Like mutual funds, exchange-traded funds (ETF), and private equity funds, hedge funds are designed to pool money from numerous investors, allowing the hedge fund manager to invest this capital based on various investment strategies. The goal is to create a positive ROI for the investors. This is, however, where the similarities to other types of funds end. Hedge funds differ noticeably in key ways:
- A wider array of strategies: In contrast to other types of investment funds, hedge funds are legally allowed to draw from almost the entire investment strategy playbook, trading in securities, derivatives, futures, and many other types of investments. A fund's investment philosophy determines which investment techniques it employs. One thing most hedge funds have in common is that they tend to trade predominantly in liquid assets.
- Open-ended structure: Most hedge fund strategies generally allow investors to purchase or redeem shares in the fund at any time. This means investors can invest money into the fund or take money out of it whenever they wish. This is in stark contrast to closed-end systems, which issue shares at the outset and allow investors to redeem them only after a set period of time.
- Absolute return: Most hedge funds aim to provide investors with a positive ROI regardless of the current market situation. This means they will invest in both long and short positions to ensure the fund can create a positive return regardless of whether it's operating in a bull or bear market.
- Risk management: Since they have legal access to a large variety of investment strategies, hedge funds can "hedge their bets" (hence the name). This involves combining risky investments with low-risk ones or combining long positions and short positions within the same fund to mitigate the risk involved.
While there is some dispute over when the first-ever hedge fund was invented, most experts agree that the investment model has gained significant traction with seasoned investors and the super-rich since the late 1980s; thanks to the combination of substantial potential returns and the availability of effective risk management strategies to offset the comparatively high risk involved in these strategies. Today, even novice investors can now engage with the hedge fund industry thanks to the tools provided by CARL.
While some countries may restrict trade in specific financial products such as derivatives, hedge funds in the US are not limited in terms of the investment strategies they are allowed to employ, from trading financial assets and derivatives to merger arbitrage or even cryptocurrency investment.
Despite this near-limitless freedom, most of these funds define themselves by an investment philosophy that clearly outlines how the fund will invest its capital and how it aims to hedge the risk. For example, a fund may specialize in investments in the healthcare sector, trading securities, or emerging markets investments. This is often dependent on the personal expertise of the hedge fund manager.
Hedge funds are often classified according to which strategies they specialize in, though they are not limited to employing only one hedge fund strategy at a time ("multi-strategy funds").
The most traditional hedge fund strategy, absolute return funds, employs a long and short equity combination, using the short positions as a hedging strategy. Typically, these funds have a net long market exposure, meaning not all of their market value is hedged.
These funds tend to follow market trends and use long positions while employing fewer hedging strategies. This means that the returns of these hedge funds are potentially higher. However, the risk involved is also more significant, as the long market exposure isn't hedged via short positions. Some directionals also employ short-only strategies.
This approach aims to create a net-zero market exposure – in other words: all long positions are typically hedged 100 % by short positions. This is meant to minimize the risk, though the strategy typically also generates smaller returns than more risky strategies.
As the name suggests, the goal of these funds is to predict market events and change their investment strategy accordingly. This strategy includes methods such as merger arbitrage which generates returns from corporate mergers and takeovers.
Global Macro Strategies
Global macro funds analyze global market trends and invest accordingly. In a way, this strategy can be considered to be event-driven, though the events in question are on a much larger (macro) scale. Examples include the recent COVID-19 epidemic or the 2008 financial crisis, both of which have had macro-scale effects on the global market environment.
Addendum: What Are Quantitative Hedge Funds?
Quants aren't distinguished so much by what they invest in but by how they invest. They employ machine learning and computer modeling to arrive at investment decisions instead of using the intuition and experience of the hedge fund manager. This means that quants can utilize all of the investment strategies outlined above while using algorithms to come to investment decisions, resulting in descriptions such as "quantitative global macro".
What’s the Role of the Hedge Fund Manager?
The manager is responsible for making investment decisions on behalf of all of the investors in the fund. In traditional hedge funds, the manager makes investment decisions in part based on their own intuition and experience, which is why many successful funds feature well-established figures from the world of finance at the helm. In quants, the manager's role is to oversee and maintain the computer models and algorithms responsible for investment decisions. That's why many quants feature experienced mathematicians and computer scientists in a management role.
The hedge fund manager is compensated for their work via a management fee (typically 2 % of assets under management) and receives a performance fee or incentive fee (usually 20 %) on profits made above the hurdle rate.
As you can see, there is a myriad of options when it comes to investing in hedge fund strategies. In the past, these complexities have led to the field being dominated by professional investors, while many ordinary US citizens have ignored hedge funds despite being legally eligible to invest. CARL aims to change this situation by democratizing access to these alternative investment options.
The CARL app includes a number of carefully vetted hedge funds to choose from, as well as valuable tools that make investing and keeping track of your investments easy as pie. This includes real-time performance updates, which allow you to carefully monitor your investments anywhere and anytime on your smartphone.
What Are the Requirements for Investing in Hedge Fund Strategies?
In the US, anyone who is legally considered to be an accredited investor can invest in a hedge fund. This means you need to have either
- a net worth of at least $1,000,000 (excluding the value of your primary residence) or
- an annual income over $200,000 for the last two years ($300,000 for married couples).
Once you've gone through the mandatory vetting process to determine your status as an accredited investor, you're good to go!
Whether you want to diversify your portfolio or you're just looking for greater returns on your investments, hedge funds might be the investment vehicle you're looking for. Since these funds have a lot more freedom in terms of the investment strategies they can employ, they can potentially out-perform other types of funds while effectively limiting the risk involved thanks to various hedging strategies.
What's more: CARL even takes care of the vetting process for you. Usually, you would need to collect information on which funds are currently looking for investors and how they operate to get a clear picture of your options. CARL takes care of that for you and presents you with a choice of hedge funds that have already undergone a rigorous due diligence process. And thanks to CARL's low minimum investment threshold of $20,000 you can start out small if you prefer to stay on the safe side.