Hedge Funds: Everything You Need to Know

What are they? How do they operate? Why are they sold to clients? Were you forwarded this email? [Sign-up to Rude Awakening here.]( [The Rude Awakening] August 24, 2022 [WEBSITE]( | [UNSUBSCRIBE]( Hedge Funds: Everything You Need to Know - I got a good question over the weekend, so I thought I’d tackle it this morning. - Hedge funds, warts and all, are here to stay. - What are they? How do they operate? Why are they sold to clients? Recommended Link [Don’t Buy Any Crypto Until You Read This New Book!]( [Click here for more...]( Do not… I repeat… [Do NOT buy a single cryptocurrency until you read this new book.]( This could be the biggest opportunity of your life, but only if you act now. [Click Here To Claim Your Copy]( Sean Ring Editor, Rude Awakening Happy Hump Day! It’s morning here in Doha. I left Doha Airport at midnight and got to my hotel room at 12:30 am. Unfortunately, I couldn’t write on the plane, so I’m going to recycle an important Rude from over a year ago. The topic is hedge funds. In this edition of the Rude, they are broken down by strategy. You’ll have a better idea of what they’re trying to accomplish… and perhaps why they’re failing badly at the moment to capture the elusive “alpha.” Alpha is the return above the benchmark the hedge fund uses to measure its performance. Enjoy! What are alternative investments? Before we get into hedge funds, let’s complete a schematic of the alternative investment universe. It’s pretty simple. Alternative investments are, in alphabetical order, commodities, hedge funds, infrastructure, private equity, and real estate. Only high net worth individuals (HNWIs), ultra-high net worth individuals (UHNWIs), and financial institutions such as pension funds, sovereign wealth funds, insurance companies, and endowment funds invest in this asset class. (Except real estate, of course.) Why do private bankers sell hedge funds to their clients? Rich people have rich people problems. Those problems are so much better than poor people’s problems. But they are problems, nonetheless. Those problems are portfolio management, tax liabilities, succession/estate planning, philanthropy, and asset protection. From a portfolio management perspective, hedge funds make a lot of sense. In theory, hedge funds enable investors to increase their returns without increasing risk. Credit: TheStreet.com Does this always happen? Of course not. Of the 10,000 hedge funds in existence, only the upper quartile of hedge funds are worth investing in. The rest are trash. What are hedge funds? From the [July 8th edition of the Rude]( When Alfred Winslow Jones, an Australian who’d partied with Hemingway and Fitzgerald in Paris, finally moved to New York in 1949, he started his hedge fund. The Investment Company Act of 1940 stipulates that you must register it with the SEC if you have a fund with more than 100 investors. He thought, “I’ll just get 99 or fewer wealthy people, so I don’t have to register.” Was Jones’s hesitance to register for some nefarious reason? No. Registered funds are not allowed to short the market. Jones thought shorting some stocks was an intelligent hedge against being long some stocks. Hence, Jones wanted a “hedged fund.” Of course, Americans love nothing more than murdering the Queen’s English, so they dropped the “d” and started calling those funds “hedge funds.” Jones’s fund is the earliest example of an equity long-short hedge fund, still the largest class of hedge funds in existence. In short, hedge funds are lightly regulated, open-ended investment schemes that invest in the market using different methods than retail or long-only investors. Hedge funds can short the market and leverage their fund by multiples, neither of which long-only funds can do. Hedge funds may also use derivatives such as futures, options, and swaps to express their market views. How do they operate? Hedge funds require a large deposit from investors. The well-known and most renowned may charge a $5 million initial investment. Some may charge only $100,000. Private banks also pool HWNI money under the bank’s name to lower the entry investment. Hedge funds then charge “2-20.” That’s 2% on the year-end assets under management (AUM) and 20% on the fund’s performance. For example, if a fund grew over one year from $80 million to $100 million, the fees would be as follows: 2% x $100 million = $2 million AUM fee 20% x $20 million = $4 million performance fee That’s a total fee of $6 million. This is a simple example. Some funds charge less, and some charge more. Also, keep in mind that a “high watermark” will be in effect. So if our fund drops down to $80 million the following year, it can’t charge performance until it goes back over $100 million again. This leads to some unethical fund managers closing down their funds and reopening the following year—dirtbags. What are the different types of strategies? Below is a schematic of hedge fund styles. There are three big groups: high to low market exposure and nine classes below them. Credit: Alpha Development Opportunistic These directional strategies take a leveraged view on market trends, currencies, or other market-based opportunities. Long/Short Like Alfred Winslow Jones’s hedge fund, this one is long the stocks it likes (underpriced, in its view) and short the stocks it doesn’t like (overpriced, in its opinion). Usually, they are net long. Global Macro These funds are based on interpreting significant macroeconomic events on a national, regional, and global scale. Most notably, famous hedge funds such as Bridgewater, Brevan Howard, and Tudor Fund Management are built on this strategy. The main strategies involve currencies, rates, and stock indexes. CTAs Sometimes files under global macro, commodity trading advisors (CTAs) use futures contracts to achieve their trading objectives. Systematic and discretionary trading are two of the strategies CTAs use. Systematic trading refers to putting all the fund manager’s knowledge into an algorithm and letting the computer take care of the trading. Dunn Capital is notable for this style. Discretionary trading lets the fund manager decide what to trade after reviewing his research. That is, trades are made at the manager’s discretion. Relative Value A relative value fund is an actively managed hedge fund that seeks to profit from temporary differences in the prices of related securities. Market Neutral Regardless of an upward or downward market environment, market-neutral funds aim to profit through paired long and short positions or derivatives. These funds can mitigate market risk as they seek to generate positive returns in all market environments. They aim to eliminate beta (or market risk) and profit from their excellent stock-picking skills (alpha). Convertible Arbitrage Convertible arbitrage involves taking a long position in a convertible bond and a short position in its underlying stock simultaneously. The idea is to capture the pricing difference between the convertible bond (or preferred stock) and the underlying common stock. Capital Structure Arbitrage Capital structure arbitrage refers to strategies hedge funds use to take advantage of the relative mispricing across different security classes (both debt and equity) issued by the same company. Fixed Income Arbitrage Fixed income arbitrage is an investment strategy that aims to profit from the minor differences in interest rates between fixed income securities. When using a fixed-income arbitrage strategy, the investor assumes opposing positions (long-short) in the market while limiting interest rate risk. Event-Driven An event-driven strategy attempts to take advantage of temporary stock mispricing, which can occur before or after a corporate event. Hedge funds use it because the method requires the expertise to analyze corporate events for successful execution. Examples of corporate events include restructurings, mergers/acquisitions, bankruptcy, and spinoffs. Merger Arbitrage Merger arbitrage involves exploiting market inefficiencies before or after a merger or acquisition. Merger arbitrage traders focus on the probability of the deal being approved and how long it will take to finalize it. Since there is a probability the merger may not be approved, merger arbitrage carries some risk. Distressed Distressed debt trading involves purchasing bonds that are trading at a distressed level in anticipation of reselling them over a relatively short period at a higher valuation, generating a profit. Wrap Up And there you have it—a 1,200-word introduction to hedge funds. I hope you find it helpful to navigate through the investing world or the business newspapers. Have a great day! All the best, Sean Ring Editor, Rude Awakening [ARCHIVE]( | [ABOUT]( | [CONTACT US]( Rude Awakening is committed to protecting and respecting your privacy. We do not rent or share your email address. By submitting your email address, you consent to Paradigm Press delivering daily email issues and advertisements. To end your Rude Awakening e-mail subscription and associated external offers sent from Rude Awakening, feel free to [unsubscribe](. Please read our [Privacy Statement.]( If you are you having trouble receiving your Rude Awakening subscription, you can ensure its arrival in your mailbox by [whitelisting us.]( © 2022 Paradigm Press, LLC. 808 Saint Paul Street, Baltimore MD 21202. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized financial advice. We expressly forbid our writers from having a financial interest in any security they personally recommend to our readers. All of our employees and agents must wait 24 hours after on-line publication or 72 hours after the mailing of a printed-only publication prior to following an initial recommendation. Any investments recommended in this letter should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.