Hedge Fund Primer

How is a Hedge Fund Structured?

The general partner (GP) and the team of investment professionals regularly track fund performance and adjust the portfolio accordingly, on behalf of the fund’s limited partners (LPs).

Investment decisions are grounded in detailed analysis, research, and forecast models, which all contribute to formulating a more logical judgment on whether to buy, sell, or hold an asset.

Furthermore, hedge funds are often open-ended, pooled vehicles structured in the form of either:

• Limited Partnership (LP)
• Limited Liability Company (LLC)

What are the Top 10 Hedge Funds?

The following chart ranks the top ten largest hedge funds in terms of assets under management (AUM).

Largest Hedge Funds in 2022 (Source: Pensions & Investments)

Largest Hedge Funds List Ranked by AUM (2024)

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What is the Criteria to Invest in a Hedge Fund?

For an individual to qualify as a limited partner at a hedge fund, one of the listed criteria must be met:

• Personal Income of $200,000+ Per Year
• Combined Income with Spouse of $300,000+ Per Year
• Personal Net Worth of $1+ Million

Documented proof that the current income level can be maintained for at least two more years must also be supplied.

The investors, or limited partners (LPs), of hedge funds are generally individual and institutional investors seeking to diversify their portfolios, while still retaining the potential to earn outsized returns.

• Institutional Investors → The institutional investor categorization refers to organizations with substantial amounts of capital to allocate across different asset classes. Common examples include pension funds, university endowments, insurance companies, sovereign wealth funds, and certain firms in the banking sector.
• High Net-Worth Individuals → High net-worth individuals are non-institutional, individual investors with significant personal wealth. In the U.S., the criteria to qualify as an “accredited investor”, one must have a net worth that exceeds $1 million, excluding the value of their primary residence, or have an income of $200,000+ each year for the past two years (or $300,000 combined income if married).
• Family Offices → Family offices are essentially private wealth management firms that serve ultra-high-net-worth investors. Unlike traditional wealth management firms, in which the offers are available to any qualified investor, financial and investment management specifically serves an affluent individual (or family), as implied by the name.
• Funds of Funds (FOF) → The fund of funds investment structure invests in other types of funds, including hedge funds. The FOF strategy is oriented around allocating capital across different funds, rather than selecting the equity or debt investments themselves.

The decision to invest in a hedge fund carries substantial risk, and the illiquid nature of the investment, as well as the higher fee structure (“2 and 20”), are drawbacks compared to mutual funds and ETFs.

The higher barrier for investors to qualify to invest in hedge funds is to limit access to more sophisticated investors.

Why? The investors that meet the criteria to become an investor at a hedge fund are assumed to understand the risks presented by the return strategies and tactics, with a higher tolerance for risk.

Learn More → Hedge Funds SEC Investor Bulletin (Source: SEC.gov)

What is the Fee Structure of Hedge Funds?

So, how do hedge funds make money?

Historically, the standard fee structure in the hedge fund industry was the classic “2 and 20” arrangement.

• 2% Management Fee → The 2% management fee is typically charged based on the net asset value (NAV) of each LP’s investment contribution, and is used to cover the costs of operating the hedge fund (and employee compensation).
• 20% Performance Fee → The 20% performance fee (or “carried interest”) is an incentive for hedge fund managers to achieve strong returns, i.e. “beat the market”.

Once the GP has caught up and earned the 20% carry, all fund profits are split 20% to the GP and 80% to the LP.

Following years of underperformance since the 2008 recession, however, the fees charged in the hedge fund industry have declined.

Over the past decade, there has been a notable marginal decline in management fees and performance fees across the industry, particularly for the larger-sized, more institutionalized hedge funds:

• Management Fee → 2.0% to 1.5%
• Performance Fee → 20.0% to 15.0%

To ensure no preemptive performance fees are obtained, the limited partners (LPs) of a hedge fund can negotiate certain provisions:

• Claw-Back Provision → The LP can retrieve fees previously paid for the original percentage agreement to be met, which implies losses were incurred by the fund in subsequent periods.
• Hurdle Rate → A minimum rate of return can be established, which must be surpassed before any performance fees can be collected. Sometimes, once the threshold is met, there is a “catch-up” clause for the GPs to receive 100% of the distributions once the agreed-upon split is met.
• High-Water Mark → The highest peak the value of the fund reached – in such a provision, only capital gains in excess of the high-water mark are subject to the performance-based fee.

What are the Different Types of Hedge Fund Strategies?

Before delving in, the following list outlines the most common hedge fund investment strategies.

• Long-Short Equity Strategy (L/S)
• Market Neutral Strategy, i.e. Equity Market Neutral (EMN)
• Short-Selling Strategy (Short-Only Funds)
• Event-Driven Investing Strategy (Special Situations)
• Relative Value Strategy (Arbitrage Fund)
• Activist Investor Strategy (Shareholder Activism Funds)
• Global Macro Strategy
• Quantitive Funds (Systematic Trading)
• Distressed Debt Investing Strategy
• Multi-Strategy Funds (Multi-Strat)
• Credit Fund Strategy (Fixed Income)

Long-Short Equity Strategy (L/S)

Alfred Winslow Jones is often cited as the pioneer of the long-short fund strategy in the mid-1940s.

The market-neutral portfolio of Jones distinguished between two different types of risk:

1. Market Risk (Non-Diversifiable)
2. Company-Specific Risk (Diversifiable)

Based upon the understanding of systematic vs. unsystematic risk, the long-short equity strategy (L/S) was derived, wherein an investor strives to profit from the upside and downside movements in stock prices.

Therefore, the long/short fund strategy is taking “long” positions on equities perceived as underpriced, while hedging the downside risk via “shorting” stocks deemed overpriced.

In effect, the long-short strategy is designed to accurately predict upward price movement on its long positions, while limiting potential losses on its short positions, i.e. the short-selling component can partially offset the losses (or in entirety).

• Long Positions → Undervalued Stocks (i.e. Intrinsic Value > Market Price)
• Short Positions → Overvalued Stocks (i.e. Intrinsic Value < Market Price)

Unlike long-only portfolios that can incur steep losses from market volatility, long/short hedge funds often profit from sudden dislocations in the financial markets, i.e. the hedging strategies offset their long positions.

Generally, most long/short equity funds hold a “long” market bias, so the long positions constitute a greater proportion of their total portfolio.

Learn More → Long-Short Equity (L/S)

Market-Neutral Strategy (EMN Fund)

The market-neutral strategy seeks to exploit market mispricings of securities by pairing long and short positions in securities in the same or adjacent industry.

Simply put, the market-neutral fund strategy tries to exploit and profit from temporary dislocations in share prices by taking both long and short positions in equivalent amounts in closely related stocks with similar characteristics (e.g. industry, sector).

Put together, the paired long and short positions balance the portfolio’s long positions with their short positions, with the core objective of achieving a net portfolio exposure of zero, i.e. a portfolio beta of zero.

In theory, the market-neutral fund strategy should exhibit returns with minimal correlation to the broad asset classes (e.g. equity, bond, credit).

That said, the returns on a market-neutral fund are structured to be independent of movements of the broader market, with less volatility risk.

However, the trade-off here is that the reduction in market sensitivity causes the upside potential in returns to also decline, even more so than long-short funds (L/S).

The objective of a market-neutral fund is to achieve a portfolio beta as close to zero as possible by pairing long and short trades to mitigate market risk.

The expected portfolio return of a market-neutral fund is the sum of the risk-free rate and the alpha generated by the fund’s portfolio.

Learn More → Market Neutral Fund Strategy

Short-Selling Strategy (Short-Only Fund)

Short-selling funds are specialists in the art of short selling, which is called “short-only”, or net short – i.e. the short positions outweigh long positions in the portfolio.

Short selling is not just intended to reduce risk and capital losses amid periods of declines in market prices but also to capitalize on and profit from such scenarios.

The short positions are intended to produce alpha, rather than serve as a portfolio hedge.

Kynikos Short Fund Business Model

“Kynikos has sometimes been called a “hedge fund,” but it is not a hedge fund following the classic model first established by A.W.Jones & Co. We operate a short fund. With the proliferation of private investment funds, however, the term “hedge fund” is now used so broadly in some quarters to refer to any private investment fund that I do not believe that it accurately describes Kynikos’ business model accurately.”

– Jim Chanos, Kynikos Associates

For that reason, short specialists tend to make fewer investments and are willing to hold onto capital for longer periods to capitalize on opportunities such as fraudulent behavior related to accounting fraud, malfeasance, and more.

Learn More → Short-Selling

Event-Driven Investing Strategy (Special Situations)

Event-driven hedge funds invest in the securities issued by companies anticipated to undergo significant changes.

The event-driven investing strategy is oriented around timing an investment around “special situations”, wherein a catalyst can soon affect the valuation (and stock price) of the underlying issuer.

The fund attempts to capitalize on a particular event, which can range from regulatory changes to operational turnarounds.

Common examples of catalyst events – often referred to as “special situations” – include the following.

• Mergers and Acquisitions (M&A)
• Tender Offers
• Corporate Spin-Offs
• Rights Offerings
• Corporate Bankruptcies
• Operational Restructuring
• Divestitures
• Financial Distress, i.e. Insolvency Risk
• Recapitalization
• Stock Buybacks

Joel Greenblatt Quote on Special Situations

“Something out of the ordinary course of business is taking place that creates an investment opportunity. The list of corporate events that can result in big profits for you runs the gamut—spinoffs, mergers, restructurings, rights offerings, bankruptcies, liquidations, asset sales, distributions.”

― Joel Greenblatt

Learn More → Event-Driven Investing

Relative Value Fund Strategy (Arbitrage Strategies)

A relative-value hedge fund uses arbitrage investment strategies and actively pursues temporary mispricing opportunities to exploit and capitalize on.

The price discrepancies, or “spread inconsistencies”, represent opportunities to profit once stock prices revert to trading at their fair value.

The relative value arbitrage investment strategy starts with identifying pricing differentials between closely-related securities, by simultaneously purchasing and selling different financial instruments based on speculations of near-term price movements.

For instance, the merger arbitrage strategy – a blend of relative-value arbitrage and event-driven investing – entails a hedge fund taking offsetting positions in two companies involved in a pending merger to profit from the pricing inefficiencies that occur before and after the transaction.

Following the announcement of a proposed merger, the stock price of the acquisition target often rises, whereas the stock price of the acquirer can decline.

The merger arbitrage strategy involves the concurrent purchase and sale of the stocks of two companies on the verge of a potential merger (or acquisition).

Oftentimes, M&A transactions fall apart from unexpected events or regulations, such as anti-trust concerns, which represent opportunities to profit and “capture the spread” between the:

1. Current Market Share Price (Normalized Basis)
2. Proposed Offer Price per Share

Amid periods characterized by widespread uncertainty surrounding the outcome of a merger or acquisition, the fund exploits and profits from the pricing inefficiencies reflected in the market.

Learn More → Merger Arbitrage

Activist Investor Fund Strategy (Shareholder Activism)

The activist fund strategy aims to influence corporate decisions by vocally exerting their shareholder rights (i.e. direct management on how to increase the value of their investment).

• Friendly Engagement → Often, the activist investor is the “catalyst” that brings positive changes to how the company is managed, which usually coincides with obtaining a seat on the board to work with the management team on good terms.
• Hostile Engagement → In other cases, activist funds can be hostile to public criticism of the company to turn market sentiment (and existing shareholders) against the existing management team – often to start a proxy fight to obtain enough votes to force certain actions.

Underperforming companies are ordinarily targeted by activist funds, as it tends to be easier to advocate for changes in such companies or even replace the management team.

The news alone of an investment by an activist investor could cause a company’s share price to increase because investors now expect tangible changes to soon be implemented.

^{“Do Activist Investors Boost Shareholder Returns?” (Source: Goldman Sachs Research)}

Learn More → Activist Investor

Global Macro Fund Strategy

The strategy of global macro hedge funds is based on investment decisions based on the broader economic themes and political landscape.

Macro fund managers closely monitor economic variables and indicators to form a thesis on the outlook of macro conditions, e.g. the Federal Reserve, inflation rates, and international developments with implications on global trade.

The range of holdings by global macro funds tends to be diverse, including equity indices, fixed income, currencies, commodities, and derivatives (e.g. futures, forwards, swaps).

The strategy of these funds shifts continuously and is contingent on recent developments in economic policies, global events, regulatory policies, and foreign policies, i.e. “directional analysis”.

Quantitative Investing Strategy (Systematic Trading)

Quantitative funds rely on systematic software programs to guide investment decisions, as opposed to fundamental analysis (i.e. automated decisions to remove human emotion and bias).

The investing strategy is built on proprietary algorithms, with significant emphasis on compiling historical market data for in-depth analysis, as well as back-testing models (i.e. running simulations)

Systematic trading strategies rely on computerized trading systems and complex mathematical models based on either technical or fundamental factors to identify patterns or trends to capitalize on within the global financial markets.

The systematic aspect of the investment strategy enables such firms to quickly identify investment opportunities and profit from temporary price patterns across different countries, contrary to fundamental investors.

Distressed Debt Fund Investment Strategy

The securities of distressed companies often trade at steeply discounted valuations, creating a risky yet lucrative opportunity for the investment firm.

The distressed fund strategy is a riskier form of investing that specializes in purchasing the mispriced securities of a troubled company (the “debtor”) that has filed for bankruptcy protection or is on the verge of doing so in the near future due to a sudden deterioration in its financial state.

Often, an investment in distressed securities can become a complex, long-winded process, since most corporate bankruptcies are in-court restructuring, rather than out-of-court.

Therefore, the time frame for the debtor and the creditors – contingent on the severity of the debtor’s financial state (and the incentives of the creditors) – can require significant time before an amicable solution is reached and approved by the Court.

• Chapter 11 Reorganization → The debtor cannot reorganize without the formal approval from the Court of its plan of reorganization (POR), i.e. the document negotiated with creditors that outlines the debtor’s plans moving forward post-emergence from bankruptcy and an attempt to return to operating on a “going concern” basis.
• Chapter 7 Liquidation → If the Court rules that the debtor’s value after the reorganization does not exceed its liquidation value, the assets belonging to the debtor are liquidated and distributed to its creditors by the absolute priority rule (APR), which dictates the order at which claims are repaid in full.

Distressed debt funds purchase debt trading at steep discounts because of the uncertainty around the outcome of the bankruptcy, i.e. Chapter 7 liquidation or Chapter 11 reorganization.

In the latter scenario, the reorganization and emergence post-bankruptcy presents the distressed fund with the opportunity to obtain a sizable stake in the new entity’s equity to generate a strong return, assuming a successful turnaround.

For instance, a distressed fund could invest in the debt of a corporate undergoing a reorganization, where the debt will soon be converted into equity in the new entity (i.e. debt to equity swap) amid the attempt to return to a “going concern.”

Learn More → Distressed Debt Investing Primer

Multi-Strategy Fund (Multi-Strat Investing)

The investment strategy used by multi-strategy funds is at their discretion, as such firms tend to prioritize capital preservation with a lower appetite for risk.

Multi-strategy funds are seldom risk-averse from the start, but rather prioritize risk management because of the expansion of their assets under management (AUM).

The higher the assets under management (AUM) of an investment firm, the more risk-averse the investor must become, since there is now more capital at risk.

Therefore, multi-strategy firms strive to achieve stable, positive returns regardless of market performance, like most hedge funds, but there is far more capital at stake.

In general, portfolio diversification is the main appeal to multi-strategy investors, where risk is allocated across different investment strategies, asset classes, and geographical locations.

That said, the risk profile attributable to the “multi-strat” fund strategy is on the lower end (and less risk coincides with lower potential returns, per usual).

Credit Fund Strategies (Fixed Income Investing)

Credit funds utilize strategies that allocate capital predominately to debt securities, which can range widely in terms of risk-reward profile.

Credit funds strive to exploit opportunities in corporate debt issuances, government bonds, and other types of financial securities.

The following list contains examples of fixed-income securities:

• Corporate Bonds
• Treasury Bills (T-Bills)
• Treasury Notes (T-Notes)
• Treasury Bonds (T-Bonds)
• Municipal Bonds (“Munis”)
• Certificates of Deposit (CDs)

Credit hedge funds can use various strategies to achieve their target returns, such as long/short credit, distressed debt, arbitrage strategies, such as convertible arbitrage (i.e. purchase convertible bonds and short the issuer’s stock to hedge risk), and structured credit (CDOs, CLOs).

Fixed-income credit fund strategies consist of investing in long-term government bonds, corporate bonds with high credit ratings, annuities, and preferred stock, all securities that pay a fixed rate of interest to the bondholder until maturity.

Credit fund managers must have a strong grasp of analyzing the risk profile of a given lending scenario, such as performing diligence on the implied default risk, credit spread risk, and illiquidity risk, to identify and profit from inefficiencies.

Opportunities to profit and the upside potential in monetary gains decline for debt securities higher in the capital structure (and vice versa).

Often, the only method for a credit fund to achieve equity-like returns is to engage in riskier strategies, such as leverage, convertible bond arbitrage, and distressed credit.

Learn More → Fixed Income Securities

Hedge Fund vs. Mutual Fund: What is the Difference?

Hedge funds and mutual funds are distinct investment vehicles, with significant differences regarding the fund structure, investor qualifications, risk-reward profiles, investing strategies, and regulatory risks.

Learn More → Hedge Fund vs. Mutual Fund