Leadership Spotlight

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Hedge Funds 101

What exactly is a hedge fund? Jack Gaine, president of the Managed Funds Association (MFA), a lobbying group for hedge funds, puts it this way: “A pragmatic definition would be a private investment pool with a limited number of high net worth individual and institutional investors on the one hand and, on the other, a manager with the utmost flexibility.”

Gaine’s definition doesn’t do much to narrow down what exactly a hedge fund actually does, and that reality is a key feature of the industry. So is a measure of secrecy, although some fund managers are realizing that their increasing influence demands more openness. Ironically, U.S. regulations sometimes discourage this, because investment funds targeted only at the wealthy aren’t allowed to advertise more broadly, and fund managers risk being accused of doing so if they say too much publicly.

Subject to the constraints agreed to with investors, hedge funds can operate in almost any market—equities, corporate credit, oil, gold, timber or insurance. As well as borrowing money, they can invest “long,” like a traditional mutual fund manager, or “short,” profiting if the value of the underlying asset falls. With rapid trading, they often punch above their weight in terms of market influence.

Then there are the famous fees hedge funds charge. “They are generally characterized by a fixed fee on the assets under management and an incentive fee,” Gaine says. The archetypal hedge fund’s annual fee structure is 2% of investors’ assets plus 20% of any gains the fund managers generate, a regime known as 2-and-20. Funds don’t usually give fees back to investors when they lose money, although most have a “high water mark” arrangement by which they have to recoup any losses before they can collect performance fees again.

With so much variety in what funds do, this type of fee structure may, in fact, be what sets hedge funds apart. “It’s probably the most accurate definition you can come up with,” says Marston. “It comes down to being able to charge an asymmetric fee.”

Asymmetric and high, hedge fund critics say—among them Warren Buffett, the legendary investor and chairman of Berkshire Hathaway, who thinks hedge funds and private equity firms take a slice of returns so large that it will hurt investors, at least in the long run.

That leads to one perennial question over the future of hedge funds: whether the 2-and-20 fee structure can survive. In some ways, that’s a question in its own right. But industry insiders see it as related to whether hedge funds can deliver good returns, after fees. For funds that perform well for investors, “if anything fees are going up, not down,” says the manager of a prominent multibillion-dollar fund.

Some funds charge well above the average. Take, for example, SAC Capital Advisors, the Greenwich hedge fund firm founded by Steven Cohen, W’77. The firm manages about $15 billion, and charges fees closer to 3-and-40 than 2-and-20. But few investors are complaining—the fund has reported returns, net of fees, averaging more than 30% annually since it started in 1992. In fact, the fund rarely accepts new money, so investors are waiting to get in.

A key question, however, is whether past returns can be sustained. The average hedge fund’s performance, as measured by HFR’s fund-weighted composite index, seems to have declined while becoming more consistent. In the last five years, returns have been 20%, 9%, 9%, 13% and 9% (the last through September last year). Through the 1990s, annual returns above 20% and even better than 30% were more common, interspersed with the occasional low single- digit return.

The question is whether what hedge fund managers call “alpha”—returns over and above those on the broad market in which they operate, presumably due to skill exploiting inefficiencies in that market—is becoming harder to come by with so many funds chasing similar strategies. Asness of AQR and others have observed that some hedge funds may even be achieving only market returns, or “beta,” albeit in non-traditional investment areas.

(There is a nascent but as yet unproven spin-off industry in which academics, Wall Street banks and fund groups are trying to replicate what some call “hedge fund beta” at lower cost using carefully designed portfolios of readily available financial instruments—potentially the exchange-traded funds of the hedge fund world. So-called 130/30 funds are also a step from a long-only approach towards a hedge fund model, with managers allowed to sell some stocks short within a primarily long portfolio.)