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What are Hedge Funds?

A hedge fund is a type of private placement investment that is managed by investment management firms and is made up of sophisticated or institutional investors. The fundamental reason why various individuals participate in hedge funds is to protect themselves from losses in other assets. Managers of investment pools employ a variety of tactics, including leverage and esoteric asset trading, in an attempt to outperform the markets in terms of returns. Hedge funds invest in portfolios built with high risk management strategies in order to produce large returns even in the worst-case scenarios.

Hedge funds displays multiple characteristics which are discussed below:

  • Hedge funds are financial instruments which requires investment of large amount of capital and thus is not available to general public just as mutual funds are.
  • Hedge funds are not regulated like mutual funds are which makes them highly risky asset acting as the second reason for not being available to general public.
  • Hedge fund employs multiple strategies like short selling of shares, long short equity, market neutral strategies, merger arbitrage, fixed income arbitrage and others. They majorly focus on borrowed funds for trading in securities. The major tool that the managers of a hedge fund uses are leveraging and short selling which is not available to a regulated investor.
  • Hedge funds charges two layered fees in the form of management fee and performance fees which is levied on outperforming a specific benchmark. Many hedge funds are structured into a 2 and 20 arrangement which implies that the management fee for the fund would be 2 percent of the assets managed by the fund annually and a bonus of 20 percent is to be received by the managers on the profit made by managing the assets.
  • After reviewing the performance of hedge funds as reported by the funds, investors get enthralled. Hedge funds are not obligated to provide performance statistics; as a result, reported return data frequently have an upward bias, since the funds reporting their performance data are frequently the ones performing best. There are indexes that record hedge fund performance, such as the Morningstar Broad Hedge Fund Index and the Lipper Tass hedge fund database, although they have an upward bias because non-performing funds close and are not required to submit data.

Hedge funds are open ended funds which essentially means that investors are required to purchase and sell shares directly to the fund and not from other shareholders or investors. The strategies used in a hedge fund require a time horizon of more than five to seven years, hence capital invested in hedge funds are not considered as liquid. The withdrawal of capital from hedge funds take place in a timely manner (quarterly or semiannually). Hedge funds' primary goal is to maximize return on investment on capital invested by high net worth clients. Hedge fund earnings are subject to capital gains taxes and hedge funds have run into financial difficulties as a result of their complex financial investing tactics, while outperforming mutual funds.

With the onset of hedge funds in the investment industry the small investors have less opportunities in the asset class as it is dominated by large pension funds and wealthy individuals who pour money into the asset class (Dummies.com 2021). The lack of transparency in the conduct of pension funds and wealthy individuals makes it increasingly difficult for the small investors to be safe and protect their capital. Hedge funds are subject to extreme market volatility and can experience violent shifts in value on a day to day basis. The popularity of hedge funds has grown over the year and has earned the title of being the second mot popular alternative investment asset category. The assets under management are expected to grow at a lower pace compared to all the other asset class with a CAGR of 3.6% every year (Falcioni 2022). The following chart represent the growth forecast of Assets under management for hedge funds till the year 2025. 

Setting up a hedge fund takes a lot of capital investment to take place and may take close to a year to be set up. The startup and initial operating costs involved in a hedge fund becomes the reason for failure of most of hedge funds within one year of launch (Economist.com 2022). It is a fact that more than half of all the hedge funds conducting operations manage assets less than $100 million in value but they represent a mere 1.4 percent of the total assets under management of $2 trillion (El Isa 2017).

Features of Hedge Funds

Hedge funds along with the advantages and benefits they come with, also has few issues and problems within then concerning the structure and layout. Long Term Capital Management was a US based large hedge fund started and operated by Nobel Prize winning economists and traders that have sufficient experience in the field of investment (Seretakis 2018). Due to improper management and excessive risk-taking tendency of the managers the fund collapsed in 1998 forcing the United States government to intervene and bailout the company with the help of fellow participants of financial market to prevent the financial markets from collapsing (Kaal and Krause 2017). There are several issues and problems associated with hedge funds from the perspective of investors and fund managers which are discussed below:

This section can be divided into parts as the issues must be divided accordingly from the perspective of fund managers managing their own assets and fund managers managing other’s assets.

  • In order to open and run a hedge funds there is a minimum requirement of assets that the funds need to manage and be able to open a managed account with a bank.
  • Higher amount of fees is attributed in the form of commissions and fixed costs as the amount of work required is huge compared to the revenue earned by the bank.
  • To sell the fund as having better performance, a significant amount of money, time, and effort must be invested auditing and promoting the manager's performance.
  • High regulatory oversight and compliances – Starting a hedge fund requires a license to be obtained from the regulatory authority which is considered to quite expensive and time consuming. The regulator needs to be assured of certain compliances like appointment of in-house risk managers, systems that checks trades before execution and other costly procedures (HBS 2003). The regulators also require necessary documents and proofs to be submitted in order to be able to start a fund.
  • Absence of high-quality audibility – The funds are obliged by law to designate administrators to oversee the fund's operations, compute the fund's NAV, settle trades, and keep track of the fund's accounting books. Due to a lag in trade settlement, there is also a lag in accountability, which can lead to unreported faults in the system (Agarwal, Mullally and Naik 2015).
  • Operational support requirement is high – The manager of the fund is required to execute, record and share the details of the trades to the fund administrator in a unambiguous and cumbersome way. This increases the number of staff required for the continue operations and enhances the load on the managers.
  • Expenses incurred in technological advancements – Risk management systems needs to be installed and serviced which is important in managing the position and reconciling exposures in certain securities. It's also crucial to maintain track of gross and net exposure, risk levels, and P&L. Such technologies are frequently costly, costing between $50,000 and $100,000 a year.

These section highlights the issues and troubles faced by individual investors in terms of investment in hedge funds:

  • Hedge funds are costly investment vehicles which charge exorbitant fees from the investors due to the setting up costs and operational complexities faced by the fund. The hedge funds tend to transfer the brunt of costs experienced by them to the investors to be able to function smoothly. The average fees that the fund charges lie around the range of 1.5% to 2%. The following graph displays the fees structure over the last decade:

 

  • Information asymmetry in hedge funds – Hedge fund performance is seldom reported, and it often incorporates biases that are unfavorable to investors. There is no large-scale database of hedge fund managers and their performance evaluations available, thus investors are compelled to participate in funds that are widely visible and well-known.
  • Funds with good performance are difficult to invest in – The funds which are performing supremely well are closed funds with asset base which are growing significantly ultimately compelling the managers of the fund to change their investment style. For instance – An outperforming small cap equity fund would not be able to invest huge amount of capital into strategies concerned with small cap equity due to issues of scale. As a result, the fund would stop accepting investments or have to adapt to different investment strategies to cater the investors demand (Cumming, Johan and Wood 2021).

While problems arise in any investment vehicle, rising asset classes such as hedge funds will change over time to solve the obstacles mentioned above. Some of the potential solutions to the problems are outlined below:

  • Eliminating the minimum investment requirement barrier – The minimum investment requirement that the are required under current hedge fund structure should be eliminated to expand the reach of the funds. Investors with limited amount of capital would be able to invest in hedge funds and grow their capital.
  • Reducing the fees charged – To be more accessible to investors with limited capital the hedge funds needs to lower their fees. This is a phenomenon that the hedge fund industry is experiencing since the past decade. According to (Picker 2021), average fees for the hedge funds in the recent years have reduced and in the fourth quarter of 2020 the average management fees that hedge funds charged was around 1.4% down from 1.6% charged in the last decade. The performance fees reached 16.4% which also witnessed a downfall compared to performance fees of 19% charged in the prior decade.
  • Decentralization of power and authority – The excessive decision-making power enjoyed by the managers are exclusive to them and often results in catastrophic outcomes like in the case of Long-Term Capital Management. Keeping in mind the safety and soundness of investors, the decision-making powers should be made less concentrated and be inclusiveness. The transparency of the funds should also be encouraged so that the investors and outside world are able to know about the functioning of the fund (Huber and Imfeld 2017).
  • Enhanced regulation – To remove the risk of malpractices and lack of transparency, regulators needs expand their purview of oversight and encourage the use of automated techniques to perform various actions across various trigger points. Reporting of performance irrespective to the size and type of the hedge funds should be made mandatory to get an idea about the prevailing trends in the industry. Regulators needs to be proactive in managing the hedge fund industry and involve technology and automation into the processes so that the investors get a perfect view of the risk that he/she will be exposed to.
  • Solution of operational hindrances – With the introduction of technology and automation, the requirement for additional staff for carrying out operations can be reduced to a minimum. In such a way the operational hindrances caused due to requirement of staffs and personals can be tackled (Kaal 2021).
  • Standardization of processes – To reduce the information asymmetry prevailing in the hedge fund industry which makes investors difficult to find suitable hedge funds to invest can be reduced by standardizing the performance reporting procedures. Hedge funds need not disclose the specifics about the strategies deployed but the performance of the firms should be reported on a consistent basis removing the upward biasness.

Hedge funds are asset classes gaining increased prominence across investors including individual investors and institutional investors (Niang 2021). All the above discussed solutions to the problems inherent in the functioning of hedge funds are focused towards reducing the barriers to entry, increasing the quality of audibility and transparency and offers a roadmap to move towards automation and decentralization. 

References

Agarwal, V., Mullally, K. and Naik, N.Y., 2015. Hedge funds: A survey of the academic literature. Foundations and Trends in Finance, Forthcoming.

Cumming, D., Johan, S. and Wood, G. eds., 2021. The Oxford handbook of hedge funds. Oxford University Press.

Dummies.com. 2021. How are Hedge Funds Different from Other Investments?. [online] Available at: <https://www.dummies.com/article/business-careers-money/personal-finance/investing/general-investing/what-are-characteristics-of-hedge-funds-198322> [Accessed 17 March 2022].

El Isa, M., 2017. What are the problems facing the Hedge Fund industry today, and how can smart contracts on the…. [online] Medium. Available at: <https://medium.com/@mona.elisa83/what-are-the-problems-facing-the-hedge-fund-industry-today-and-how-can-smart-contracts-on-the-7d1fbc25d04e> [Accessed 17 March 2022].

Falcioni, J., 2022. Future of Alternatives 2025: Hedge Fund Industry Growth Will Be Reduced by Outflows to 2025. [online] Preqin.com. Available at: <https://www.preqin.com/insights/research/blogs/hedge-fund-industry-growth-will-be-reduced-by-outflows-to-2025> [Accessed 17 March 2022].

HUBER, C. and IMFELD, D., 2017. Operational Risk Management for Hedge Funds. Hedge Funds: Structure, Strategies, and Performance, p.320.

Kaal, W.A. and Krause, T.A., 2017. Hedge funds and systemic risk. Hedge Funds: Structure, Strategies, and Performance, pp.305-319.

Kaal, W.A., 2021. Financial Technology and Hedge Funds. The Oxford Handbook of Hedge Funds, p.232.

Launch bad (2013). Available at: https://www.economist.com/finance-and-economics/2013/04/20/launch-bad (Accessed: 17 March 2022).

Niang, J.A.F., 2021. Artificial intelligence and hedge fund performance: An analysis of hedge fund trading styles.

Picker, L., 2021. Two and twenty is long dead. Hedge fund fees fall further below onetime industry standard. [online] CNBC. Available at: <https://www.cnbc.com/2021/06/28/two-and-twenty-is-long-dead-hedge-fund-fees-fall-further-below-one-time-industry-standard.html> [Accessed 17 March 2022].

Seretakis, A., 2018. EU Hedge Fund Regulation: Hedge Funds and Single Supervision. Eur. Company L., 15, p.213.

The Problem with Hedge Funds (2003). Available at: https://hbswk.hbs.edu/item/the-problem-with-hedge-funds (Accessed: 17 March 2022).

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