Before 1949, hedge funds didn’t exist. It was during the bear market of that year that the first fund was developed. The concept was to offset the loss in value of traditional stock portfolios during market declines.

To accomplish the objective, a hedge fund uses techniques and strategies other than direct equity investments across the board. Consequently, hedge funds tend to involve the use of sophisticated instruments such as derivatives, or the purchase and sale of foreign currencies.

George Soros, Hedge Fund Manager

A derivative is simply a financial instrument derived from a fundamental asset. A future’s contract is a derivative, as is an option. One is making an agreement to buy or sell some type of asset, or some component of an asset, without actually taking delivery.

Derivatives tend to be more volatile than their underlying assets. Foreign currency prices are also volatile, especially when leverage is used in the transaction.

Investment operations in a hedge fund utilizes a number of strategies. Examples include: event-driven, Global macro, relative value (economics) and directional strategies.

Because of the nature of the instruments which hedge funds rely on, these funds must be privately managed. And as most of us know, hedge fund managers earn high fees for their efforts.

Since a hedge fund is more speculative than straightforward equities, and involve often complex strategies and financial instruments, the cost of entry is usually quite high: $1 million, $5 million, even $20 million. Thus these funds are usually available only to institutions, which constitute about 61% of hedge fund holdings, and qualified eligible persons (QEP).

Due to their size, and the rules of trading, hedge funds can affect the overall market. They are not regulated, although this may change in the future.

Hedge Fund History

After the first funds were established, the industry grew and robust trading provided higher than average returns to investors. This growth lasted until the downturn of 69 to 70. After a brief period of growth, funds began to lose heavily during the stock market crash of 73 to 74. By the nineties, the number of hedge funds had grown considerably, and their strategies expanded into new territories such as fixed income, quantitative, credit arbitrage, distressed debt, multi-strategy and, currency arbitrage

Of the $2 trillion currently invested in hedge funds, about 65% is held by the top 225 hedge fund managers in the US. The largest funds include Bridgewater Associates JP Morgan Chase Paulson & Co, Brevan Howard, and Soros Fund Management.

Fee Structure

Like a managed account, a hedge fund primarily charges two types of fee: the management fee, and the performance fee. Hedge funds, however, charge annual performance fees, rather than monthly high-water fees typically charged by managed accounts.

Their performance fees can run as high as 50%. Management fees can run from 1% to 4% per annum. The standard, however, is 2% of Net Asset Value.

High water marks and hurdle rate calculations are the two principal methods of calculating the performance fees of a hedge fund.

Hedge fund structure

The legal structure of hedge funds is fairly simple, and somewhat comparable to a limited partnership. At the “top” is the management company which runs the fund and takes care of administrative operations, reporting, strategy decisions, broker relations, investor relations, and any other executive functions associated with the fund. The fund itself is much like a large brokerage account with large holdings.

Some functions of the fund are administered by specialized service providers. These include the Prime broker, the Administrator, and the Distributor (i.e. the marketer).

Hedge fund risk management

The “ideal” hedge fund will have virtually zero correlation to the performance of standard markets or indices such as the S&P 500 or the DJI. Zero correlation does not mean zero risk. Even so, hedge funds during the period of 1993 to 2010 were approximately 1/3 less volatile than the S&P.

In most countries, only sophisticated investors who are familiar with the risks involved can participate in hedge funds. The managers themselves, by virtue of their expertise in hedging, have deep understandings of risk and will use well-defined systems to ameliorate risk as much as possible.

Some funds employ “risk officers.” Their sole function is to evaluate the risks of the fund’s holdings. In doing so they approach risk from a number of perspectives and employ risk models to determine a fund’s specific vulnerabilities.

How to Invest in a Hedge Fund through a Managed Account

Some hedge funds allow account managers to acquire an interest in their funds. This practice is gaining popularity, as it allows retail investors to participate at levels much less than the $1 million or more minimums generally set by the hedge fund managers.

The Review lists a number of managers who take stakes in hedge funds. When you request a disclosure document (D-Doc) from a manager, the document will advise you of any managed account interests and allocations in any hedge fund.