Hedge Funds are evil, right? Go on, you know you want to say yes. Almost everyone has an opinion about them, but very few people can actually tell you what they are.
Indeed, there’s am awful lot of nonsense written about Hedge Funds, and this piece might just end up being a worthy addition to that body of baloney. But, the intention is somewhat different.
The objective behind this piece is to provide a quick look at where the modern hedge fund started; what they are; how they work; the mechanics of participation; and who traditionally has put their money into them.
Of course, this piece is a necessary simplification of what is a fascinating aspect of the alternative investment universe.
To begin at the beginning
In 1966 Carol J. Loomis[i] blew the lid on one of the best kept investment secrets of the 20th century.
In an article penned for Fortune titled “The Jones that nobody keeps up with”, Loomis revealed that over a five year period a fund run by Alfred Winslow Jones had consistently outperformed the Fidelity Fund, the most successful mutual fund of that time, by a remarkable 44%.
Not only that, but between 1956 and 1966 the Jones fund had outperformed the Dreyfus Fund, the best performing mutual fund of that decade, by a massive 87%.
Jones was born in Melbourne, Australia, but from the age of four he lived in the USA. He graduated from Harvard in 1923, and before becoming involved in the finance industry he toured the world working on steamships. He was to serve as a diplomat in Germany, and also worked as a journalist covering the Spanish civil war.
In 1941, with conflict raging in Europe, Jones returned to the USA. He then studied for, and obtained a doctorate in sociology at Columbia University, and became a reporter for Fortune.
His thesis, Life, Liberty and Property, is a reference text in sociology.
In 1949 Jones formed a company, A. W. Jones & Co., arguably the first modern Hedge Fund.
Robert A. Jaeger characterised the fund as “an opportunistic equity hedge fund”, that relied heavily on discerning stock picking abilities, combined with bets on long positions (rising prices) and short positions (falling prices).
In 1952 the fund was converted into a limited partnership, and during the 50s other such partnerships were set up, including the sage of Omaha’s Buffet Partners, and WJS Partners, founded by Walter Schloss.
What they are; how they work
Hedge funds are loosely regulated, exclusive and limited-membership investment clubs, usually run as partnerships or as corporations. They focus on absolute returns on investments, for themselves and their members, regardless of market conditions.
Direct participation in Hedge Funds is theoretically limited to between 100 or 500 investors, depending on the class of investor. Moreover, because of the unregulated status of most hedge funds, they are not allowed to actively market their products, so they have to use more exclusive means to attract investors, typically word of mouth.
Hedge Funds typically invest in traditional securities, such as stocks, bonds and commodities, but they can also invest in real estate, art, wine or any number of other non-traditional areas of investment. In fact, they are free to use virtually any pick and mix of strategies from the entire range of investment possibilities.
That said, a lot of Hedge Funds will opt for a specific investment strategy and will stick with that strategy for the life-time of the fund.
So what’s in it for the Hedge Fund managers and administrators?
Hedge Fund Managers typically charge a management fee of between 1and 3 percent of the value of the assets under management, regardless of performance. They may also – almost always in the past – charge a performance fee, which can start at around 20 percent of any fund gains above a certain minimum performance hurdle or target value. Managers also generally ‘eat their own dog food’, in that they will also invest in their own Hedge Fund.
Investors in Hedge Funds are informed of the value of their investments via a statement that shows the calculated value of shares in the fund, the Net Asset Value (the NAV). This can be calculated monthly, quarterly or even yearly, depending on the fund. In addition funds are free to choose if they wish to publicly disclose performance figures or not.
Some hedge funds may require additional fees and commissions, and may impose lock up periods, and strict and narrow redemption periods. They may also reject some applications for subscriptions without giving any reasons, and they may also forcibly redeem shares held, and without having to justify their actions.
In addition, some hedge funds use equalization methods – and there are a number of variants – to equitably distribute hedge fund fees amongst its partners, yet other hedge funds do not use equalization methods at all.
The mechanics of participation
So, briefly, how do you get to invest in a Hedge Fund (subscribe), how do you liquidate that participation (redeem), and what happens between ‘subscription’ and ‘redemption’.
Offer: A Hedge Fund details what’s involved in a particular offer in an ‘Offering Memorandum’, also known as a ‘private placement memorandum’. This is typically an ‘enriched’ business plan tied to a specific issuance of shares in a fund. It basically sets out the stall.
Subscription: In order to subscribe to a fund the potential participant in the fund signs up to a subscription agreement, and the conditions laid out in that agreement. Conditions may cover aspects such as minimum subscription amounts; minimum share increments, rules governing the liquidation of participation in the fund; management and performance fees; and, so on and so forth.
Redemption: This is the liquidation of shares in a fund. Typical redemption points can occur from anything from 15 days to up to 180 days, and sometimes more than this, depending on the fund and the rules related to lock-ups, redemption. In addition, redemption options may be linked to other financial charges, penalties and constraints.
So what happens between subscription and redemption?
Custody: A hedge fund subscriber may wish to use the services of a large and reputable financial service provider to act as custodian of their hedge fund shares. In addition to holding securities for safekeeping, most custodians also offer other services such as account administration, transaction settlements, collection of dividends and interest payments, tax support and foreign exchange. (Source: Investopedia).
Dividends: It is very uncommon for hedge funds to pay dividends, as any accruable earnings are realized upon redemption of the shares. However, some fundsdo incentivize the maintenance of subscriptions through the payment of dividends.
Calculating NAV: Periodically – or even on a real-time basis – a hedge fund will recalculate the Net Asset Value of the fund shares. This is done by dividing total value of all securities held by the number of shares. The NAV is more or less subjective in cases where the associated assets are more or less liquid. An extreme example of this may be the calculation of a NAV that has to take into account the theoretical market value of art.
Of course, the mechanics of participation is typically more involved and complex than this.
Who plays, who pays
Investors in Hedge Funds are individuals and institutions (such as foundations, endowments, family offices, pension funds, insurance companies, private banks and funds of funds).
One of the key criteria in the Hedge Fund business is that only people and institutions with money can invest in them. On face value this prerequisite seems a tad bizarre, but there are some very valid reasons for it.
In order to be able to invest in Hedge Funds an investor will need to meet certain legal requirements. They have to be either a credited investor or a qualified purchaser. The qualification is based on net worth and individual income. The qualified purchaser has a higher net worth than a credited investor.
In my opinion the practical rules of Hedge Funds are clear, albeit wrapped up in more indirect language. The biggest rule is: ‘do not put any money into a Hedge Fund that you are not prepared to lose’. The second big rule is: ‘only subscribe to a Hedge Fund with money that you can lose and without the risk of significantly and adversely affecting your lifestyle.’
Of course, this didn’t stop people from jumping on the Hedge Fund bandwagon with little or no clue about what they were getting themselves into.
That’s all folks
Hedge Funds are subject to a dire circle of misleading, banal and frequently reactionary published and public opinion. Which is unfortunate, because it ignores that almost all of the Hedge Funds reflect a culture and style of their managers and administrators, and that in the business there is a a lot of plurality and diversity.
Some Hedge Funds have been the epitome of sharp investment practice, hubris and good old fashioned albeit legal duplicity.
There are macho funds, and non-macho funds, high risk funds and risk-averse funds, highly leveraged funds and funds that use little or no leverage.
Some funds are discrete, some are ugly, some are charming, and some are boisterous and incredibly aggressive. Some are socially responsible, and others might ask “is social responsibility part of the NAV calculation?”
Some funds delight in planning raids on markets, mounting shark attacks on political systems and find ‘justifiable’ enchantment in destabilizing economies and currencies. Other Hedge Funds – in my opinion the vast majority – would never dream of doing such things.
Furthermore, some funds actively encourage responsible investment in developing countries and in other ethical investment strategies. Moreover, there are plenty of examples of funds that sit somewhere between the extremes, so there is no one size fits all when it comes to characterizing funds.
But whatever the style of the Hedge Fund, at the heart of each individual Hedge Fund culture is the culture of the team leaders and team players.
So, are Hedge Funds intrinsically evil?
No, I don’t think so. But that sort of headline grabs a lot of people’s attention, and frequently for all the wrong reasons.
Thank you so much for reading.
[i] Loomis, Caroll J. The Jones that nobody keeps up with. Fortune, April 1966
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