The hedge fund industry is one of the largest in Wall Street. The industry has produced hundreds of billionaires in the United States and around the world. In the past, it was an obscure industry that was not understood well. Today, the industry manages more than $3.2 trillion in assets. This article will explore the hedge fund industry, explain what it is and how you can start your own fund.
What is a hedge fund?
A hedge fund is made up of two parts. A hedge is an investment that reduces the risk of adverse movements in securities. A fund, on the other hand, is a sum of money that is used for investment purposes. Therefore, a hedge fund is a company that receives money from investors with the aim of investing in various securities. The goal of a hedge fund is to achieve returns that are better than that of the market while mitigating risks.
The hedge fund industry has existed for decades. The first fund was established in 1949 by an Australian known as Alfred Winslow Jones. Since then, thousands of funds have been formed. In the United States, there are more than 10,000 hedge funds. The biggest hedge fund manager in the world is Ray Dalio who runs a company called Bridgewater Associates. It has more than $160 billion in assets.
These companies generate income through what is known as the 2:20 rule. With this, the fund deducts 2% from the investors’ funds. This is known as the administrative fee and is used to pay salaries, office rent and other administrative duties. The 20% is the incentive fee which hedge fund managers deduct from all the profits they generate. Therefore, if a hedge fund manager has $1 billion in assets under management and he delivers a return of 10% per year, the annual income for the firm will be $40 million.
Types of hedge funds
There are a number of types of hedge funds. Some of these types are:
Activist hedge funds: These are funds which invest in a company and then move to actively interfere with the management of the companies. They first conduct research on an undervalued company, find the reason why it is undervalued, invest in it and then work to fix the company. They fix the companies using a number of strategies. For example, they might seek to overhaul the board, break down the company and sell some segments. Examples of the best known activist hedge fund managers are David Einhorn, Bill Ackman, and Nelson Peltz.
Quantitative hedge funds: These are funds that use computer algorithms to make decisions. The algorithms are created by leading mathematicians and computer scientists. These algorithms open and exit thousands of trades every day. Historically, these funds have outperformed other types of hedge funds. Examples of these funds are Rennaisance Technologies, AQR Capital Management, Two Sigma, and DE Shaw.
Macro hedge funds: These are funds that seek to benefit from the swings that come from global events. For example, a macro fund may conduct research of the emerging market economies. After finding some opportunities, they can invest in emerging market stocks, their currencies, indices and bonds. Examples of these funds are Bridgewater Associates and Caxton Management.
Event-driven funds: These are hedge funds that invest with the goal of benefiting from specific events. For example, there are funds that aim to benefit when there are mergers and acquisitions. Other event-driven funds seek to benefit by investing in the earnings season and when there are news events. These funds don’t hold assets for a long time. Examples of these funds are Kellner Merger, GAMCO, and Quaker Event Arbitrage.
Short Only Funds: These are funds that conduct research on securities and short them. To short is to borrow a company’s stock, sell it at market prices and wait for it to decline. Once it reaches your target, you buy back the stock and return it to the lender. These funds are not very common because of their risks. This is because when you buy a stock, the maximum profit potential is infinite because the stock has no limit. Similarly, when you short a stock, the losses are infinite too. An example of a short only fund is Kynikos Associates.
Long Only Funds: These are hedge funds that invest in a portfolio of companies. Their goal is to benefit when the price of a security goes up. Most hedge funds are in this category. Examples include: Tiger Global Management, Glenview Capital Management, and Millennium Capital.
Distressed capital hedge funds: These are funds that invest in companies that are going through a difficult period. When companies are in trouble, their stocks usually trade at depressed levels. Therefore, these funds buy their stocks with the goal of fixing them. The risk in all this is when a company goes bankrupt.
Long-Short funds: These are hedge funds that invest in stocks they believe will move up and shorting those they believe will go down. The benefit of this is that the losses of one portfolio is usually offset by the gains of the other. Examples of these hedge funds are Third Point Management and GreenLight Capital.
Arbitrage funds: These are funds that use correlations in investments. For example, merger arbitrage funds buy companies that are being acquired while simultaneously shorting companies that are acquiring. Other types of arbitrage funds are those that use political arbitrage, risk arbitrage, and fixed income arbitrage funds.
Starting a hedge fund
As mentioned above, hedge funds collect funds from outside investors and then invest for them. Their investors are usually high net worth individuals and institutions like pension firms. To start a hedge fund, most managers usually come from respected financial institutions like investment banks and hedge funds. For example, more than 10 large hedge funds have been started by managers who used to work for Tiger Global Management.
If you are not in a position to start or even invest in a hedge fund, the financial markets are not closed to you. You can learn about the markets by trading with your own online trading account and build your capital over time. With access to hundreds of financial securities such as currencies, stocks, indices and commodities, you get ample opportunity to understand the ins and outs of the financial industry.
As you develop your trading skills and you discover an aptitude for investing in financial securities, an alternative to setting up your own hedge fund is to become a Master Trader. This is an online account that allows you to have investors from around the world who can copy trades from you. As you gain more experience from trading for others, you also increase your profit potential and open up doors with your proven track record.
Hedge fund management may not be out of sight for you as an investor. The advantages are that you don’t need a lot of starting capital, as you don’t need a large office space and also don’t need a lot of employees to start with. In fact, most funds have less than five employees. Another advantage is that the industry does not have competitors. In fact, the more the number of participants there are, the better.