Before entering the hedge fund industry, like yourself, we always wondered what it’s like to work in a one. Are people super smart? What’s the secret sauce? What’s a day in life inside a hedge fund? These are just a handful of questions we will address in this article.
What is a hedge fund?
Loosely speaking, hedge funds are actively managed investment funds that employs varied investment strategies. These can include various asset classes such as equities, fixed income, commodities, futures, options etc.
Furthermore, hedge funds are also known for its leverage. For this reason, hedge funds are generally only available to accredited investors. While we have experience managing funds of different asset classes, equity hedge funds remain one of the most popular.
How do hedge funds make money?
Like private equity, hedge funds also operate under the 2 and 20 fee structure. This means 2% management fees (fixed) and 20% performance fees (conditional). For example, say you invested $100 in a hedge fund with that fee structure. By the end of year 1, the fund returned +20% before fees, so your investment is now $120.
All else being equal, the hedge fund will draw $2 as management fees (2% of your $100) and $4 as performance fees (20% of the gains, which is $20). You’re left with $114.
In addition, for hedge funds to continue to charge performance fees, it must have reached a high-water mark. This is the highest value the fund has ever reached. Following on from the example above, say in Year 2 your investment fell from $120 to $100, and then grew from $100 to $115 in Year 3. Note that because $120 in Year 1 was the highest value, hence, there will be no performance fees charge during these two years.
How do hedge funds invest?
As its name suggest, they may employ different strategies to hedge itself relative to the market. It involves simultaneously going long (buy) and short (sell something you don’t own) securities. We discussed several commonly used hedge fund strategies.
One of the more well-known strategies is Global Macro. This encompasses the prediction of global events stemming from politics and economics. Much of strategy focuses on analysis and forecast of interest rates, macroeconomics factors such as consumption, global growth and international trade payments, government policies etc. Strategies such as Global Macro are usually directional, ie a strategy that doesn’t hedge, or only partially hedge. As you can imagine, Global Macro is extremely volatile! George Soros and Ray Dalio made their name employing such strategy.
Another popular strategy is the Long/Short Equity. This can either be a fully hedged or partial hedged equity investment strategy. The idea here is to simultaneously go long and short different stocks and make a return on the difference, or spread. Think of it as pair.
For example, if you’re long X and short Y, and X goes up by +10%, and Y by +8%, you gain +2%. Strategies in the Long/Short space can be either directional or non-directional. The latter being a less market-dependent and less volatile strategy. Such strategies are termed "market-neutral" with the goal to profit irrespective of how the market performs.
Next, the Commodity Trading Advisors (CTA) strategy. Usually, this involves futures using strategies such as trend following and systematic trading. In fact, CTA has be traced back to when hedge funds were in their infancy. For example, Caxton Associates, founded in 1983 by Bruce Kovner, that is still operating today.
Lastly, quant funds or quantitative-driven funds. Most funds in this sphere are systematic, ie: everything is automated, and requires little (none) human involvement. In the hedge fund world, quant funds are generally known to be the best resourced from a technology stand point. In addition, they also have a tendency to hire PhDs from computing and quantitative background to develop and research new cutting-edge quant strategies.
Consequently, quant funds pride itself on its secretive “black-box” liked investment strategies. And they have good reasons for it. The more well-known a strategy is, the chances of making a profit is less.
One such strategies that was discussed some time ago was “Google Search Investing”. Essentially, this strategy attempts to invest based on the number of searches in Google of a particular stock.
One quant fund that stood out to us is Renaissance Technologies. Founded by Jim Simons, a mathematics and an ex-code breaker with the NSA, its flagship Medallion Fund delivered an unfathomable +39% (after fees) per annum since 1988. Roughly speaking, $1 invested in 1988 in the Medallion Fund is now worth ~$37,000!
Day in the life of a hedge fund analyst
The day usually starts around 6 in the morning. The first thing we do is to scan for any overnight news that we may have missed. Specifically, we try to connect the dots of what has happened and how will it affect our portfolio or sector going forward. We do our analysis primarily through financial modelling using spreadsheets & various modelling software.
For example, if the market is pricing in a lower crude oil prices, what would happen to the revenue of an Asian company that is highly dependent on oil? By how much?
The numbers or forecasts only mean something if there are reference points, which the market termed it as consensus, or market expectation. Usually, these are numbers submitted by equity analyst of various brokerage firms. For example, if our numbers are vastly different from that of consensus, that will almost surely warrant further investigation.
Once the market opens, we’re actively engaged with the market looking at news flows, speaking to sell-side analyst (brokers) to understand their side of the story. In addition, we have frequent communications with company management teams. The goal here is to gain the full spectrum of publicly available information.
Analyst also build models and triangulate data on new companies and trends to support its investment merits when pitched to the Portfolio Manager. Finding what the market knows and doesn’t know summarises the work of a hedge fund analyst.
Hedge funds vs mutual funds
Hedge funds have less regulations compared to mutual funds. Generally, this means that hedge funds can employ more sophisticated strategies that are usually not available elsewhere. For this reason, most hedge funds are only applicable to accredited investors. On the other, mutual funds must follow strict mandate given by the fund. For example, can only invest in securities that meet certain pre-defined criteria.
Hedge funds are generally absolute return funds, which means that it aims to make money regardless of what the market does. This differs from mutual funds, who targets performance relative to a benchmark. For example, if the market is down 20%, and a mutual fund returns -18%, it can be argued that the fund “outperformed” the market, despite losing money in absolute terms.
As mentioned earlier, hedge funds are generally more expensive on an ongoing basis. But does expensive implies better performance?
How to invest in a hedge fund?
For retail investors, it is generally extremely difficult to invest directly in an established hedge fund given the reasons we have discussed. Fortunately, there are ETFs that can provide easy access to popular trading and investing strategies employed by hedge funds. These may include merger arbitrage, long/short and managed futures.
(Info is correct as of 16 June 2020)
|IQ Merger Arbitrage ETF||$686m||0.77%|
|RPAR Risk Parity ETF||$546m||0.50%|
|Aptus Behavioral Momentum ETF||$153m||0.81%|
|First Trust Dorsey Wright Dynamic Focus 5 ETF||$240m||0.71%|
|WisdomTree Managed Futures Strategy Fund||$103m||0.65%|
|WisdomTree CBOE S&P 500 PutWrite Strategy Fund||$122m||0.44%|
|Invesco S&P 500® Downside Hedged ETF||$73m||0.39%|
|Cambria Global Momentum ETF||$72m||0.94%|
|Gadsden Dynamic Multi-Asset ETF||$65m||0.71%|
|SPDR SSgA Multi-Asset Real Return ETF||$54m||0.50%|
|IQ Real Return ETF||$52m||0.44%|
Are hedge funds in trouble?
Yes, no and it depends. Hedge funds have been under pressure in recent years. The combination of the demanding fee structure together with lackluster performances are causing investors to think twice.
In fact, the 2 and 20 structure has been under tremendous pressure lately. Historically, the strong investment performance gave hedge funds the bargaining chip. Unfortunately, the tide has turned for most hedge funds today. In addition, the rise of low and even zero fee funds are forcing institutional investors to revisit its investment strategy.
The growing importance of technology in the hedge fund industry cannot be denied. Technology not only allows for operational efficiency, but also act as an enabler in building an edge in investing. In fact, funds who shun investing in its tech infrastructure are gradually being priced out of competition.
In our view, well-invested hedge funds will continue to thrive while funds who are left behind in the technology arms race may soon start to show signs of underperformance.
What have we learned working in a hedge fund?
We have and continue to learn many things in working in this industry that are applicable to both life and investing. Here are some of the key takeaways.
- The market always humbles you.
- Being the smartest doesn’t always make money in the markets.
- Discipline, discipline and discipline. You need to develop an investment framework.
- Always have at least a plan C.
- The art of taking losses, learning and moving on.
- How to be an emotionally powerful investor.
An extremely fast-paced, cut-throat and competitive environment, the hedge fund industry offers a plethora of learning opportunities. Only if you’re willing.
The hedge fund industry has evolved rapidly over the past decade and we do not expect this to pause. Tech advances will continue to drive innovation in the industry. While hedge funds are expected to consolidate, it remains to be seen how hedge fund will perform going forward.
Finally, it is important to note that, while quick money is great, generating consistent return is more important than generating higher return.
The industry may not be for everyone, but we genuinely think the work here is an excellent learning curve that offers much more than just investing. If you have any questions that we have yet to addressed or even remotely thinking about how to break into the “dark side”, drop us message here. We love to hear from you.