. What is Hedge Fund

    hedge fund business model definition

  2. What is Hedge Fund

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  3. What Is a Hedge Fund?

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  4. typical US hedge fund structure

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  5. What Are Hedge Funds And How Do They Work?

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  6. What are Hedge Funds? Definition, Features, Strategies, Reasons

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