Hedge Funds: Explained

May 21, 2021

4 min read

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What are they?

Hedge funds are pooled investment funds that offer alternative investment opportunities, employing different strategies to earn active returns for their investors. They are often regarded as extremely risky investment options, and are undertaken by accredited investment whizzes and billionaires, not the likes of you and I.

What does this mean?

Breaking it down, “to hedge” means to protect, and a “fund” refers to a pool of money. Essentially, therefore, the purpose of a hedge fund is to “protect money”. This is what they were intended to do, anyway. Over the years they have gained a name for high risk and high losses.

The way in which hedge funds work is that they take money from clients, companies, wealthy individuals or corporate pension funds, and invest these in the financial markets. Typically, large institutional investors or high-net-worth individuals invest in them. They may be aggressively managed, or make use of derivatives (a type of financial security with a value that is reliant or derived from an underlying asset such as stocks, bonds, commodities, currencies or interest rates – see our report explaining derivatives here).

Hedge funds can use a lot of “leverage” in order to multiply trades by taking on the burden of a lot of initial debt. For example, a hedge fund may borrow £1,000 from a wealthy investor, and £10,000 of borrowed debt, in order to invest a total of £11,00 with the aim of gaining a larger return.

Hedge funds are a unique way of investing; they can be invested in the short or long term, which differentiates them from other means, and they can take negative bets as well as positive ones. For example, if one predicts a company is going to perform poorly over the next few years, a hedge fund allows one to invest negatively in that company.

They make their money through a scheme referred to as “2 and 20”. This means a 2% asset management fee and a 20% cut of any gains generated which go to the investor.

As mentioned, this method of investing is not for the likes of everyday people such as you and I. Hedge fund investments are undertaken by wealthy individuals such as George Soros, the Hungarian-born 90-year-old American billionaire investor and philanthropist. As of May 2020, Soros had a net worth of $8.3bn. They are also strictly undertaken by investors who are accredited; hedge fund managers in the UK must be authorised by the Financial Conduct Authority (FCA).

What's the big picture effect?

A lot of investors are attracted to hedge funds because, in times of low returns in the financial market, hedge funds can seek much higher returns, which appeals to some people’s risk appetite. They are risky as they are not as heavily regulated compared to other areas of the market. Their use of leverage also enables them to be extremely risky in attaining huge profits or if unlucky, huge losses.

The meltdown of some multi-billion hedge funds can be viewed as financial disasters. This can occur when such a fund loses a staggering amount, for example, 20% or more in a matter of a few months or weeks. The investors may have recovered 80% of their investments, but the issue lies in the fact that most hedge funds are designed, sold and therefore reliant on the premise that they will ensure a profit regardless of market conditions. 

Such disasters include Aman Capital which was set up in 2003 by top derivatives traders at US, the largest bank in Europe. It was once intended to become Singapore’s “flagship” in the hedge fund business, but its leveraged trades in derivatives resulted in an estimated loss of hundreds of millions. The fund held $242m in assets by March 2005, and issued its closing statement in June 2005.

Alongside individual hedge fund disasters, there are debates around whether they “caused” the 2008 financial crash. Some argue that hedge funds caused the crash by adding too much risk to the banking system. It seems ironic that such an investment option is designed to “protect money”. Whilst the performance of hedge funds as “beating the market” was admired during the 1990s and early 2000s, since the financial crisis, many hedge funds have underperformed.

The standards imposed by the FCA on “approved persons” in charge of such asset management can be extreme. For example, in 2014 a prohibition order was imposed against Jonathan Burrows, Managing Director at Blackrock Asset Management. He was stopped at the ticket gates in Cannon Street Station merely because he admitted to evading his rail fare on a number of occasions! The FCA concluded that Burrows was demonstrating a lack of honesty and integrity, and as such he had failed to meet their standards. Such controversies have led some to argue that regulatory controls on hedge fund activities should be tighter. 

Report written by Hannah Parker

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