What Is A Hedge Fund? What Are Their Objectives? + More Information
A hedge fund is an investment fund that pools money from wealthy individuals or institutions and uses flexible, often aggressive strategies to try to generate returns—in both good and bad markets. Certain funds have different strategies. Some take a macro approach, some are event-driven, some use a quant multi-strategy, some use a multi-manager equity strategy, some are long and short, some are long-only, and some focus on credit. Every fund has its own benchmarks and objectives, but some common objectives include absolute returns (making money regardless of market direction), achieving high risk-adjusted returns (think high Sharpe ratio), capital preservation with upside, and many more.
Why is it called a hedge fund? Originally, the idea was to hedge risk (long stocks + short stocks). Ironically, many modern hedge funds are less hedged than the name implies. We focus on the original objective, though benchmark-beating returns are very important to us. There are a myriad of ways you can hedge risk to protect your capital. Common ways include protective puts, pair trades (long and short stocks), VIX calls for volatility risk, treasury futures, and duration matching for interest rate risk. You name a risk—it can be hedged one way or another.
Are we a hedge fund? No, we are not. Let me explain.
A hedge fund is a specific legal and operational structure for managing capital. It has general and limited partners, typically charges a 2% management fee and a 20% performance fee (we can charge performance fees as well), and comes with high operational costs. These costs, along with regulatory and structural constraints, can limit flexibility when serving different clients.
For these reasons, we chose a traditional RIA (Registered Investment Advisor) structure. With an RIA, we can accomplish almost everything a hedge fund can, but in a more flexible and cost-efficient way for us and for clients. There are a few things hedge funds can do that we cannot due to our legal structure, including:
Use more leverage – Hedge funds are not limited by Regulation T, whereas RIAs are capped at roughly 2:1 leverage.
Operate with fewer diversification constraints – Regulators may take issue if too much of a single holding is in a client account.
Short hard-to-borrow securities at scale and for long durations – Hedge funds have more flexibility here.
Control investor liquidity – Hedge funds can impose lockups, gates, or side pockets to manage capital inflows and outflows.
There are additional differences, but these are some of the most notable examples.
Here is a video that goes more into hedge funds.
When you hear “hedge fund” think legal structure. Do not think better investment management. Some things below that I have found true from living and working in financial services when it comes to investment management.
Hedge Funds do not = better investment management
CFA/CFP/CAIA/MBA/The credential letters game does not = better investment management.
Lots of money under management does not = better investment management
Wharton'/MIT/Stanford/ Harvard/Ivy League Education does not = better investment management
Can these things be part of a really good investment manager? Yes. Do they automatically equal a better investment management experience? No. I can show you the data and I can also point to a myriad of well credentialed veteran investment professionals that underperform the benchmarks.
