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The Cut: Hedge Funds - What you Need to Know

Chamal Abeytunga

Author

Director of Publications

Anne-Marie Behn-Katz

Editor

Vice-President of Publications




i. What is a Hedge Fund?

Let’s start from the beginning; a Hedge Fund is essentially a pool of money, contributed to by individual investors, as well as other sources, such as superfunds and funds reinvested by banks. A hedge fund is run by a fund manager, whose main goal is to maximise the returns, and minimise risks for investors. The pooled structure is often organized as either a limited partnership, or a limited liability company, and due to the high-risk nature of hedge funds, only a select few qualified investors and institutions have access. The money initially pooled within the hedge fund is not an investment itself, but rather the fundraising effort for future investments.

Before moving forward with an explanation of hedge funds, it is vital to understand what long and short selling is:

  • Short Selling: When short selling, the investor will profit if the value of the stock falls. The investor borrows a stock, sells it, then buys the stock back at a lower price, once the price of the stock has fallen – before then returning the original stock to the lender
  • Long Selling: Long selling is essentially buying the stock at a low price, then selling it at an increase.

Hedge funds hold both long and short stocks, with the positions ‘hedged’; hence the name ‘Hedge Fund’. The funds also invest in other assets and derivatives, such as cryptocurrencies. The most famous hedge funds, like ‘Bridgewater Associates invest in multiple assets; however, a majority of hedge funds specialize in a certain asset area. There are hedge funds that focus only on common stocks, while others concentrate on assets, such as ‘junk bonds’, real estate, and private equity. Similarly, there are also hedge funds which are composed of multiple smaller hedge funds.


ii. Requirements to Invest in a Hedge Fund

Those who are looking to invest in a hedge fund must first attain a certain net worth and income. Furthermore, there are several government regulations that oversee the accreditation of investors; however, these requirements vary from country to country.

The requirements below are the requirements of USA however, other countries also have similar regulations. These regulations are imposed as hedge funds are immune from regulations which protect average investors. Accredited investors should meet the following requirements.

For individual investors:

  • A personal income of above $200,000 annually. If married, the household income should be more than $300,000 annually. In addition, there should be sufficient proof of having an income above the required for the past two years, and also the potential to continue the requirement for the foreseeable future.
  • In addition, the individual or combined net worth of the household should be more than $1 million excluding the primary residence.

For Institutions:

  • If the investor is an institution, it may be a trust fund managed by a sophisticated fund manager. The trust fund must have a net worth above $5 million.               
  • If the investors of the institution are accredited, then the institution as a whole can be considered accredited.

In Australia, investing is a clear-cut difference between the rich and the poor. All an Australian investor will need is $50,000 AUD. Unlike the US, there aren’t any net worth requirements, and Australian hedge funds are known to invite people with average incomes to invest with them. This gives the ordinary investor access to the expertise of skilled investment managers. Australia’s hedge funds are small in number and don’t have a lot of assets under management. According to a report published by ASIC in 2015, single-manager hedge funds, at $83.7 billion under management, represent only 3.5% of all Australian managed fund assets. There are 473 local hedge funds with about half of them managing just $50 million in investments.

ASIC Report: https://download.asic.gov.au/media/3278608/rep439-published-1july2015.pdf


iii. Fund Manager Fees

Managers of hedge funds are compensated based on terms and arrangements in the fund operating agreement. Their fee is based on a concept known as the “2 and 20 principle”; the fund manager receives 2% of the net assets, and 20% of the profits above the pre-determined returns. However, the fund manager fee can ultimately vary according to the Fund operating agreement.


iv. A Quick History of Hedge Funds 

The first known successful hedge fund was the Graham-Newman partnership. Benjamin Graham is one of the best-known investors in the modern era. His book, The Intelligent Investor, has produced many investors, such as Warren Buffet. Initially, hedge funds specialized only in one asset class, and the investing strategies used were very basic compared to today’s strategies; the most common among them being the aforementioned long/short strategy. The concept of hedge funds gained momentum in the early 1970s; however, with the shutdown of many hedge funds during the Recession of 1969-1970, hedge funds became less popular, even among the wealthy. The funds eventually regained momentum, until the 1973-1974 stock market crash.

Even though Hedge funds didn’t cease to exist after turbulent economic conditions, the confidence in hedge funds was very low. Subsequently, with Ronald Reagan’s presidency in the US, investor confidence increased, bringing with it an economic boom; more investors used hedge funds as a vehicle for their investments, enticed by the high returns hedge funds provided, as compared to other investments. During the 90’s, hedge funds advanced drastically and the associated strategies expanded to concepts such as credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy. Many US institutional investors, such as pension funds, trust funds and endowment funds, started to allocate a higher proportion of their portfolios to hedge funds.

Before the 2008 financial crisis, the industry value of hedge funds had reached a staggering $1.93 trillion US dollars in 2019. Following the crash, there was very low confidence in hedge funds and the industry value fell. Currently, after more than a decade, the industry value of hedge funds is $3.14 trillion USD; the most prominent hedge fund In 2021 being Bridgewater Associates, with $150 Billion USD worth of assets under management.

Distressed Debts:  https://en.wikipedia.org/wiki/Distressed_debt
Fixed Income: https://en.wikipedia.org/wiki/Fixed_income
Quantitative Analysis: https://en.wikipedia.org/wiki/Quantitative_analysis_(finance)
Bridgewater Associates:
 https://en.wikipedia.org/wiki/Bridgewater_Associates

 

v. The Difference between Hedge Funds and Private Equity

In private equity, investors raise funds from other investors, and once they reach the target amount of the investment, they close the fund and invest in promising companies, then finally list the companies publicly or sell them privately. The commonly shared aspect between hedge funds and private equity, is that both appeal to individuals with high net worth, and both are generally structured as limited partnerships, involving the payment of basic management fees plus a percentage of profits to the managing partners.

Private equity funds are like venture capital firms, in that they invest directly in companies. They purchase private companies and acquire controlling interest in companies through stock purchases, and buy failed companies through leverages buyouts. Furthermore, private equity funds are more focused on long term profits, unlike hedge funds who seek short term profits. Additionally, Private Equity funds acquire then improve a company through management changes, merging two or more companies and streamlining operations. Finally, these companies are sold through an initial public offering in a stock market. To ease the operations of a private equity, there is a fund manager and a group of corporate experts who are assigned to manage the acquired companies. The very nature of their investments requires their more long-term focus; looking for profits on investments to mature in a few years, rather than having the short-term quick profit focus of hedge funds.

In contrast, hedge funds are focused on liquid assets – Investors can usually cash out their investments in the fund at any time they wish. However, in private equity funds there is a minimum period, ranging from 3-10 years, of expected commitment from the investor. There is also a substantial difference in risk level between hedge funds and private equity funds; both combine high risk investments with safer investments, but hedge funds are considered to be riskier due to the short-term profit expectations. Furthermore, the investment structure of hedge funds and private equity funds are considerably different: Hedge funds are open-ended, and investors can continuously add or redeem their shares in the fund at any time, while private equity funds are closed-ended and new money cannot be invested after an initial period has expired.

 

vi. How to Get a Job at a Hedge Fund

The recruitment processes of hedge funds are very opaque, and job opportunities are rarely publicized. Hedge funds are the perfect place of employment if you love handling money and financial markets, and you have an interest in following companies and securities. The first step of landing a job at a hedge fund is networking. Networking does not necessarily have to be face-to-face; LinkedIn and emails are some of the greatest ways to reach the people in control of employment for your dream job. Furthermore, writing letters to hedge fund managers may be a great way to show your passion for working around hedge funds.

Most of hedge fund managers perform public interviews and speak at conferences – the best way to begin the conversation with an already established investor would be to talk about investing itself, and about their principles when it comes to investing; listening to their speeches and public interviews would help you drastically.

With the rise of index funds and passive investing via automated trading and AI, many people believe hedge funds are a dying industry. Although new technologies will cause some changes to the requirements hedge funds are looking for in their potential candidates, there is no doubt the industry will continue to grow steadily in the coming future.

There are three main roles at Hedge Funds:

  • Investment Analysts (IAS) or Research Analysts: This position is for younger junior employees, who generate investment ideas through analysis and presentation.
  • Portfolio Managers: Portfolio Managers review the analysis of the investments analysts, and choose the best investments to pursue.
  • ETS (Execution Traders): Execution Traders fulfill the ideas of the managers, using their innate knowledge of the market.

If an individual is skilled enough, they could perform a mixed role of in investment analysis and trading.  At quantitative hedge funds (funds that rely upon algorithmic/systematic strategies when implementing trading decisions) there are also opportunities for programmers and statisticians.  In addition, hedge funds require legal and IT teams, although these teams rarely engage in the investment process.

A common entry point into the world of hedge funds is through the position of Investment Analyst. This role requires solid experience in an investment bank, or in equity research. Nevertheless, working in mutual funds or asset management’s funds would also prepare you for work at a hedge fund as an investment analyst. It should be noted that the exit opportunities of hedge funds are very low, therefore when you are choosing the best hedge fund for employment, you should prepare extensive research.  The most enticing aspect of working at a hedge fund is usually the opportunity for high income earnings; however, income is proportional to performance. Junior investment analysts can take home between $500,000 USD and $1,000,000 per annum.

A high GPA in a finance related degree, technical skills (such as coding, especially in programs like python), and your University’s reputation, are some of the main factors which will determine your employment opportunities at a hedge fund; nonetheless, there are on-cycle and off-cycle pathways for finding work at hedge funds. Due to the more fragmented and less standardized skillsets required in hedge funds, off-cycle recruiting is more prevalent. Mega funds, such as Citadel and Bridgewater, do have on-cycle recruiting; However, they tend to use headhunters, as extensive experience is needed to work in these mega funds.

In order to secure a job as an investment analyst, you should be very passionate about financial markets, and should have a solid knowledge about the stock market and how it works. Many universities, including UQ, have a student-managed investment fund (SMIF), which provides invaluable experience when applying for hedge funds after uni.

If you are hoping to work in a hedge fund, you should have a hedge fund and a few investment banks in mind. As mentioned above, hedge funds tend to use headhunters, who usually dominate the process of recruiting. If you perform very well at an investment bank, there is a high chance you will be noticed by these headhunters. Furthermore, interviews in a hedge fund usually go 4-5 rounds, with several individual interviews, investment pitches and modelling tests. Like every other industry, there are medium-sized and small-sized firms. By maintaining a high GPA, solid extracurricular activities, and decent coding skills, along with deliberate and effective networking with key members of the industry, you can increase your chances in landing an investment analyst position in a medium or small-scaled hedge fund; this way you can work your way up to mega funds.