“Hedge funds, private equity and venture capital funds have played an important role in providing liquidity to our financial system and improving the efficiency of capital markets. But as their role has grown, so have the risks they pose.” Jack Reed
During the past few decades, hedge funds have evolved from obscure investment vehicles to highly popular investments in the global market. Institutional investors including pension funds, endowments, insurance companies, private banks, and high-net-worth individuals and families are attracted to hedge funds. Not surprisingly, hedge funds have drawn considerable attention from investors, practitioners, and academics. The period after the financial crisis of 2007-2008, also called the Global Financial Crisis (GFC), was tumultuous for hedge funds and resulted in startling headlines. Today, hedge funds have become, and are likely to remain, an essential part of the financial landscape. After taking a brief historical look at hedge funds, we discuss current hedge fund debates and controversies, and take a glimpse into their future prospects.
A hedge fund is a pooled investment vehicle that uses various strategies to invest in different asset classes. Professional investment managers administer these privately offered funds. Hedge funds attempt to produce above-average investment returns using many strategies and tools ranging from traditional stock-picking to complex derivative and arbitrage plays.
Characteristics of Hedge Funds
Several key characteristics differentiate hedge funds from other types of pooled investments such as mutual funds as well as other alternative investments including private equity. First, not all investors have access to hedge funds. In the United States, for example, hedge funds are only open to “accredited” or qualified investors. Until recently, being qualified as an accredited investor simply involved having or making a sufficient amount of money. As of February 1, 2016, the US requirements changed. The Financial Services Committee and the US House of Representatives passed HR 2187, known as the Fair Investment Opportunities for Professional Experts Act. Now individuals can qualify as accredited investors based on measures of sophistication such as having a minimum amount of investments, certain professional credentials, and experience investing in exempt offerings, being knowledgeable employees of private funds, or by passing a qualifying accredited investor examination. The expanded definition of an accredited investor still continues to exclude many, if not most, investors.
Second, hedge funds have wider investment latitude than many other types of pooled investments. For example, hedge funds are highly flexible in their investment options because they can use financial instruments generally beyond the reach of mutual funds. Hence, they can engage in more aggressive strategies and positions, such as short selling, trading in derivative instruments including options, and using leverage (borrowing) to enhance the risk/reward profile of their bets. However, a hedge fund does not necessarily use hedging techniques given that the classification scheme for hedge funds has broadened considerably over time. The only limitation to a hedge fund’s investment universe is its mandate. Thus, some hedge funds can invest in anything including stocks, derivatives, land, real estate, and currencies. By contrast, most mutual funds follow the traditional “long only” model of investing in that they mainly stick to investing in stocks or bonds. Few mutual funds short-sell stocks because they face some restrictions and the higher costs of operating a long-short portfolio.
Third, hedge funds often use leverage. That is, they can borrow funds to potentially increase their returns. However, leverage can destroy hedge fund returns as seen during the GFC.
Fourth, the compensation or fee structure differs for hedge funds. Besides charging various fees, which are associated with more traditional pooled investments such as mutual funds, hedge funds also have a performance or incentive fee. For example, a once common fee structure called “2 and 20” enabled hedge fund managers to charge a flat 2 percent of total asset value as a management fee and an additional 20 percent of any profits earned. However, these fees have trended lower in recent years.
Finally, hedge funds are lightly regulated. Yet, as a result of the GFC, hedge funds have come under increased regulatory scrutiny. For example, as of July 2010, the Dodd-Frank Wall Street Reform Act requires hedge funds with more than $150 million in assets to register with the Securities and Exchange Commission (SEC). Further, under the “Volcker Rule”, banks are now restricted in their ability to sponsor hedge funds and are prohibited from proprietary trading of them.