What is a Hedge Fund?

What is a hedge fund: Hedge fund in English is Hedge Fund, which means “funds for hedging risks”, also known as “hedge funds” or “arbitrage funds”. After reading this article, you will learn in detail: What is a hedge fund? Hedge fund rankings? How do hedge funds work? What is short selling by hedge funds? How do hedge funds make money? How do hedge funds make profits?

Hedge Fund , in English , means ” fund for hedging risks “, also known as ” hedge fund ” or ” arbitrage fund “. The typical characteristics of hedge fund transactions are:

• Transaction-oriented, not investment-oriented;
• Keen on leveraging and pursuing high profits, but also accompanied by high risks;
• The goal is arbitrage, and both long and short strategies will be adopted.

Currently, global hedge fund managers have approximately US$3.3 trillion in assets, with the main investors being financial institutions and high net worth individuals.

Hedge funds are not something that ordinary retail investors can invest in. They have high entry requirements and extremely high investment risks.

Hedge funds have a long history, but their significance has changed fundamentally in different eras. Although not many people can participate in hedge fund investment, hedge funds are involved in almost all financial investment fields.

How did hedge funds develop?

Hedge funds first originated in the United States in the early 1950s. The main purpose of their operation is to use financial derivatives such as futures and options, as well as long buying and short selling of different related stocks, to avoid and resolve investment risks to a certain extent.

Simply put, it refers to a fund that uses gains to offset losses .

In the 1980s, with the rapid development of financial liberalization and the increasing maturity and diversification of financial instruments, the role of hedge funds has undergone major changes:

• The purpose of hedge funds has gradually changed from “offsetting losses” to “making greater profits” ;
• The timing of hedge fund operations has also changed from being conducted after other investment operations, using their own profits to hedge the risk of investment losses, to being conducted independently and proactively, relying on the hedge funds themselves to make profits;

It can be said that today’s “hedge funds” are no longer the “hedge funds” of the past. They just keep the same name, but their investment purposes and methods have changed greatly.

The current understanding of “hedge funds” in the financial community is that fund managers make full use of various financial derivatives such as futures, options, interest rate swaps, foreign exchange swaps, etc. to make speculative investments, pursuing high-risk and high-return investment funds, and usually bear greater risks than the overall market.

What are the characteristics of hedge funds?

Current hedge funds have the following characteristics:

1. Fund Type

A hedge fund is a private fund that is independently run by a fund manager who decides the financial products to invest in.

2. Regulatory intensity

Hedge funds are not as strictly regulated as mutual funds and typically have more leeway to pursue investments and strategies that could increase investment returns or risk.

3. Participants

Hedge funds are only allowed to take money from so-called “accredited investors,” such as individuals with annual income of more than $200,000 in the past two years or a net worth of more than $1 million, excluding their primary residence.

4. Investment Target

Hedge funds can invest in almost any financial product, including land, real estate, stocks, various financial derivatives, and currencies, and can go long or short, while mutual funds usually only go long.

5. Investment Methods

Hedge funds are almost always leveraged investments , usually using borrowed funds to magnify investment returns, and are allowed to make aggressive short-selling investments. This approach may earn high returns, but it may also cause heavy losses and even bankruptcy.

6. Investment costs

The high risk of hedge funds requires fund managers to have extremely high market judgment capabilities.

As a result, the fund manager’s returns will be much higher than the income of ordinary fund managers. Hedge funds usually adopt a 2-20 fee structure:

• 2%: During the investment process, whether the investment fails or succeeds, the hedge fund manager will charge a 2% asset management fee;
• 20%: If the investment is successful, a 20% fee will be extracted from the client’s earnings;

How do hedge funds work?

Taking stock investment as an example, let’s take a look at how hedge funds operate in the early and late stages.

Early

In the initial hedging operation, the fund manager purchases a stock and at the same time purchases a put option of a certain price and time limit on the stock.

When the stock market value rises, the rising profits will offset the cost of purchasing put options. Similarly, when the stock falls, investors can sell the stocks they hold at the price specified by the option, thereby hedging the risk of stock price decline.

It can be seen that early hedge funds did play a “hedging” role and were used by conservative investment strategists for risk hedging and preservation.

now

Once people realized that hedging could make money in a bear market, its nature began to change.

Hedge fund managers began to make high-risk investments with an aggressive attitude through a combination of various investment models.

For example, from 1999 to 2002, ordinary public funds lost an average of 11.7% per year, while hedge funds made a profit of 11.2% per year during the same period.

For example, during the 2008 subprime mortgage crisis, Bridgewater Hedge Fund’s Pure Alpha Fund achieved a profit of 9.5%.

Sometimes, hedge funds make already fragile stocks or financial markets even more vulnerable through “short selling”. For example, in 1991, the “financial tycoon” Soros attacked (shorted) the British pound through the Quantum Fund, which dealt a heavy blow to the British economy and forced the pound to withdraw from the European exchange rate system. However, Soros made a profit of $1 billion through hedge funds.

The most well-known investment methods of hedge funds are: short selling and long selling .

What is short selling by hedge funds?

Short selling, in English, is the biggest difference between hedge funds and other funds. This also makes it possible for hedge funds to profit in a bear market or destroy a certain stock in a more aggressive way to make a profit.

For example, the GameStop incident in February 2021 was initially caused by two hedge funds, Melvin Capital and Light Street Capital, shorting GameStop stocks, which were jointly bought by Reddit WallstreetBet.

The operation method of short selling is as follows:

• If a hedge fund believes a stock will fall, it will borrow the stock through futures trading and promise to return it at a future time.
• After borrowing the stocks, the hedge funds sell them in large quantities, which will cause the stock price to fall rapidly. Due to the huge number of stocks sold, it often causes a chain reaction in the market. If more retail investors and institutions follow suit, it will cause the stock price to fall further.
• When the stock price falls to a certain level, the hedge fund will buy back the stock at a low price and return it to the institution.
• Therefore, during the short selling process, if the stock price falls, the hedge fund can earn the difference in the stock price decline.

The risk of short selling is that when hedge funds sell a large number of stocks, a large number of investors in the market quickly take over, causing the stock price to rise instead of fall.

At this time, the hedge funds have to buy back the stocks at a high price and return the stocks to the institutions, and they themselves lose the difference in the stock price increase.

The WallstreetBet vs. Melvin Capital incident is a typical case of failed short selling, and it was a group of enthusiastic retail investors who attacked the hedge fund, which can be called a historic operation.

What’s up with hedge funds going long?

Compared with short selling, long investing is a more normal investment strategy, which means buying low and selling high.

When hedge funds believe that a certain stock will rise sharply in the future, they buy a large amount of it at a low price, pushing up the stock price. The rising momentum of the stock price will attract more capital injection, and the stock price will continue to rise.

When the stock price reaches the hedge fund’s expected price, the hedge fund will sell a large number of stocks in its hands and earn a high profit from the difference.

The risk of going long is that the stock price does not rise, or even falls. For hedge funds holding a large number of shares, the losses will be much greater than those of ordinary investors.

How do hedge funds make money? How do hedge funds make profits?

As an investment, hedge funds invest in a wide range of financial products in order to make huge profits from price differences.

For hedge fund managers, the profits are also considerable, and the current fee structure is 2-20.

• 2 stands for 2%: This is a fixed fee for asset management. Regardless of the investment results, investors must pay 2% of the managed assets.
• 20 represents 20% commission fee: when investors obtain profits, fund managers can obtain a high proportion of 20% from the profits as commission fee;

Although this fee ratio may seem excessively high to ordinary investors, for high-capital investors, the profits they may earn are considerable.

What are the hedge funds in the United States?

Currently, well-known hedge funds in the United States include: Bridgewater Associates, Renaissance Technologies, etc.:

1. Bridgewater Associates

Bridgewater Associates is the legendary “Bridgewater Fund”. In terms of assets, Bridgewater Associates, located in Connecticut, is still the largest fund in the world. It was founded in 1975 by Ray Dalio.

As of February 2020, it manages $160 billion in assets. Some of Bridgewater’s clients include institutional investors, charitable foundations, university endowments, and pension funds.

According to Forbes , Ray Dalio received more than $2 Billion in compensation in 2019 alone.

2. Renaissance Technologies

James Simons, co-founder of Renaissance Technologies, also earned $1.5 billion in 2019.

Renaissance is one of the oldest and most popular hedge fund firms, with investment strategies that have achieved high returns and approximately $68 billion in assets under management. It serves corporations, trusts, individual investors, and financial institutions.

Renaissance is currently run by Peter Brown, with James Simons remaining on the board.

3. Quantum Group of Funds

Quantum Group of Funds is the largest hedge fund managed by the Soros Fund, a subsidiary of the American financial tycoon Soros. It is also one of the largest hedge funds in the world. It was founded in 1970 by Soros and Jim Rogers.

The fund has profited from multiple attempts to attack the currencies of multiple countries through financial instruments, most notably the 1992 attack on the British pound, an event known as “Black Wednesday.”

During the Asian financial crisis in 1997, Soros used short selling to attack the currencies of Thailand, Malaysia and other countries, and then prepared to attack the Hong Kong dollar. However, due to the strict defense of the Hong Kong government and the strong capital injection from mainland China, Soros finally gave up the attack. However, this also caused heavy losses to the Hong Kong economy. At that time, the Hong Kong Hang Seng Index plummeted by more than 3,000 points in one trading day.

4. Millennium Management

Millennium Management Hedge Fund was founded by Israel Englander in New York in 1989 with initial capital of US$35 million. It currently manages approximately US$48.3 billion in assets and has operations in the United States, Europe, and Asia.

Israel Englander also earned $750 million in 2019.

5. Elliott Management

Elliott Management is one of the largest activist funds in the world. Headquartered in New York, it was founded by Paul Singer in 1977. The company not only invests in hedge funds, but also provides private equity and other businesses. Its total assets currently amount to approximately US$42 billion.

6. BlackRock

Founded by Larry Fink, Robert S. Kapito and others in New York in 1988, it was originally a risk management and fixed income institutional asset management company and currently manages approximately US$8.67 trillion in assets.

7. Two Sigma Investments

Founded in New York in 2001, Two Sigma was co-founded by John Overdeck, David Siegel and Mark Pickard. Siegel holds a doctorate in computer science and Overdeck is a silver medalist in the International Mathematical Olympiad. They established Two Sigma using a variety of modern high-tech technologies including artificial intelligence and machine learning. Currently, it manages approximately US$58 billion in assets.

8. Citadel LLC

Citadel LLC was founded by Kenneth Griffin in New York in 1990 and is the world’s largest alternative asset management company, with current assets of approximately $35 billion. In February 2021, after Melvin Capital failed to short GameStop and lost 53% of its assets, Catadel and Point72 Asset Management injected $2.75 billion into Melvin.

9. DE Shaw & Co.

Founded by David E. Shaw in New York in 1988, it is known for developing complex mathematical models and sophisticated computer programs to make profits from market anomalies and currently manages approximately $50 billion in assets.

10. AQR Capital Management

Co-founded by Cliff Asness, David Kabiller and John Liew in Greenwich, Connecticut in 1998, it uses a “systematic and consistent approach” to determine portfolio strategies and adheres to diversification within the asset portfolio. It currently manages approximately $143 billion in assets.

11. Davidson Kempner Capital Management

Founded in 1983 by Marvin H. Davidson as MH Davidson & Co., Thomas L. Kempner, Jr. 

In 1984, the company was renamed Davidson Kempner Capital Management and was later managed by Anthony A. Yoseloff. It currently manages approximately $34 billion in assets.

Are hedge funds risky?

Today’s hedge funds are no longer the hedge funds that were established to hedge investment risks.

The multi-field and relatively aggressive investment model once frightened the targets of short selling by hedge funds in the market.

But in fact, while hedge funds have such high profits, they also face equally high risks.

The main investment risks are as follows:

1. Less regulatory intensity

They are less regulated by the federal Securities and Exchange Commission (SEC) than other funds.

Legally, hedge funds are typically set up as private investment limited partnerships, so investment operations that are solely controlled by fund managers are not adequately regulated and protected.

2. More concentrated profits and losses

Hedge funds are mainly controlled by hedge fund managers, and once the investment strategy fails, it will cause concentrated and large losses. This process cannot be regulated and protected like ordinary funds.

For example, Melvin Capital’s short selling on GameStop resulted in a loss of 53% of its assets, which can be said to be a heavy loss.

3. Low liquidity

Investments placed in hedge funds lack effective liquidity because hedge funds typically require investors to keep their money for at least a year, a period known as a lock-up period. Some fund managers may then require that funds be locked up for longer periods.

Withdrawals of investment funds may only occur at specific time intervals, such as once a quarter or once every two years. This means that once investment risks are expected to occur, investors cannot withdraw funds in time and change their investment strategies on their own.

4. Higher risk ratio

Hedge funds usually adopt a leveraged investment model, which increases the investment risk proportionally.

Are Hedge Funds Harming the Economy?

The high risk of hedge funds themselves may lead to mutations in a certain industry, and in the interconnected macro-economic environment, mutations in one link often lead to a series of chain reactions.

For example, as we mentioned before, Soros shorted the pound, which eventually caused severe damage to the British economy; and Melvin Capital shorted GameStop, which almost caused GameStop to completely disappear from the stage of history.

What’s the deal with WallstreetBet vs. hedge funds?

The Wallstreet Bet vs Hedge Fund incident in February 2021 caused a sensation. It can be said to be a hearty game of gambling between retail investors and Wall Street hedge funds.

The incident was caused by the hedge fund’s bearish view on the stock of Gamestop, a long-established physical game store that is a fond memory for many American teenagers.

GameStop, whose performance was already hit by virtual online games, was hit hard in 2020 when the epidemic raged. This attracted Wall Street hedge funds to start shorting GameStop in an attempt to further pressure GameStop’s valuation.

But at this time, some investors, such as “Big Shots” legend Michael Burry, were long on GameStop.

So, for a while, GameStop stock was in a stage where long and short selling were competing with each other, but short selling had a greater advantage.

Finally, the uncles on the Reddit forum came to their senses. The teenagers back then, now uncles, saw that Gamestop, which was like their childhood playmate, was about to be completely defeated by hedge funds. A “battle to defend childhood” was about to break out.

On the Wallstreet Bet forum, which is dedicated to complaining about Wall Street, a slogan of war was shouted, which gathered a large number of retail investors. The former “leeks” have become “fighters” after investing money.

Retail investors buy as many GameStop shares as hedge funds sell, and some even continue to inject capital, taking an “ALL IN” approach.

As a result, at the beginning of 2021 when the stock market was sluggish, GameStop’s stock price rose at an almost vertical angle like climbing a mountain, catching hedge funds such as Melvin Capital off guard.

Although the situation was finally calmed down, the hedge funds suffered heavy losses. For example, Melvin Capital lost 53% of its assets. This also made people realize the high risk of hedge funds.

Frequently asked questions

Question 1: What is a hedge fund?

Hedge fund means “fund for hedging risk”, also known as “hedge fund” or “arbitrage fund”. In the 1980s, with the rapid development of financial liberalization, financial instruments have become more mature and diversified, and the role of hedge funds has changed greatly. Now the financial community understands “hedge funds” as an investment fund that fund managers make full use of various financial derivatives such as futures and options to make speculative investments, pursue high-risk and high-return, and usually bear greater risks than the overall market.

Question 2: Hedge fund rankings?

Currently, the well-known hedge funds in the United States include:
1. Bridgewater Associates
2. Renaissance Technologies
3. Quantum Group of Funds
4. Millennium Management
5. Elliott Management
…

Question 3: What is hedge fund in English?

Hedge fund, in English it is called Hedge Fund.

Question 4: How do hedge funds make money?

As an investment, hedge funds invest in many financial products to obtain high profits from the price difference.
For hedge fund managers, the profits are also considerable, and the current fee system is 2-20.