Hedge Fund Q&A
Hedge funds are regularly disparaged in the media. Mostly, this is simple envy of the wealthy. Mostly, it is based on misunderstandings about hedge funds. So, here are my answers to basic questions:
What is a hedge fund? A hedge fund is a private investment partnership. A group of people agree to hire an investment manager to invest their funds on a pooled basis. The agreement is private and it is voluntary.
How do hedge funds invest? Hedge funds invest in the manner specified in the contract agreed upon by the partners. There are as many ways of investing as there are private contracts between people.
How risky are hedge funds? All investments have the risk of loss. The degree of risk is determined by the particular investing strategy of the hedge fund manager, which is agreed upon by the partners. The agreement can specify what type of securities can be invested in, such as stocks, bonds, options and/or commodities. The agreement can specify whether the manager can invest in foreign securities, and to what degree. The agreement can specify whether the manager can use leverage (borrowed funds), and to what degree. It is entirely up to the partners and the manager to agree among themselves the limits on the investing strategy of the manager. The level of risk is agreed upon by the partners.
How are hedge fund managers paid? Managers are paid according to the agreement between the manager and the partners. Typically, a manager is paid an annual maintenance fee of 1% or 2%, and a percentage of the fund’s profits, which can range from 10% to as high as 50%. The fee is contractually set and can be anything that the partners and manager find to be mutually beneficial. One typical provision of a hedge fund contract is a “high water mark” provision. This provision means that a manager cannot be paid a percentage of the fund’s current profits until losses from prior periods are made up.
Are hedge funds regulated? Unfortunately, hedge funds are extensively regulated. Federal law states that only accredited investors are permitted to become hedge fund partners. That limit is currently being raised so that only investors with $2.5 million in liquid funds can invest in hedge funds. Someone with less money is legally forbidden from investing in hedge funds.
Hedge funds can accept no more than either 100 or 500 investors, depending on the applicable regulation.
Hedge funds are not permitted to advertise. They cannot publicly advertise their performance or explain their strategies. They cannot even have websites accessible to the public that explain their funds.
Other rules. Special rules prevent hedge funds from easily investing in both commodities and stocks in the same fund. Special tax rules make it impractical for foreigners to invest in domestic
These are just a few of the rules hedge funds operate under. Hedge funds are private agreements between willing investors and the manager they hire to invest their funds. Nevertheless, they are highly regulated, and the regulations grow every day. Large legal and accounting costs must be borne by any hedge fund to comply with these changing and growing rules.
Are hedge funds less regulated than other business enterprises? How many business enterprises are legally forbidden to advertise? Even tobacco companies still have some legal advertising avenues open to them. Hedge funds cannot even legally advertise with a public website. How many businesses must legally turn away customers who aren’t wealthy enough? How many businesses must stop accepting customers when the number of customers reaches a legal limit? Hedge funds are more regulated than most other businesses.
Despite these rules, investors keep putting money into hedge funds. Globally, investment in hedge funds grew 30% last year to $2.1 trillion dollars under management, $1.4 trillion managed in the
Why do investors keep putting their money into hedge funds? One reason is because the other investment alternative, mutual funds, faces different regulations that make them less attractive as investment vehicles for many investors. The differences affect the incentives that mutual fund managers face, and their freedom to invest. In both areas, mutual funds suffer disadvantages relative to hedge funds.
Incentives: Hedge fund investors can pay their manager in whatever manner they mutually agree upon. The method typically used, where the manager gets a percentage of the fund’s profits, provides an enormous incentive for the hedge fund manager to work hard and generate profits. Both he and the fund’s investors share in the fund’s profits proportionately.
Mutual funds are not allowed to pay their managers in the same manner. Under the Investment Company Act of 1940, which regulates mutual funds, mutual fund managers cannot be paid a straight percentage of the fund’s profits. That is why mutual fund managers are typically paid a salary plus a variable bonus that is more loosely connected to the fund’s profitability. A weakened connection to profitability means a weakened incentive to work hard to find profits. Mutual funds are also not allowed to have a “high water mark” provision where they agree to forgo their fee until a prior loss is made up. This also reduces their incentive to achieve profits.
Freedom to invest: Hedge fund managers have few legal limits on what they can invest in. Their limits are those agreed upon by the partners and the manager. A particularly important advantage is that hedge fund managers have the legal ability to take short positions in securities. A short position in a security is one where the investor makes money when the security price goes down, instead of up. Short positions are very advantageous when the stock market is declining, as it did for much of 2000, 2001 and 2002. Because of their ability to invest in short positions, hedge funds as a whole outperformed most other investment categories, such as mutual funds, during those years. If risk of loss is a concern, hedge funds as a whole were less risky than mutual funds during those years. Such a reduction in risk was possible because hedge funds could take short positions.
Mutual funds face regulations that make it very difficult to invest in short positions. Although those rules have been loosened recently, as a practical matter most mutual funds find they can only invest in long positions. Long positions go up in a rising market and decline in value in a falling market. Hedge funds can blunt the loss of value in a falling market through short positions; mutual funds are largely legally precluded from taking the same steps to protect the value of their portfolios.
Advantages of mutual funds. Mutual funds have some advantages that hedge funds do not have. The biggest are that they can legally advertise and they can accept money from anyone. There are also no limits on the number of investors they can have. So, their role in the financial world is assured. While only rich people (those with more than $2.5 million in liquid assets) are allowed to invest in “secretive” hedge funds (which are secretive largely because they are forbidden by law from discussing their performance), the so-called little guy can invest in mutual funds which he can study and learn about from advertisements, websites, etc.
There are other investment vehicles that are alternatives to hedge funds, such as exchange traded funds and closed-end funds. Each of them is a product of the peculiar regulations that govern it. Each has advantages and disadvantages, many of which are solely a consequence of differences in regulation.
Conclusion. In a world where everyone had the freedom to invest his money as he saw fit, without facing Depression-era rules designed to “help” the so-called little guy (but really just close off certain investment opportunities from him), there would be no legal distinction among investment pools. The distinction between hedge funds and mutual funds is a creature of regulation. To escape from the rules limiting mutual funds, hedge funds agreed to operate under a different set of rules that limit who they can accept as investors. By accepting one set of rules, they are freed from others, including those that limit investing in short securities, and how managers are paid.
Quite often, the history of financial innovation is a history of creatively finding ways around government edicts. The rise of the hedge fund industry is an example of that phenomenon. I look forward to the day when all those rules are repealed, when everyone’s inherent property right to contract with whom they please on whatever terms they choose is acknowledged in the law. When that happens, the creativity of investment managers, lawyers and accountants will be spent solely on developing the best investment vehicles for their willing clients, instead of having to destroy a portion of their time complying with the growing, changing and arbitrary rules emanating from
The larger issue is that all individuals can manage their own lives and should have complete freedom to do so. This includes the freedom to manage all aspects of their financial affairs. The only role for government is as protector of property rights. Governments exist to enforce the terms of contracts and punish those who commit fraud. The current hostility against hedge funds is of similar ilk as the hostility toward the “robber baron” industrialists of the late 1800s and early 1900s, and the junk bond and other financial innovators of the 1980s and 1990s. It is envy of the successful for being the successful, and resentment of the rich. The current hedge fund rules do nothing other than close off that investment vehicle from the masses, keeping them with their faces pressed to the glass looking in on a world that they enviously want and can’t have. Therefore, they will use the power of government to throttle and destroy that world.