While many investors around the world are looking into hedge funds, very few people actually know the defining characteristics of these funds. Here, we’ll take a close look at the structure and characteristics of hedge funds.
Hedge funds have been around since 1949, when Alfred Winslow Jones set up one of the first funds. Jones built up a private partnership and placed his equity fund under the trusteeship of this partnership.
Jones started by melding leverage and short sales into one fund to create a conservative investment. He believed that choosing the best stocks was a far better option than simply predicting the direction of the market. So, let’s take a look at some of what Jones helped to create.
Corporate Structure
Most US-based financial services companies and managers will build hedge funds as Limited Partnerships. Foreign hedge funds sometimes organize themselves as corporations so they can let in as many investors as they like.
Open Ended or Closed Ended
There are generally two types of hedge funds available; closed-ended and open-ended. In open-ended funds, the fund manager will issue new shares to incoming investors. At that point, the existing investors can issue a call for shares at the current net-asset value, as long as the fund has established redemption policies.
Transparency Not Required
The majority of hedge funds conform to a variety of SEC exemptions that allow them to withhold performance information and earnings. Managers structure hedge funds this way so that they can protect trade secrets.
Performance Fees
The majority of hedge funds will pay their managers around 20% of profits. This means that managers only make money if the hedge fund is successful. If previous losses were incurred, many hedge funds stipulate that a “hurdle” rate of return must occur before the manager is compensated.
Combination of general partner and limited partner
A hedge fund manager will usually contribute quite a bit of his or her own wealth to any hedge fund. Most hedge fund managers, therefore, work as limited partners. However, the job function as hedge fund managers also grants the manager status as general partner.
A High Barrier of Entry
Hedge funds require investors to deposit a sizable amount of assets into the hedge fund in order to take part. The fund manager needs a lot of capital to accomplish his or her objectives.
Chasing After Absolute Return
Good hedge funds will strive to pull in a risk-adjusted absolute return instead of trying to outdo standard market indexes.
A High Degree of Flexibility
Hedge funds have unparalleled access to a wide variety of securities and instruments. Most hedge funds focus on derivatives, which are instruments to mitigate their risk and focus on a market niche by accurately speculating on inherent price complexities.
Since hedge funds utilize a great deal of strategic diversity, they don’t often correlate to equity market standards. This is because hedge funds profit from stock selection, not market performance.
Hedge funds have low liquidity, but this is because their payouts come in large chunks. While hedge funds are generally too expensive for the average investor, some hedge funds have popped up that offer easier qualifications. That’s a basic rundown of hedge funds, so now you know the gist of how they work.
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