Hedge funds are famous and infamous at the same time; they are big ego-ed and often – to outsiders at least - incomprehensible and opaque in their dealings. They do things regular funds can’t or aren’t allowed to do and take bigger risks. They are the envy of many a regular investment manager. But hedge funds are exciting too, there are no two ways about that.
Some fast facts first. Global assets under management (our savings and investments) are about $111.2 trillion (yes trillion) today and are expected to reach about $145.4 trillion in 2025. Of this enormous amount of money, $4.5 trillion is allocated to hedge funds, most of them based in the US. There are about 26,896 registered hedge funds globally, with only about 1,467 managing assets of $1 billion or more.
What is the difference between regular investment funds and hedge funds?
The regular asset management industry tend to buy and hold stocks, bonds and real estate and they can only buy and sell real assets. Short selling is not permitted as it is too risky for the average investor/saver/pension-holder. Fees tend to be low. Investors in regular funds can mostly take their money out of the funds easily, but some fees for early redemption could apply. Mutual funds are not allowed to refuse a shareholder’s request for redemption.
So, what sets hedge funds apart from the large bulk of mutual funds? The most important distinction between hedge funds and their regular asset managing counterparts is that hedge funds can short sell the market, meaning they can benefit from both the market going up and down. They use a variety of strategies and financial engineering (derivatives) to pursue profit and can invest in much wider range of asset classes. Hedge funds take bigger risks and hence charge bigger fees than mutual funds. Hedge fund clients/investors must be wealthy enough to withstand the potential losses and knowledgeable enough to understand the investment strategies and the associated risks.
Hedge fund managers’ remuneration is heavily geared towards their performance; they were – for a long time - entitled to keep a whopping 20% of the profits for themselves (this in addition to charging a 1.4% management fee to cover expenses). This reward structure is only applicable to hedge funds and the industry hence attracted the best and boldest asset managers out there and in the wild investment days pre the 2008 Crisis, many hedge fund managers turned into billionaires and were treated like rock stars.
Another, quite important difference between mutual funds, exchange traded funds (ETFs) and hedge funds is that hedge funds can effectively block their investors from redeeming their investment. Many a hedge fund has done so in the past and has forced investors to stay invested in a fund even when losses accumulated. The reason for this is to avoid the fund having to sell assets in a downturn for a discount to repay investors, potentially further increasing losses. Investors in hedge funds should be prepared to stick with their manager through thick and thin, another reason not to put your last chips with a hedge fund.
Hedge funds are rather disliked by the general investment community: by ‘normal’ fund managers first of all because of the big sums hedge fund managers take home and their loud and luxurious lifestyles. But the biggest bean of contention is their shorting strategies and the consequential downfall of companies targeted by their short selling, which was on full display with the 2021 GameStop short selling saga, which was also the first time a hedge fund ‘lost’ and possibly a turning point?
Elon Musk and Tesla have been plagued for years by short selling and Musk famously sent the Tesla ‘shorters’ shorts with the Tesla logo as Christmas gifts. Big (new) short positions against Tesla recently have been taken by Michael Burry – he who was portrayed as the shorter of the US housing market in the film the Big Short – and by Bill Gates, dragging down regular Tesla investors with them in this billionaire food fight, exactly what every normal investor hates and why big hedge funds and shorters are bad news for your own investment portfolio.
But, despite the cynical nature of short selling, it remains a profitable business in the 2022 bear market and many hedge funds are indeed doing well in this environment. Notwithstanding some of the much-deserved criticism, hedge funds are exciting, high velocity and rewarding places to work. You just have to accept some hate coming your way.
Links & sources:
https://www.pwc.com/ng/en/press-room/global-assets-under-management-set-to-rise.html
https://www.barclayhedge.com/solutions/assets-under-management/hedge-fund-assets-under-management/
https://www.hedgefundassoc.org/about_hedge_funds/
https://www.preqin.com/academy/lesson-3-hedge-funds/hedge-fund-fees-types-and-structures
https://www.talksforteens.com/finance/meme-stocks-is-gamestop-back
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