Hedge Fund Investing Guide for Wealthy Investors

Worthune’s Hedge Fund Investing Guide is a comprehensive overview of key aspects of alternative investments universe including whether to invest in hedge funds, how to select the right fund/manager, where to invest, and how to measure the performance.

The Hedge fund investing guide is for wealthy investors and families who have heard of the concept of hedge funds but are unsure into what hedge fund does, how hedge funds work, and how to conduct due diligence on a hedge fund before committing a portion of their net worth.

Hedge funds are a large and increasingly important part of the overall stock market, and hence wealth investors need to be cognizant of the hedge fund universe, irrespective of whether they invested, given its impact on the broader stock, currency, commodity, and physical assets markets.

The Fed is the greatest hedge fund in history. – Warren Buffet 

Content Outline of Hedge Fund Investing Guide for Wealthy Investors:

What is a Hedge Fund?

What are different types of Hedge Funds?

How much money is in Hedge Funds?

What is the structure of a Hedge Fund?

Who invests in Hedge Funds? What are the eligibility criteria?

Why should one invest in a hedge fund?

Who should invest in a hedge fund?

How does a Hedge Fund work?

How do Subscriptions, Lock-ups, Redemptions, and Gates work in Hedge Funds?

How much does a Hedge Fund charge in Fees?

How does a Hedge Fund Manager’s compensation work?  Or how much money top hedge fund managers’ make?

What are the risks of investing in a Hedge Fund?

Which are some of the largest Hedge Funds?

How to evaluate a Hedge Fund and a Manager?

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What is a Hedge Fund? Understanding the definition of what it means to be a hedge fund.

Technically, a hedge fund is an alternative investment vehicle that is managed by a professional money manager on behalf of wealthy investors and institutional clients to invest into various investment vehicles to attain the fund’s mandate.  The mandate could be investment maximization, capital preservation, focusing on a sector or a commodity, investing in negatively correlated investments when compared to the traditional stock markets, and every possible combination thereof.

Hedge funds are not noted for their long-term thinking – for them, a quarter is an eternity. – Joseph Stiglitz

Let’s dissect the terms a little bit.  One of the Merriam-Webster’s definitions of the word “Hedge” is “to protect oneself from losing or failing by a counterbalancing action.”  And the word “Fund” means “a sum of money or other resources whose principal or interest is set apart for a specific objective.”  Combining the words Hedge and Fund we get to the concept of a hedge fund’s true purpose (at least in historical terms), “Hedge Funds are pooled investment vehicles which aim to protect investors’ money against market movements by taking counterbalancing actions necessary to achieve the investment objectives.”

Today, of course, the word hedge in a Hedge Fund is a misnomer today as most funds are striving for return maximization and not necessarily risk mitigation. Of course, there are a few hedge funds that are perennially bearish and have significant short positions. However, that again is not for balancing risk per se, but maximize return in the event of the investment thesis coming true.

Hence, a hedge fund could be short the market, long the market, have a combined long-short strategy, use leverage (or margin) that is way above the traditional investing norms, and range from short-term high-frequency trading to long-term buy and hold investing.

Now that we have a clear understanding of what is a hedge fund let’s move ahead with the other topics in the Hedge Fund Investing Guide.

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What are different types of Hedge Funds?

There are many types of hedge funds, and in most cases, the investment strategy or underlying thesis is what drives a particular hedge fund to be classified into a specific category.  Also, factors like market outlook, leverage, derivatives usage, leverage, geographic focus, asset class, and sector determine the hedge fund classification.  Some hedge funds are substantively different, and others are different in degree and not in kind.

Here is a listing of different kinds of Hedge Funds:

Multi-Strategy:  Multi-strategy hedge funds are very broad regarding investment mandate and can include long-short positions, high leverage, global focus or a narrow niche focus, and include fundamental, technical, and quantitative analysis methods.

All Weather: While multi-strategy is a reflection of the broad strategic focus, all weather is all about portfolio management across all types of markets – bull, bear, neutral and varying economic climates – growth, inflationary, stagnation, recession, and all the way to depression.

Short Bias: The focus of short-bias hedge funds is to short overvalued stocks and try to generate returns in both growth and declining markets. Depending on the original mandate, the short bias funds may maintain some long positions while shorting the market or the securities. This strategy may include using leverage and derivative instruments.

Sector Funds: Hedge funds may focus on one or more sectors and try to employ various techniques to generate above market returns. Traditionally, hedge funds choose sectors like energy, real estate, technology, biotechnology, and healthcare.  Today, one can see hedge funds focused on crypto assets like Bitcoin (and other coins of their ilk) as well as the underlying blockchain technology.

Quantitative Directional: Using quantitative techniques such as statistical arbitrage or factor modeling, hedge funds in this category buy and sell investments based on which direction they deem the prices are going to go and make bets to capitalize on the market thesis.

What are the typical Strategies of Hedge Funds? Here is a quick summary of various hedge fund strategies.

Equity – Growth: Typical long-only or long-short investments in equity.

Market Neutral: A hedge fund that strives for above-average returns while keeping a neutral exposure to the broader market.

Equity – Value:  A hedge fund strategy which focuses on unearthing undervalued stocks.

Special Situations: A hedge fund strategy that tries to capitalize on some corporate event or decision such as a spin-off, stock issuance, repurchase, sales of assets, etc.

Merger Arbitrage: Merger arbitrate strategy focuses on identifying pricing inefficiencies and capitalizing on them during a corporate merger or acquisition.

Distressed:  Distressed securities hedge funds focus on buying stocks or debt of companies that are in deep financial trouble.

Credit Arbitrage: A hedge fund strategy that tries to exploit the minor differences between different tranche of credit instruments and different seniority of the corporate debt offerings.

Activist: A hedge fund strategy where after accumulating a position, the hedge fund managers push to change the corporate direction of a company.

Event-Driven: An event-driven hedge fund strategy involves focusing on macroeconomic, industry, or company level events for return opportunities.

Convertible Arbitrage: A hedge fund strategy to capitalize on differences between convertible debt and the equity of a company.

Global Macro:  Investment strategy with a top-down approach.

Fund of Funds: A fund that invests into other hedge funds.

Risk Parity: A hedge fund strategy that focuses on volatility allocation.

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How much money is invested in hedge funds?

Investors are pouring money in hedge funds. Hedge fund investing is no longer a niche. According to Barclays, at the end of Q2, 2018, the total assets under management (AUM) in hedge funds exceeds $3.25 trillion.  The hedge funds have the lion’s share of this AUM – at about 90%, and about 10% is in Fund of Funds.

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What is the structure of a Hedge Fund?

As we mentioned before, a hedge fund is a pool of investors contributing money to a money manager who invests into various vehicles in line with the portfolio strategy and investment mandate.

Hedge fund structures can vary according to various considerations and are mostly constituted as an LLP (Limited Liability Partnership) or LLC (Limited Liability Company).

The corporate parents of the hedge funds also follow different corporate structures – C Corp, LP, LLP, LLC.

SEC mandates that large hedge funds and some special exceptions must register and all others can operate without an SEC registration.

The hedge fund organizational structure is similar to most investment firms and includes functions such as client relationship management, client onboarding, investment research, trading, portfolio management, operations and recordkeeping, client reporting, and LRC (Legal, Risk, and Compliance).

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Who invests in Hedge Funds? What are the eligibility criteria for investing in a hedge fund?

As the saying goes if you ask what the price of something is, then the reality is that you probably cannot afford it anyway.  Similarly, who can invest in a hedge fund, who should invest in a hedge fund, and who is generally invited/allowed to invest in a hedge fund varies quite a bit.

The question who invests in hedge funds is simple: Wealthy investors, family offices, and institutions like endowments, foundations, pension funds, sovereign funds et al.

The minimum eligibility criteria for the U.S. are set by the SEC (Securities and Exchange Commission).  SEC allows sophisticated investors – the official term is “Accredited Investor” – who are capable of understanding the risk and rewards and then make appropriate investment decisions and possess a certain threshold of net worth, or an annual income are eligible.

The SEC defines an accredited investor as follows:

An accredited investor, in the context of a natural person, includes anyone who:

1. earned income that exceeded $200,000 (or $300,000

together with a spouse) in each of the prior two years,

and reasonably expects the same for the

current year,

OR

1. has a net worth of over $1 million, either alone or

together with a spouse (excluding the value of the

person’s primary residence).

While this may be the legally defined threshold, no hedge fund would typically solicit or allow such individuals to be a part of their investor pool.  Typically, one needs more than $10 million in investable assets before fund of funds consider an investor and for other funds, the net worth requirements are much higher. For investing in marquis hedge funds, the invitation to invest will not happen until there are nine digits in your net worth statement.

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Why should one invest in a hedge fund?

There are several reasons a wealthy investor or an institution may consider investing in a hedge fund.

• Access to sophisticated investment strategies
• Need for uncorrelated asset class exposure
• The desire to outperform the market
• Diversification and distribution of wealth
• Weatherproof the portfolio (particularly against downturns)
• Use leverage to boost returns
• Gain access to asset classes or sectors that are not a part of the mainstream investment markets

In general, two complementary and at times diametrically opposite instincts drive investment into hedge funds – fear and greed. Or to put it in different terms, the desire to maximize returns and/or mitigate against risk.

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Who should invest in a hedge fund?

Technically, any accredited investor should invest in a hedge fund.  We at Worthune believe that minimum eligibility is just that and not a barometer of whether one should invest in a hedge fund. The following are some guidelines and we acknowledge that these are not set in stone.

Worthune’s Rules of Thumb on who should invest in a hedge fund:

• Net Worth: We believe that $10-15 million in net worth is the right threshold to consider investing in a hedge fund.
• Investable Assets: Investable assets of more than $5 million are a good benchmark. We are not suggesting investing all the $5 million of investable assets into hedge funds (or other alternative investments.)
• Investment limit: We suggest a total investment of between 5% and 10% of the investable assets into alternatives. Taking the example of a wealthy investor with $10 million in investable assets, $500,000 – $1,000,000 in hedge funds would be prudent.
• Sophistication: An advanced understanding of the alternative investments’ markets (or at least have trusted advisors who understand the alternatives field in-depth.)
• Volatility and Max Loss: Ability to withstand volatility and potential losses that may wipe out the principal.
• Not all eggs in one basket: Within the alternative investments’ basket, we suggest diversifying into various investment strategies and also diverse money managers to mitigate the risk. Imagine if an investor put his/her faith for all the chips into Long Term Capital Management or Bernie Madoff.

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How does a Hedge Fund work?

To think about how a hedge fund works, please imagine how an investment partnership or a mutual fund works and add in a few layers of additional terms and conditions and a slightly different operating model.  A hedge fund works similar to other investment entities in that the principals raise money (including their own) and then invest it according to a set of strategic mandates and guidelines and charge a fee.

Where the operation of a hedge fund gets complicated is in a few areas like fee, leverage, hurdle rate, watermark, investor gates, etc. We will address each of these concepts here and elsewhere in the hedge fund investing guide.

From a structural point of view, hedge funds categories are:

Master-Feeder Funds:

This is a popular structure when a hedge fund wants to combine both US and non-US investors into one master fundraising vehicle.

How Master-Feeder structure in hedge funds work?

A hedge fund has one onshore feeder fund for US investors and institutions. There is an offshore feeder fund for non-U.S. investors and institutions.  There is a master fund, which is typically domiciled in an offshore location. The fund manager or management company is also an offshore entity.  And they can make investments in line with the strategy.

Investors fees are at a feeder fund level.

The U.S. entity (onshore feeder fund) is generally a limited partnership to work as a flow-through entity for tax purposes, which are beneficial to US investors. The offshore entity is generally a company which is attractive for non-U.S. investors as well as tax-exempt U.S. entities.

In the master-feeder hedge fund structure, there is typically a consolidation of many portfolios into one investment vehicle. This consolidation lowers operational costs, attains a higher level of diversification, and provides investors to a larger and consequently more stable assets.

The master-feeder structure is flexible and can be structured in any way that benefits the investors and the hedge fund firm. One can create focused single strategy funds or multiple strategy funds. Or one can create a fund for a specific set of investors based on investor type, domicile, or focus.  With fees negotiated at a feeder fund level, the sky is the limit to come up with varying terms and features.

A major drawback for the offshore feeder fund for non-U.S. investors is the tax withholding on dividends from American companies.

Standalone Funds:

Standalone funds, as the name suggests, are hedge fund structures where each investment is structured as a separate fund – typically one structure for U.S. investors and another structure for non-U.S. investors and tax-exempt US entities.

In the case of standalone structure for US investors, it is typically a Limited Partnership or a Limited Liability Company to offer flow-through tax benefits.

For the non-US and tax-exempt standalone hedge fund structure, it is typically a company that is constituted as a separate legal entity for tax purposes.

The fund investors partake in the profits and risks of the standalone fund structure, and the accounting is also at the standalone fund level.

A standalone fund structure may also increase the overall expenses and offer less diversification than in a typical master-feeder structure.

Fund of Funds

A fund of funds, as the name indicates, is a structure where a fund collects money from investors and invests into several funds – proprietary vehicles or outside managers. The fund portfolio management happens at two levels – at the overall fund of fund structure, the investment team defines the asset allocation, investments strategies, and manager selection. The individual fund managers then determine the specific securities or investment instruments. In many cases, the fund of fund level also provides overlay management across all the underlying funds/managers.

The advantages of a fund of funds structure are diversification, strategic asset allocation, the professional due diligence of underlying managers, and the overlay management at a holistic portfolio level.

The fundamental disadvantage is another layer of fees and expenses.

A fund of funds structure may be the most optimal stepping stone for HNW families as getting into some star fund managers investment vehicles may not be possible directly.

Side Pockets:

A side pocket in a hedge fund is a way to segregate a specific set of investments and assets from a hedge fund into a separate account.  Typically, hedge funds take illiquid and/or volatile assets into side pockets. The side pockets are managed as separate entities.  The investor’s participation in the side pockets is proportional to their participation in the overall fund.  Newer investors who join a hedge fund structure after the creation of a side pocket do not participate in the legacy side pockets.

One of the key reasons to have a side pocket is not to let a highly overvalued or undervalued asset to influence the hedge fund manager compensation.

The side pockets impact existing, new, and redeeming shareholders differently. An existing shareholder gets proportional interest in the side pocket. A new shareholder, who is joining after the creation of a side pocket, does not have any entitlement to the existing side pockets. A redeeming shareholder’s investment interest in a side pocket is not paid out until the investments in the side pocket can be valued appropriately.

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How do Subscriptions, Lock-ups, Redemptions, and Gates work in Hedge Funds?

Subscription: A subscription into a hedge fund is how an investor enters a hedge fund – whether through a Master-Feeder structure, a standalone fund, or a fund of funds structure.

Redemptions: Hedge Fund redemptions are typically complicated given the illiquid nature of many hedge funds and the managers’ need to deploy capital at a holistic level. Unlike a mutual fund, hedge fund redemptions are full of restrictive covenants.

Lockup Period: A lockup is an initial number of days when an investor is not allowed to redeem any monies from the hedge fund.

Fund Gates and Investor Gates: A gate is another way hedge funds’ restrict the outflow of funds. A fund gate sets the aggregate funds that can be withdrawn from a hedge fund entity. Investor gate is when, if, and how much an individual shareholder can withdraw from a hedge fund. A Fund gate provides for stability at the fund level by limiting overall outflows. An investor gate staggers the redemption amounts and exit path for individual shareholders.

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How much does a Hedge Fund charge in Fees?

A hedge fund charges a lot. Quite a lot. Let’s look at the hedge fund charges:

Administrative Fees: A hedge fund charges an administrative fee to pay for the general expenses running of the fund. The typical industry standard is 2% of the AUM.  For example, if a hedge fund has $100 million in investor assets, the overall management fee will be $2 million.

Hedge Funds Performance Fee or Incentive Compensation:  Hedge funds, in addition to the management fee, also charge a performance fee or incentive fee. The industry standard is 20% performance fee after crossing a hurdle rate. The percentage of performance fee can vary based on the reputation of the hedge fund manager and the fund. Some may be lower and some higher, but 20% is the common ballpark number.

For example, a simple example to illustrate the performance fee. A hedge fund with $100,000 million AUM has gains of $50 million.  Now, ignoring the management fee and keeping the arithmetic simple, the hedge fund charges $10 million as their performance fee (20% of $50 million.)

Hurdle Rate: A hurdle rate is one of the constructs for hedge funds to cross a certain threshold in gains before they can charge a performance fee.  The hurdle rate acts as the de minimus returns the fund has to achieve before paying the performance fee. The hurdle rates are typically pegged to some index or a blended benchmark.

For example, if a hedge fund hurdle rate says 8% and if a hedge fund with $100 million has $7.99 million in gains, the managers are not eligible for a performance fee.

High Watermark:  High watermark is another method that sets the performance bar for hedge funds high.  The high watermark means that a hedge fund manager is not eligible for performance fee unless a manager performance above a specific threshold of AUM, which is the watermark.

For example, a hedge fund with $100 million in AUM lost 50% of its value in the first year due to bad bets. Now, in the second year, it had a stellar year and gained $50 million increasing the AUM to where it began. However, since the high watermark is $100 million (as it is the highest value ever achieved), the manager is not eligible to receive the performance fee.

Withdrawal/Redemption Fee: Some hedge funds also charge investors a withdrawal or redemption fee. The withdrawal fee is to discourage frequent money movement and allow the hedge fund manager to invest for a longer term. Another way hedge fund discourages or minimizes outflows is through lock-up periods. A lock-up period prohibits investors from redeeming their funds for a specified time.

What are the benefits of investing in a hedge fund?

Professional Management:  Hedge fund managers are some of the best in the industry employing sophisticated strategies.

Downside Risk Protection: Many hedge funds try to navigate the vagaries of the stock markets by overweighting and underweighting sectors, asset classes, and geographies thus providing some downside risk protection.

The possibility of Low or Negative Correlation:  As hedge funds tend to invest in the market and non-market securities, in general, they have a low or no or negative correlation to the broader market indices. This also acts as a hedge against the broader market going down.

Potential Outsized Performance:  Both in part to making outsized bets, using leverage, and relying on short positions, hedge funds have an opportunity to generate massive returns. (Of course, the other side of the coin is that hedge funds could potentially wipe out their assets due to bad investment decisions.)

Access to Alternative Asset Classes: Choosing hedge funds that are focused on niche areas will provide access to assets outside the mainstream markets.

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What are the risks of investing in a hedge fund?

• Loss of Principal: Like any other investment, hedge funds may underperform or blow up, and hence loss of principal is a critical risk. In hedge funds that employ significant leverage, even a relatively minor downside risk can exacerbate the actual investment amount.
• Liquidity Constraints: Hedge funds employ a variety of tactics to slow the outflows and stagger redemptions – at a fund level and an individual shareholder level. These liquidity and redemption constraints can lead to difficulties when an investor wants to sell and get out – whether to fulfill a cash outlay need or time the market.
• High Fees and Expenses: The combination of administrative fees, management fees, and performance fees can diminish the returns that a hedge fund generates and ultimately what ends up in an investors’ pocket may be a lot lower than the glitzy gross returns.
• Opaqueness (or lack of transparency): Hedge funds are not known for transparency, and the opaqueness can lead to many risks. Not knowing what is happening, the inability to time the exit decision due to various covenants, and unable to take timely remediation measures in other parts of the portfolio.
• Concentration: Unless your family belongs to the Forbes 400, for the rest of the UHNW and HNW clients an investment into a hedge fund could be a significant portion of their overall investable asset base. If there is a structural downturn or a black swan event, unless the hedge fund has taken a contrarian stance, the risk to overall wealth is rather high.

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Which are some of the largest hedge funds?

Source: HFM.Global

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How does a Hedge Fund Manager’s compensation work?  Or how much money top hedge fund managers’ make?

Hedge Funds have many employees, even though the star money managers are often the focus on attention, adulation, envy or scorn – based on one’s perspective. While the rest of the employee partake in the spoils by way of both salaries and bonuses, the latter depends on the profits the hedge fund generates and are not in the poor house by any stretch, the eye-popping compensation are often the prerogative of a few denizens of the hedge fund industry.

If I had to sum up my practical skills, I would use one word: survival. And operating a hedge fund utilized my training in survival to the fullest. – George Soros

Many hedge fund managers invest their own money into the funds they manage and generally it is a great indicator of alignment of interests of shareholders and managers.

So, the top hedge fund manager’s compensation boils downs to the following:

A Base Salary: Obviously, for a successful hedge fund manager this is peanuts.

Growth in Personal Assets: The amount of personal net worth the manager has in the fund and the growth thereof (or in some years losses).

Carried Interest or Carry: A portion of the performance fee that is allocated to the hedge fund manager.  This is a portion of the aforementioned 20% performance fee and the manager’s portion will be a smaller percentage.

There are a handful of hedge fund managers who make over a billion dollars and many in the tens of millions to the hundreds of millions range.

According to Forbes magazine, in 2017, four hedge fund managers earned over a billion dollars and a couple not far behind. The highest earning hedge fund managers are as follows:

Source: Forbes Magazine

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How to evaluate a Hedge Fund and a Hedge Fund Manager?

The following are some of the evaluation Criteria for conducting due diligence on a hedge fund manager.

Availability: Many hedge funds may not be available for general investors. So, a primary factor is whether or not the fund is open to new investors.

Strategy: What is the strategy of the hedge fund? Is it compatible with your goals and objectives and does it fill a specific need in your overall investment strategy and asset allocation?

Fund firm track record: How well has the firm done over several years? Or if the firm is new, what has been the track record of the principals at prior firms?

Manager Track Record: What is the track record of the hedge fund manager – in the current fund as well as previous ones.  How much alpha did the manager generate?

Size of the Fund: If the fund is too small, there are risks such as higher expense ratio as well as redemptions causing the hedge fund strategy to go awry. On the other hand too big of a hedge fund will have trouble moving the needle.

Fees: What is the fee? Is it comparable to the standard fee schedule in the industry?

Returns: What are the returns – gross, net of fees, risk-adjusted, etc.? What has been the performance over 1, 3, and five years? Or perhaps since the inception of the fund.  (Risk-adjusted measures such as Sharpe Ratio, Jensen’s Alpha, Treynor’s are useful in understanding the value the manager is adding.)

Drawdowns: What are the drawdowns and redemptions picture look like? If there are too many investors heading for the exits that may not bode well for the manager.

Alignment of Interests: Do the manager and his/her cohorts have their money in the fund and what is it as a percentage of their net worth? Typically, the higher the investment as a percentage of their net worth, the better the alignment.

Volatility: How does the fund perform in good times, bad times, and ugly times?  How much risk is inherent in the fund? (Statistical measures like standard deviation and beta provide a peek into the volatility.)

Service Providers: Who does the hedge fund work with – such as auditors, custodians, prime brokers, etc. A slate of reputed service providers is generally a positive indicator.

Other Investors: Who are the other investors? Highly reputed and well-known investors in the fund is again a vote of confidence. (Obviously, history is replete with savvy investors betting on managers who are busts.)

Notes: 

Hedge Fund Investing Guide for Wealthy Investors is for informational purpose only.  Please do not construe the information as financial, legal, or tax advice. Please consult an attorney, accountant, and financial advisor for specific advice pertaining to your situation.  While we strive to provide up to date information, some of the data may be outdated.

Hedge Fund Investing Guide is specifically for wealthy investors and families who qualify as Accredited Investors.

If you wish to receive the Hedge Fund Investing Guide as a PDF, please contact us.