While individual funds generally have an individual strategy assigned to them, that approach could be one of numerous investment styles. A fund's investment strategy is generally a function of a hedge fund manager's expertise and experience or in response to opportunities in the markets. The amount of money that investors direct into various strategies ebbs and flows in response to changes in economic and market conditions and as a result a strategy can go in and out of style.
Hedge funds are part of the alternative investment category as managers take a non-traditional approach as they try to deliver profits that surpass what's earned by the rest of the markets. Once considered lightly regulated, hedge funds managing a minimum of $150 million in assets began registering their funds, which included divulging details about trading strategies, with the U.S. Securities and Exchange Commission in 2010. As a hedge fund investor, you can expect to pay a 1.6 percent management fee and 18.7 percent performance fee, costs that are deducted from your returns. You must be an accredited investor to invest in hedge funds, which means you must earn at least $250,000 in annual income or have a net worth of more than $1 million.
The very first hedge fund trading strategy was a long/short style and the approach is still used in the investment community. In 1949, Alfred Winslow Jones was the first to attempt to make money both when individual stocks increased and decreased in value by placing long and short trading positions, respectively, on those stocks. He also added leverage, or debt, to his trades to increase the size of returns, a tactic that puts the trader at risk of greater financial loss should the strategy fail. In 2012, as much as 65 percent of the hedge fund industry's assets were split between two strategies, one of which was long/short, according to a 2012 CNBC article. The other was a trading strategy known as global macro.
In 2012, $488 billion of the hedge fund industry's $2.25 trillion in assets under management was directed into funds using a macro trading strategy. It is an approach that takes advantage of changes in monetary policy in regional economies around the world, including the differences in the value of currencies, interest rates and equities, or stocks. This trading strategy can be performed in one of two ways: professional traders can manually decide which financial instruments to trade, which is known as discretionary trading, or they can rely on computer algorithms to identify these opportunities, which is a systematic approach. In the decade leading up to September 2010, global macro strategies generated annual returns of 12 percent, according to a 2010 report issued by consulting firm NEPC.
Managers of event-driven hedge funds seek to earn profits from changes in stock prices that occur as a consequence of deals that happen in the markets, including mergers and acquisitions, initial public offerings and corporate bankruptcies. For instance, the assets of a bankrupt company are generally considered distressed because the business may be in danger of failing but investors willing to take a chance can earn higher-than-average returns if and when the value of these assets improve. In 2009, during the financial crisis, event-driven hedge funds investing in distressed debt generated returns of 28 percent, according to a 2012 Hedge Funds Review article.
Fund of Funds
Hedge fund of funds are investment vehicles that invest in a variety of hedge fund trading strategies on behalf of investors. Like hedge funds, they combine clients' capital, or money, together but instead of managing their own funds, hedge fund of fund managers then proceed to select as many as dozens of other hedge funds in which to invest. You can wind up paying an additional layer of fees in a hedge fund of funds, however. In addition to a management and performance fee, you may be expected to pay a placement agent fee should the hedge fund of funds use a third-party service provider to help them identify the hedge fund strategies in which to invest, according to a 2012 "Forbes" article.
Video of the Day
- A.W. Jones: The First Hedge Fund
- NEPC: Global Macro Hedge Fund Investing -- An Overview of the Strategy
- Forbes: JP Morgan Hedge Fund of Funds -- Out-of-this-World Fees and Egregious Conflicts
- The New York Times Dealbook: Imagining a Future of Lower Hedge Fund Fees
- U.S. Securities and Exchange Commission: Speech by SEC Staff -- What SEC Registration Means for Hedge Fund Advisers
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