A pooled investment vehicle is a legal entity where multiple investors combine their money to invest in a portfolio of assets managed by professionals. Its main benefits include diversification, economy of scale, cost savings, and access to expertise. Mutual funds, hedge funds, and private equity funds are examples of these vehicles.

Hedge funds are pooled investment vehicles that employ a wide range of investment strategies. They are favored by investors seeking higher returns and greater diversification. However, hedge funds also carry higher fees and elevated risks due to their complex strategies, higher leverage, and less regulatory oversight.

Alfred Winslow Jones is widely considered to be the pioneer of the hedge fund industry. He popularized key concepts of modern hedge funds, including short selling, leverage, diversification, and performance-based compensation. Born on September 9, 1900, Jones was a graduate of both Harvard and Columbia University. He worked as a diplomat, journalist, and financial analyst before founding A.W. Jones & Co., the first hedge fund, in 1949. Jones laid the groundwork for the explosive growth of the hedge fund industry.

In investing, alpha measures the outperformance of an investment relative to its benchmark. Beta, on the other hand, measures the sensitivity of an investment relative to the benchmark. A positive alpha is desired, and a high beta investment is considered riskier.

To visualize, you can plot the returns of a fund on the vertical axis against that of a benchmark on the horizontal axis, and draw a straight line over the data points to the best you can.  The slope of the line is Beta and its intercept on the vertical axis, is the alpha. A positive alpha indicates that the fund manager has skills.

A hedge fund usually includes two types of legal entities: the fund and the fund manager. These entities are often structured as limited partnerships or limited liability companies. The fund often comprises a master fund and feeder funds, and they are usually located offshore in places like the Cayman Islands for tax benefits and regulatory flexibility. The feeder funds gather capital from investors and transfer it to the master fund to invest. The fund manager is responsible for making investment decisions, supervising fund operations, and ensuring compliance with all laws and regulations.

A hedge fund is governed by a legal agreement known as the offering memorandum or private placement memorandum, which outlines the fund’s investment strategy, governance, fees, terms and conditions, as well as the rights and obligations of both investors and the fund manager.

Hedge funds and mutual funds are both pooled investment vehicles but differ in their investment strategies, regulation, liquidity, fee structures, and investor base.

Hedge funds use aggressive strategies such as using leverage, short selling, and derivative trading in pursuit of higher returns. They also have less regulatory oversight, longer lock-up periods, and charge higher fees. Mutual funds use traditional investment strategies such as long-only stocks and bonds investments, have strict regulations, offer daily liquidity, and charge lower fees.

Mutual funds are available to the public and may allow a minimum investment of as little as a few hundred dollars. In contrast, hedge funds are exclusively for accredited investors and other qualified purchasers and typically require minimum investment ranging from US$100,000 to US$ 1 million.

Hedge funds focus on trading public securities with higher liquidity. Private equity funds invest in private (and at times public) companies and often exert influence on investees’ strategy and operations.  Private equity investments usually are long-term in nature, have less liquidity, and have the potential for substantial gains over time. Hedge funds are more aggressive and less regulated, while private equity is subject to strict regulations.

Both hedge funds and private equity funds are exclusively for accredited investors or other qualified purchasers.

Criteria to be an accredited investor vary from countries. Presently in the United States, to be considered an accredited investor, a natural person must have income of at least $200,000 each year for the last two years (or $300,000 combined income if married) and expect to make the same amount this year, or have a net worth of at least $1,000,000 alone or together with a spouse excluding the value of one’s primary residence, or holds in good standing a series 7, 65 or 82 license.

An institutional investor is an entity that pools money to invest in various financial markets on behalf of their members, clients, or stakeholders. Institutional investors include sovereign wealth funds, pension funds, mutual funds, insurance companies, endowments, foundations, hedge funds, and banks. It also includes operating companies investing their excess capital.

Hedge funds employ a wide variety of investment strategies. The main categories of these strategies include global macro, long short equity, market neutral, event-driven, quantitative trading, arbitrage, and relative value. There are overlaps among categories.  Please refer to Types of Funds for details.

Hedge fund operations involve its fund manager and a host of service providers including custodian banks, prime brokers, fund administrators, accountants, lawyers, and other specialty consultants.

Fund manager gathers capital and keeps it secure at custodian banks and prime brokers. It researches, invests, manages risks, and trades through prime brokers. The fund administrator consolidates trades, conducts position reconciliation and tracking, produces reports, communicates with investors, and handles subscriptions and redemptions. The administrators and fund managers also work closely with accountants and lawyers to ensure compliance and produce regular fund audit reports and regulatory filings.

Manager quality, investment strategies, fund size and performance, liquidity, risk parameters, and service provider reputation are key considerations when choosing a fund.

Costs of operating a hedge fund include manager fees, service provider expenses, and master and feeder fund expenses.  Fees to managers represent the lion’s share of the total costs.

Investment managers receive management and performance fees. Management fees usually range from 1% to 2% annually of the total assets under management (AUM). Performance fees typically range from 10% to 20% of the annual gains above a certain threshold, known as the Hurdle Rate. Frequently, performance fees are only paid when the fund’s net asset value (NAV) exceeds its previous high, known as the high watermark.

Service provider expenses include the cost of asset custody, order execution, fund administration, accounting, legal, and other services.  Costs of operating funds include fees for the board of directors and regulatory filings, among others. A fund’s placement memorandum outlines all fees and expenses. They are factors in evaluating funds.

Hedge funds borrow money, buy on margin, or use derivatives to create leverage. The typical maximum leverage, which is the notional value of its portfolio holdings versus assets under management (AUM), is 2 times for long short equity funds. However, it can be higher for fixed-income or currency funds. Leverage can boost returns, but it also creates risks. The placement memorandum specifies the maximum leverage a fund can use.

Investors should also be aware that there are significant leverages in the global financial system. Such systemic leverages can create crises where normal correlations, on which many risk management systems rely, fail. In such events, funds with extreme leverage often get wiped out. Therefore, it is wise for investors to stay away from excessive leverage unless they can afford the total loss of their invested capital.

Hedge funds are risky operations that employ a wide range of complex strategies, involve a host of third-party providers, use leverage, and operate in an often unpredictable environment. The risks they face include market, leverage, liquidity, counterparty, operational, regulatory, concentration, model, and systemic risks. Each type of hedge fund often has its unique risks. Effective risk management is vital for hedge funds to protect investor capital and achieve investment objectives. We will discuss fund-specific risks in Types of Funds.

Hedge funds use absolute and risk-adjusted returns to measure performance. Absolute return is net gains over a period divided by the initial invested capital. Risk-adjusted returns measure excess returns above the short-term treasury rate per unit of risks.

There are several risk-adjusted return measures – Sharpe, Treynor, and Sortino Ratios. Sharpe and Treynor use the standard deviation of returns and beta as risk measures, respectively. Sortino, meanwhile, uses the standard deviation of negative returns, recognizing that upside volatility is beneficial. Please check Type of Funds for typical absolute and risk-adjusted returns of strategies. 

In general, hedge funds underperform benchmarks on absolute returns and outperform on the risk-adjusted basis, except for outstanding funds. The ability to identify funds that consistently generate superior absolute and risk-adjusted returns is what sets star investors apart from the crowd.

Hedge funds were lightly regulated before the 2008 financial crisis in which many funds failed and Madoff’s Ponzi scheme, the largest fraud in the industry, unraveled. In response, the US passed the Dodd-Frank Act in 2010, the EU implemented the Alternative Investment Fund Manager Directive (AIFMD) in 2013, and the rest of the world followed suit.  

Today, hedge funds that exceed certain asset thresholds are required to register with regulators such as the U.S. Securities and Exchange Commission (SEC) and the Cayman Islands Monetary Authority (CIMA). Hedge funds are now also subject to disclosure, reporting, leverage limitations, anti-money laundering (AML), and other regulations across jurisdictions to protect investors and maintain stability in the global financial system.

The new regulations added burdens to managers but made it safer to invest in hedge funds.

Hedge funds offer advantages such as diversification, potential gains regardless of market direction, active management for potential outperformance, access to alternative strategies that have low correlations, risk management, flexibility, and potential for higher risk-adjusted and absolute returns. However, they also carry risks including higher fees, use of leverage, lack of transparency, and potential for losses.

While top hedge funds have consistently outperformed the market, average hedge fund returns lag the market indices. Investors must carefully select funds that can produce superior future returns.

A fund of funds is also a pooled investment vehicle.  Its structure and operations resemble that of a hedge fund.  However, a hedge fund invests in securities such as stocks, bonds, and their derivatives, while a fund of hedge funds invests in other hedge funds. There are more than 15,000 hedge funds of all types of strategies and asset classes worldwide.  For comparison, there are around 8000 stocks listed on the US stock exchanges. A fund of funds in general provides enhanced diversification, access to expertise, economy of scale, and risk control. 

A fund of funds however adds a second layer of fees. Investors need to carefully evaluate if the benefit outweighs the additional costs, and if a fund of funds manager has what it takes to deliver superior absolute and risk-adjusted returns.

Alternative investments differ from traditional categories such as stocks, bonds, and cash. They include real estate, commodities, hedge funds, private equity, venture capital, cryptocurrencies, collectibles, and more. Alternative investments in general have the potential for higher returns and provide diversification benefits, but they also have limited liquidity and carry higher risks. It is crucial to research and understand their unique characteristics before investing.

Hedge funds, relatively liquid, are the major component of alternative investments.