What is a hedge fund?
Hedge funds are a popular way for wealthy people to invest, but how do they work?
A hedge fund is a set of pooled investments, collected from a number of underlying investors – either wealthy individuals or institutional investors such as pension funds, insurance companies or sovereign wealth funds.
In this sense, they’re like many other investment funds. They invest in a range of different assets, from stocks and bonds to alternatives, but typically use more complex trading techniques and risk management systems to carefully manage the level of risk and expected potential returns available.
In the same way that the manager of a standard investment fund may invest using different styles, hedge fund managers also invest using different approaches.
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Because hedge funds can invest in different ways, they’re useful for introducing diversification to a portfolio but come with very specific risks, which we’ll explain shortly.
Some common approaches include:
- Long/short
Unlike traditional investing, which relies on the principle of buying an asset at one price and selling it at a higher price, short-selling (or ‘shorting’) a stock or an asset is where an investor buys an asset on the expectation that its price will fall.
The short-seller (in this case, a hedge fund manager) borrows some stock and sells it at today’s market price, hoping for the stock to fall in price so they can buy it back more cheaply and profit from the difference.
- Global macro
These are common hedge fund approaches that take big directional ‘bets’ on entire countries’ economies, currencies, commodities and other macroeconomic variables, such as interest rates, inflation and other big political or financial events.
- Event-driven
Event-driven strategies tend to focus on very specific corporate events like mergers and acquisitions (M&A), bankruptcy or company restructures that can create short-term opportunities, such as temporary share price movements or shifts in bond pricing.
- Quantitative
These automated maths- and rules-based models saw a resurgence in popularity after the financial crisis when the importance of investing according to factors – such as size, value and momentum – became apparent, as well as simply investing by asset class.
The proliferation of technology-based models, big data and more recently artificial intelligence means so-called ‘quant’ models are becoming ever faster and more sophisticated.
What can hedge funds invest in?
Hedge funds, like traditional funds, can invest in different asset classes. Any of the strategies outlined above could apply to stocks and shares, bonds or commodities, for example.
Often the difference between hedge funds and other types of fund is the range of strategies that can then be applied over the top of these assets, allowing them to trade flexibly within certain parameters. Using these rules and parameters mean hedge funds are useful strategies when a degree of predictability is important.
They tend to borrow heavily to execute their strategies, which is known as leverage.
They tend to not invest with any particular benchmark in mind, rather based on the expectations of where a profit might be made.
These strategies could also apply to currency trading on the foreign exchange (FX) market, or the alternative space. Hedge funds often trade commodities such as natural resources (oil, gold or other precious metals), or soft commodities such as agricultural assets (coffee, sugar, soy beans or other grains).
Other physical assets such as real estate or land also lend themselves well to hedge fund strategies.
Hedge funds also often make significant use of derivatives, which are financial contracts such as futures, options or swaps that ‘derive’ their value from agreements made between buyers and sellers on expected price changes to the underlying asset.
Who can invest in hedge funds?
Hedge funds are regulated but are typically only open to investors that meet certain criteria. They can’t be marketed to everyday investors but tend to be reserved for professional or institutional clients, high net-worth individuals (HNWIs) and sophisticated investors.
According to the Financial Conduct Authority (FCA), the regulatory definition of a HNWI is someone with an annual income of at least £100,000 and net investable assets of at least £250,000 – not including property, pension or life insurance policies.
If you don’t meet the criteria for a hedge fund but are interested in similar styles it might be worth looking at the Investment Association (IA) Targeted Absolute Return sector. This category includes funds that are suitable for retail investors but through careful risk management aim to achieve positive returns in any market conditions over a set timeframe.
These funds may use strategies such as long/short equity, global macro and absolute return bonds. They are difficult to benchmark because they will use a blend of different strategies.
As with all investments, positive returns are a target and never guaranteed.
Currently the UK hedge fund industry is regulated by the Alternative Investment Fund Managers Directive (AIFMD), which oversees managers of alternative investment funds like hedge funds. The Financial Conduct Authority (FCA) and HM Treasury are currently undertaking a review of the regulatory framework, expected to replace the AIFMD with a UK specific AIFM regime, currently scheduled to take effect in 2028.
What are the main benefits of hedge funds?
One of the key benefits of investing in a hedge fund is the potential for higher returns compared to other types of investments. Because hedge funds use complex strategies and invest in a wide range of assets, they have the potential to generate significant returns.
Another benefit of investing in a hedge fund is the potential for diversification. Because hedge funds invest in various assets, they can help spread risk across different types of investments, such as equities, bonds, property and even private businesses. This can help to reduce the overall risk of an investor's portfolio.
However, with this potential for higher returns comes a higher level of risk. Hedge funds are not regulated like other types of investments, which means that investors may be exposed to greater risk.
What risks do hedge funds introduce?
Investors taking on higher-risk investments typically have to sign a disclaimer expressing their understanding of the risk they are taking and that they understand the instruments they are investing in.
Hedge funds often invest in less liquid, non-traditional assets. They use different techniques, use more borrowing and will take a more tightly defined approach to managing their risk and potential returns. They tend to be appropriate for a longer-term objective and as part of a wider portfolio of investments.
Critics point out their high performance fees, which typically follow a ‘two and 20’ model, which is a 2% annual management fee on the assets under management (AUM) of the fund alongside a 20% performance fee, which tends to be based on annual profits.
Another potential drawback of hedge fund investments is the lack of transparency. Because hedge funds are not as heavily regulated as other types of investments, investors may not have access to the same level of information about the fund’s holdings and performance.
This can make it difficult for investors to make informed decisions about whether to invest in a particular hedge fund.
Also be mindful of the tax situation of any hedge fund you are considering investing in. Some hedge funds are set up in tax-efficient locations through offshore vehicles that may have different rules for investors based in the UK, or for expats.
