In the world of finance, there are certain terms that get thrown around frequently,
and often people within the industry just assume that everyone knows what they mean.
In fact, sometimes people even assume that they themselves understand what it means,
but when they actually stop and think about it, they really don't know at all.
One of these terms is the infamous "hedge fund".
These types of companies gained a bit of notoriety thanks to their perceived involvement
in some of the darkest days in the financial markets and with specific assets.
But although we are all familiar with the term "hedge fund",
it seems not everyone is familiar with what it actually means.
So in this video I'm going to be giving you a basic overview of hedge funds,
including their history, how they've evolved. Some of the key attributes of them, their
strategies and their role in the financial markets.
This will allow you to make more sense of when this term is used in the financial media
and hopefully allows you to differentiate between other types of investment firm.
The birth of the hedge fund can be attributed to Alfred Winslow Jones who in 1949 took long
positions of undervalued securities and short positions
of overvalued securities as an insurance against the
downturn in the market, thus creating a “Hedge Fund”, as he was hedging the position.
However, according to Warren Buffet, the roots of the concept dates back to the mid-1920s.
Benjamin Graham who is widely known as the father of “value investing”, used the
same strategy to hedge his investments and also to charge an
incentive fee to investors. The strategy was to generate returns irrespective
of the market’s direction. Hence, the name of the funds comes from the
strategy itself.
The authorities have yet to assign the hedge fund a legal definition.
Essentially, many regard hedge funds as an alternative investment vehicle,
a pool of private funds managed by a sophisticated manager for the sophisticated and wealthy
investors. Due to their requirements and the structure,
hedge funds, unlike other funds, such as mutual funds or ETFs, are partially not regulated.
In addition to that, hedge funds cannot seek funds from the general public.
They operate on a private investment partnership. Therefore, they have more operational freedom
and can aim to generate returns in any kind of market regardless
of the market condition.
In general, hedge funds and mutual funds fall under the same category of pooled investments.
However, they are differentiated by the distinguishing attributes of the investors' requirements.
According to the SEC, an investor is considered accredited when they have earned an
income of $200,000 in the last two years and expects the same in the current and the future
year or hold a net worth of more than a million
dollars. This is required to ensure that the investor
is able to take on the risk of investing in these unregulated securities.
Therefore, the investor needs to be conscious of the uncertainties of
taking such risk which in case of unexpected events could destroy their entire investment.
Unlike the traditional mutual fund managers, the managers of hedge funds are more diverse
in nature and have the technical know-how to use exotic or complex
instruments like derivatives to generate returns. The ability to go long or short in an asset,
means they can also make use of more complex strategies such as equity hedging, tactical
trading and arbitrage, where they take advantage of pricing inefficiencies in an asset,
although this is not so common anymore, with their being fewer opportunities due to the
rise of high frequency trading and the overall competitiveness of the market.
So basically, the managers have the skill to formulate their own trading strategies
depending on the market conditions. Therefore, they can charge an extra incentive
fee on top of a management fee for their performance.
The annual management fee ranges from 1% to 2%, independent of the performance of the
fund. Additionally, the incentive fees typically
range from 20% to a whopping 50%! This fee acts as an incentive for the manager
to outperform and generate better returns in the market.
There has been a lot of pressure on hedge fund managers to reduce their fees.
And in fact, this year we have seen a lot of capital being withdrawn from hedge funds,
particularly in Asia, due to the excessive fees they are charging
and the availability of alternatives. This is also partly due to the relative underperformance
of macro-related funds. This has led to a lot of money moving to private
equity and real estate instead.
Overall there has been a big rise in the number of hedge funds, from a mere 610 in 1990
to a phenomenal amount of 15,000 in 2017. The funds that practice automation in their
investment procedure have seen enormous growth in the hedge fund segment.
Barclays claims that “Quants” are now responsible for around 17% of the total hedge
fund assets.
This past decade has seen a sharp rise in the technological fields such as machine learning
and Artificial Intelligence. In fact, a new kind of hedge fund is now combining
machine intelligence to manage the investment of an American hedge fund.
It is believed by some that the high usage of technology might prove to be helpful in
preventing the market from large shocks in the future
as with time AI (artificial intelligence) will eventually exceed human abilities and
perhaps get closer to solving the stability puzzle.
By nature, hedge fund managers tend to be secretive.
Therefore, transparency remains a big issue when considering investing in hedge funds.
The managers tend to be secret in their ways and the use of their strategies
and may even keep the funds under a lock-up period whereby investors can
only take out their funds during specific intervals that are set by the manager.
This overall issue was heightened by the infamous ponzi scheme run by Bernie Madoff.
Madoff took the money from investors and portrayed false returns to get away with it.
This multi-billion-dollar scam affected many, many investors and charities.
and Madoff was later sentenced to 150 years in prison for various charges.
These events suggest that this level of secrecy might be wrong.
And pressure from institutional investors has compelled some of the hedge fund managers
to present their financial report on a regular basis.
Hedge fund managers often use leverage to boost their returns and
to make the fund more attractive. While leverage has of course got its benefits,
it also has its downsides, as it increases the
volatility of the fund, thereby making it much more vulnerable to downside risk.
This is illustrated in the case of Long Term Capital Management (LTCM).
LTCM was formed in 1994 and was highly publicised around the world,
due to the reputation of the founder and the board members:
John Meriwether, the former vice chairman of bond trading at Saloman Brothers
and Myron Scholes and Robert Merton who both won a Nobel prize for
their work on the valuation of derivatives, including their famous Black-Scholes options
pricing model.
LTCM generated an average annual return of 30% after fees up until 1997.
Due to their reputation and popularity, LTCM was able to obtain extremely high leverage
from large banks and was in a position to enter large swaps contracts.
But soon, disaster struck. After the Russian crisis, LTCM was hit by
a loss of more than $4 billion. Its loan-to-value had reached 250:1 at its
peak leverage. And ultimately the US Federal Reserve had
to come in and bail out LTCM as this kind of event could have resulted in
a complete financial meltdown. However, the blame for this does not fall
solely with LTCM, it's also the fault of the banks that provided
such ridiculous levels of leverage without fully assessing the risk in LTCM's
strategy. Nevertheless, operating on such high levels
of leverage is an invitation to a lot of trouble.
Perhaps the most documented role of hedge funds, was their involvement in the financial
crisis. Now although this is something that does warrant
a whole series of videos of its own, let's just go over a very quick and brief overview.
So in response to the recession of 2001, the US Federal Reserve lowered its rates down
to 1.5% which also meant there were low returns on bonds.
Hence the pension funds moved their investments into hedge funds to earn greater returns.
This resulted in managers generating riskier investments such as the Mortgage-Backed Securities.
There were a pool of mortgages which at the time were really profitable.
Due to the huge demand for Mortgage-Backed Securities, some of the larger institutions
also started to form their own hedge funds. It was also at this time that the lowered
interest rates resulted in large amounts of people opting for interest only mortgages.
Homeowners would take a home loan from the lender who would then sell them on for a commission
to investment banks, the investment banks bundled these mortgages
along with other debt such as student loans, car loans and so on.
and created something called a Collateralised Debt Obligation (a CDO)
and passed it onto to the investors as it gave the investor a wide variety of choice
in terms of risk.
However, in order to tackle inflation, the US Federal Reserve increased their interest
rates. As you can imagine, this resulted in more
defaults by homeowners - and especially the subprime segment.
The wake of 2007 saw many of the eminent hedge funds collapsing due to their high-risk levels.
And finally, when the housing bubble burst this whole chain was jolted and the markets
collapsed.
Hedge funds managed to avoid a lot of the responsibility, since these risky investments
were also used by the banks, insurance companies and other funds.
And the hedge funds were not directly responsible for the formation of the destructive securities.
However they did actually hold the largest amount of CDOs at the start of the crisis
- 47%. And it can be argued that hedge funds gave
the CDOs the impetus which ultimately led to part of the crisis.
This suggests a stricter regulation of hedge funds should be put in place to avoid these
kinds of events happening i nfuture.
Although there has been a lot of skepticism about investing in hedge funds, most of the
criticism actually lies with their high fees and lack of transparency.
However there has been a gradual shift over time towards more transparency, better regulation
and lower fees and these issues are also expected to further improve in the future
Hedge funds are accessible to retail investors via funds of hedge funds.
And statistically speaking, hedge funds have in general outperformed other asset classes
while remaining relatively stable amidst various crises.
The structure of hedge funds gives the hedge fund managers the freedom to invest in any
market using any kind of investment, naturally giving them a wide variety of choices.
Historically, hedge funds have proved to reduce volatility and provide diversity in an investor's
an overall portfolio and with the advent of machine learning and
AI, we may see even better stability in the future in one of the most complex systems
in the world - the capital markets.