Hedge funds are pooled funds, it comprises a professional fund manager and an investor or multiple investors. The fund manager is often known as the general partner and the investor/investors are known as the limited partner(s), and the money that is invested into the fund is pooled in by both of these parties.
WHERE DOES A HEDGE FUND GET ITS MONEY FROM?
Since a hedge fund is essentially a coalition investment of two parties, the general partner is the one who draws out the investment strategies and forms the structure of the hedge fund. He chooses where to invest and makes all the investment-related decisions of the fund. This person would then seek out potential investors and persuade them to invest their money.
Once there is sufficient amount of investment, the general partner or the firm that the fund is being managed by will earn money based on its Assets Under Management (i.e. is the total market value of the investments that the individual or the firm manages on behalf of their clients) and the performance of their fund. The more money a fund can collect and the better it performs, the more it can make for itself.
Hedge funds source their money from high net worth clients, corporations, foundations, endowments, and pension funds. Hedge funds do not look for small investors as they require a larger amount of investment than what an average person is willing to make. This is one of the main differences between a hedge fund and a mutual fund. Sometimes, the initial investment comes from the general partner themselves and they do this to get the fund started and establish a good investing record to attract clients.
HOW DO HEDGE FUNDS MAKE MONEY?
Hedge funds use a variety of ways to make money. Let us take a look at some of them:
- Two and Twenty
This is a common method of making money for the individual or the firm. It is a standard fee arrangement where the client is charged a management fee and also a performance fee.
The “two” refers to 2% of the Assets under management and is the management fee charged for the hedge fund annually.The “twenty” refers to 20% of the profits made through the hedge fund investments, above and over a pre-set benchmark.
This mechanism of fee-charging has come under fire many investors as little as 2% of the assets under management can add up to large amounts and if the returns aren’t as profitable as expected, the investment firm still gets a hefty amount of money through that 2%.
- Using Leverages
Borrowed capital to fund the management assets are called leverages. Many general partners and hedge fund investment firms use this as a means of gathering funding. They leverage an investor’s money and use the credit to increase their funds. Leverages can attract a lot of capital for asset collection but it can also magnify losses and can increase the risk of failure.
- Long and Short Equity
Long and Short equity is a strategy by which the investor takes long positions or buy equities that are expected to increase in value and short positions when the equity is expected to decrease in its value. This strategy helps in minimizing market risks and has proven to be profitable on a net basis.
HOW DO HEDGE FUNDS DIFFER FROM PRIVATE EQUITY FUNDS?
Hedge funds and private equity funds also seem very similar in ways that they both look for high net worth investors and look forward to paying general and managing partners an annual fee along with a part of the profits.
But they do differ in some aspects like private equity funds, unlike hedge funds, focus on long term potential of the portfolio of their clients and they mostly partner with companies and not individuals.
Another difference can be spotted in their investment structure wherein hedge funds are open-ended, implying that the investors can add more money whenever they wish. Private equity funds on the other hand are close-ended, implying that no money can be added by the investor past the initial period of investments.
Hedge funds focus on more liquid assets, therefore it is easier for the investor to cash out the fund whenever they want. But in case of private equity funds, they are long term investments and cannot be cashed out until a fixed amount of time which can range anywhere from 3-4 years to even 7-10 years.
This also leads to different lock-up periods for both of these funds. A lock-up period is a time span within which the investors are not allowed to cash out or sell shares of their investment.
For hedge funds it is shorter and ends within a year or two, but for private equity funds, it is much longer and can span up to 4-7 years. Hedge fund investors also take a greater risk while investing in the funds, whereas private equity funds are comparatively low risk as they are long term investments.
IMPACT OF COVID 19 ON HEDGE FUNDS
According to a Bloomberg report, three out of every four hedge funds have lost money and some of them have even come down to as low as 40% of their collection in March itself. Only a small number of hedge funds have been able to overcome the losses caused due to the coronavirus and thrive through the pandemic.
The profits from such funds were derived out of a variety of approaches, ranging from credit, debt leverages, and long/short equity. But most of them have failed to keep up with the economic losses and have fallen into the market turmoil. Some of the popular ones like Ray Dalio and Michael Hintze are examples of such funds. A report by the Hedge Fund Research Inc. said that clients have withdrawn a net of $33 billion in the first quarter of 2020. This figure is said to be the highest money withdrawn in a decade.
HOW LONG WILL THE HEDGE FUNDS BE AROUND FOR?
It has been reported that funds that were formed in the 1990s and the 2000s were captains of Wall Street and other trading markets of the world. However, presently it has been observed that nowadays hedge fund managers and firms are riding on a sinking ship. Several of the most high-profile hedge funds have closed in recent years. An Investopedia article states that if investors stop investing their money in hedge funds, they may come to a certain end. But it seems like hedge funds will continue in the future as long as it comes with some modifications to its investment policies and makes it accessible to the “average” person as well.
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An aspiring civil servant, a curious mind but also an avid binge watcher- Prerna is currently pursuing BA Prog in English and Political Science from Kirori Mal College. She belongs to Chandigarh but really enjoys the hustle of Delhi. Her favourite pastime is taking naps and recognises herself as a pro at it.