The Showtime series “Billions” stars Damian Lewis as Robert “Bobby” Axelrod, a hedge fund titan based in New York City. The popularity of the show introduced millions of viewers to the complexities of working in capital management.
Regardless of how you developed your interest in hedge funds, there’s far more going on behind the closed doors of a firm than you can imagine. Billions did an excellent job of portraying the lives and lifestyle of hedge fund owners, managers, traders, and lawmakers that regulate the industry.
However, understanding the origins and the internal operations of a hedge fund requires a bit more study than watching a TV show. In this article, we look at everything you need to know about hedge funds and how they operate in the capital markets.
Hedge Funds Explained
At its core, a hedge fund is merely a title for an investment partnership. Investors pool money, relying on the expertise of the fund manager to grow their wealth. The investors, also known as the “limited partners,” contribute the funding, and the “general partner,” or the fund manager, controls the assets under management.
A hedge funds sole purpose is to provide investors with the best returns possible.
Each hedge fund operates a unique investment strategy overseen by the general partner. Most hedge funds have teams of traders that place orders for a variety of assets on the financial markets. The general partner ensures that the managers running the trading teams are all executing the strategy.
Talented general partners will also look to eliminate as much risk in the investment strategy as possible. While the structure of the HF may sound similar to a standard mutual fund, HFs take more risk, invest aggressively, and only make their services available to the wealthy.
Hedge funds receive their name from the way that they implement an investment strategy. Typically an investor that’s purchasing securities like bonds or stocks will go either long or short in the trade. Going long means that the investor is betting on the price action of the security trending upward. Going short implies that the investor is going to make money if the securities price action falls.
HFs use a strategy of investing in assets that cancel out the risk in either deal. For example, the general partner may decide to bet on the S&P500 rising over the next year. If the market were to experience a crash, it could wipe out a significant sum of the funds capital. Therefore, to reduce the risk in the trade, the general partner may take a similar sized position in gold futures as well.
Gold typically rises when the stock market falls, and by purchasing gold futures, the hedge fund eliminates the risk of losses that may occur from a stock market crash. If the stock market starts rising at an exponential rate, and gold starts to fall, the general partner will release the hedge in gold, and minimize any loses for the fund and the investors.
While hedging strategies are successful, they also have a considerable amount of risk attached that could result in the loss of investor funds. However, hedging strategies do allow HFs to make money regardless of whether the market trends up or down.
The Elements of a Hedge Fund
There are a few critical components of a hedge fund that make it far different from other pooled investment vehicles, such as mutual funds. The most prominent discrepancy between the two is that hedge funds are only available to the wealthy.
Hedge funds require all investors to be either qualified or accredited to open an account. This terminology means that the investor must have at least $1-million in net worth, excluding their primary residence. HFs will also accept investors that have an annual income exceeding $200,000.
A hedge fund also has broader portfolio options than most mutual funds. An HFs investment portfolio consists of assets outlined in its mandate, and this mandate can include asset classes like derivatives, real estate, forex, and equities.
Mutual funds typically only invest in stocks and bonds, giving them a limited scope of investment, as well as a higher risk. HFs diversify assets as much as possible, reducing the risk of loss to their investors.
Hedge funds also make use of leveraged assets in the investment strategy. HFs may rely on margin in trades to increase their buying power when purchasing securities like stocks, bonds, and currency lots.
This leverage allows them to use funds they don’t have, to make realized profits. For instance, if you have an account balance of $100, you can purchase one share of a $100 stock. With 6:1 margin, you can take six shares of the $100 stock, and only have $100 in your trading account.
Leverage allows HFs to amplify their gains on any trades they make. However, the downside of using leverage id that one bad trade can cost the firm a substantial financial setback. With a margin account, trading has unlimited risk, and there are numerous stories of HFs that lost all of their capital in one lousy trade levered to the hilt.
Mutual funds charge investors an expense ratio that eats into the annual profits of the fund, reducing investor returns. HFs charge both an expense ratio and a performance fee. The most common fee structure in use at hedge funds is “2 and 20.”
The investors pay 2-percent of their capital under management to the HF for management fees every year. The HF also takes a commission of 20-percent on all profits made for the fund as well. Some talented hedge funds offering superior market returns may charge clients a 3/30 fee structure.
Some investors have a problem with the 2-percent on capital. If the HF manages $1-billion worth of assets, then they receive an annual fee of $20-million, without as much as lifting a finger to place a trade. These fees also stand when the firm loses money as well. Can you imagine being an investor that receives the news of losing money, only to find out the find manager is taking their fee?
HFs don’t share in the losses with clients, and that’s why it’s such a profitable industry.
Hedge Fund Strategies
While hedge funds share a similar title, each of them has a unique investment strategy set by the managing partner. The strategy outlines the type of assets invested in by the fund, as set out by the mandate. Here are a few examples of the common strategies employed by HFs.
Equity hedge funds invest in stock market indexes and individual stocks. The portfolio may include the US and international securities in either developed or emerging markets across the world. The fund manager will go long on attractive stocks over weeks to months while hedging the trade with shorts in other indices or overvalued stocks.
Macro hedge funds invest into bonds, currency lots, and stocks. The strategy relies on changes in the macroeconomic conditions of the world. Changes in geopolitical situations and global interest rates help these firms turn a profit.
Relative-value hedge funds look for opportunities to capture profit in the spread of assets. The difference between the asking and selling price of an asset is known as “the spread,” and these hedge funds take advantage of these price inefficiencies to make a profit.
The “fund of funds” strategy invests into other hedge funds and investment vehicles.
Hedge Funds and Regulation
The co-starring role in the Showtime series Billions was that of Charles “Chuck” Rhoades, played by Paul Giamatti. Chuck is the US attorney, and later the Attorney General in the show. He plays the lead of the justice department and its fight against financial criminals.
In reality, hedge funds face a lower level of scrutiny from the Securities and Exchange Commission, (SEC), than other investment vehicles like pension and mutual funds. Since HFs receive funding from accredited investors, the SEC does not feel the need to investigate the operations of these firms as thoroughly as other vehicles.
However, the SEC’s attitude toward hedge funds is starting to change. Studies show that hedge funds across the world control nearly $1-trillion in AUM, making them more powerful than the economies of some small countries.
The SEC looks into issues such as insider trading and money laundering to ensure that all hedge funds toe the line legally.
Hedge Fund Advantages
While hedge funds may cost its investors a significant amount of money and commissions, the returns are worth the expenses. Investors that park their money with an HF may see returns as high as 80-percent on their capital, depending on the talents of the general partner and their investment strategy.
Hedge funds can create profits in both rising and falling markets, with the ability to short financial instruments in the event of a market crash. There was a famous excerpt on CNN a few years ago where a trader at a hedge fund admitted on air that he was hoping for a market crash. The trader went on to say that he makes most of his money on the downside.
Unfortunately, the general public did not share his enthusiasm and branded the trader as a traitor to the American economy for betting against the markets. A similar event occurs in the Billions series, where Axelrod places shorts against the airlines in the moments after the planes struck the towers on 9/11.
While Axelrod makes billions off of his shorts, the public outrage against his unethical behavior leads to exile from his community.
By hedging assets against each other’s performance, the HF reduces risk in the trade. The use of leverage also helps the HF maximize profits. Hedge funds are also home to some of the worlds most talented asset managers. HFs pay employees with a bonus system that’s similar to large banks. The better the trader does throughout the year, the higher their bonus.
As a result, traders and managers are in high demand by HFs, and securing a job at a top firm is a golden ticket for many quants, traders, and money managers.
Investors reap the benefits of parking their money with profitable HFs. They are more than willing to pay the exorbitant fees of the firm, provided they are receiving a generous return on their capital.
Hedge Fund Disadvantages
The primary disadvantage of working with hedge funds is the expenses involved in managing your capital. As an investor, you need to be sure that the fund is performing to validate your reason for leaving your money with the firm.
As a hedge fund owner, the use of leveraged financial assets may end up sinking your firm. If you aren’t paying close attention to your trading team, then they could make a fatal mistake that leads to a margin call. The concentrated strategy may expose the firm and its investors to catastrophic losses in the event of a market crash.
Wrapping Up – Key Takeaways
A hedge fund describes an official financial partnership between investors and a professional money management firm.
While hedge funds appear similar to mutual funds, there are distinct differences between the two investment vehicles.
HFs have stringent minimum investment requirements and are only available for qualified or accredited investors. High net-worth individuals earning more than $200,00 per year, or with assets exceeding $1-million may apply.
Hedge funds also operate with less transparency and disclosure to their investors when compared to mutual funds. This reporting structure allows the HF to be more aggressive with investments and enter into risky strategies.
Hedge funds all have the goal of achieving “Alpha.” Alpha refers to the percentage gain of the fund over the year. However, funds use different strategies to deliver their investment goals.
Hedge funds provide investors with an “offering memorandum,” that serves as the company’s prospectus. Inside the memorandum, you’ll find the specifics to the fund’s investment strategy, as well as the amount of leverage they use in trades.
Hedge funds charge a “2 and 20” fee structure. Investors pay the HF a 2-percent fee for managing their money, and the firm receives a 20-percent commission on all profits.