How Does A Hedge Fund Work?

How does a hedge fund work involve a lot of aspects to be covered, the first being that it works to help investors make a profit on a very small working capital without risking the entire budget. A hedge fund is an alternative private investment vehicle that utilizes pooled funds using Diverse and Aggressive Strategies to earn Active and Large returns for its investors.

• The concept is pretty similar to a Mutual fund; however, hedge funds are comparatively less regulated, can use broad and aggressive strategies, and aim for large returns on the capital.
• Hedge funds serve a small number of huge investors. These investors usually are very wealthy and tend to have a considerable appetite to absorb the loss on the entire capital. Most hedge funds also hold criteria to allow only investors ready to invest a minimum of $10 million.
• The fund is managed by a Hedge Fund Manager responsible for the investment decisions and operations of the fund. The unique feature is that this manager must be one of the large investors in the fund, which will make them cautious while making relevant investment decisions.
• Funds with regulatory Assets Under Management (AUM) over $100 million must be registered with the U.S. Securities and Exchange Commission. Furthermore, hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934.

This option, however, is not available for the general public. Instead, it is offered to the qualified investors, including high net worth individuals or institutional investors.

To understand how does a hedge fund work, it is important to identify its structure properly. It operates based on a specific framework, of which the following are significant elements:

Master - Feeder

The structure of a hedge fund shows the way it operates. The most famous format is a Master-Feeder one, commonly used to accumulate funds raised from U.S. taxable, U.S. Tax-exempt (Gratuity funds, Pension funds), and Non – U.S. investors into one central vehicle. This can be shown with the help of a diagram:

• The most common form of a master-feeder structure involves One Master Fund with One onshore feeder and One Offshore feeder (Similar to the chart above).
• The investor begins with feeding capital into the feeder funds, which invests in the master fund similar to the purchase of security since it will purchase the "shares" of the master fund, which in turn conducts all the trading activities.
• This master company is generally incorporated in a tax-neutral offshore jurisdiction such as the Cayman Islands or Bermuda. Through the investments in the master fund, the feeder funds participate in the profits on a pro-rata basis depending on the proportionate investment made.
• For instance, if Feeder fund A's contribution is $500 and Feeder Fund B's contribution is $1,000 towards the total master fund investment, fund A would receive one-third of the master fund profits, while fund B would receive two-thirds.
• U.S. taxable investors take advantage of making investments in a U.S. Limited partnership feeder fund, which through certain elections made at the time of incorporation, is tax effective for such investors.
• Non-U.S. and U.S. tax-exempt investors subscribe via a separate offshore feeder company to avoid coming directly within the U.S. tax regulatory net applicable to U.S. tax investors. Management Fee and Performance Fee are charged at the level of the Feeder funds.

Features of the Master Feeder Fund structure are given below:

• It involves the consolidation of various portfolios into one, giving an advantage of diversification and standing larger chances of gaining even in volatile market conditions.
• Consolidation generally leads to lower Operational and Transaction costs. E.g., only a single set of risk management reports and analyses must be undertaken at the master level.
• A broad portfolio will have economies of scale and more favorable terms offered by Prime Brokers and other institutions.
• Such structures can be extremely flexible. It can be employed equally for a single strategy fund (e.g., a fund will only consider earning by making investments in Equities) as well as umbrella structures using multiple investment strategies (a fund that will impact investment in Swaps aggressively, Derivatives, or even Private placements).
• Flexibility is also maximized at the investor level since multiple feeder arrangements can be introduced into the master fund catering to different classes of investors, which adopt other currency, subscription, and fee structures.
• The primary drawback of this structure is that funds held offshore are typically subject to withholding tax on U.S. Dividends. Withholding tax is the tax imposed on interest or dividends from securities owned by a Nonresident or any other income paid to nonresidents of a country. The withholding tax in the U.S. is charged at a rate of 30% or less depending on treaties with other countries, whereas in Canada, it is imposed at a flat rate of 25%.

Standalone Fund

Such a fund is an individual structure set up for investors with a common approach. The structure can be shown with the help of a diagram:

• As the name suggests, this is an individual fund catering to the needs of a particular category of customers.
• For their tax purposes, Non- U.S. and Tax-exempt investors may want to invest in an " Opaque structure." On the other hand, U.S. taxable investors may prefer a "transparent" system for U.S. Income tax purposes, typically limited partnership.
• Hence, such structures will either be set up individually or in Parallel, depending on the skills of the hedge fund manager.
• The benefits or drawbacks of the funds are borne by all the investors and not spread out in this case.
• The accounting methodology is also simple since all the accounting will be done at the standalone level.

Fund of Funds

A fund of funds (F-O-F), also known as Multi-manager investment, is an investment strategy in which an individual fund invests in other types of hedge funds.

• It aims to achieve appropriate asset allocation and broad diversification with investments in various fund categories wrapped into a single fund.
• Such characteristics attract small investors who want better exposure with fewer risks than directly investing in securities.
• Investments in such funds give the investor Professional Financial Management services.
• Most of these funds require formal due diligence procedures for their fund managers. Applying managers' backgrounds are checked, which ensures the portfolio handler’s experience and credentials in the securities industry.
• Such funds offer the investors a testing ground in professionally managed funds before they take on the challenge of going for Individual fund investing.
• The drawback of this structure is that it carries an operating expense, which indicates that investors are paying double for a cost already included in the underlying funds' fees.

Though Fund of Funds provides diversification and less exposure to market volatility in exchange for average returns, such returns may get impacted by investment fees, which are typically higher than traditional investment funds.

After allocating the money towards the fees and tax payments, the returns on the fund of funds investments may generally be lower compared to the profits that a single fund manager can provide.

Side Pockets

A side-pocket fund is a mechanism within a hedge fund whereby certain assets are compartmentalized from all the regular assets of the fund, which are relatively illiquid or difficult to value directly.

• When an investment is considered included in side pockets, its value is computed in isolation compared to the fund's main portfolio.
• Since side pockets are used to hold illiquid or less liquid investments, investors do not possess regular rights to redeem them. This can only be done in certain unforeseen circumstances with the consent of the investors to whom the side pocket is applicable.
• Profits or Losses from the investment are allocated on a pro-rata basis only to those investors when this side pocket was established and not to the new investors. These side pockets were included. They have participated in the fund's post.
• Funds typically carry side pocket assets "at cost" (purchase price or standard valuation) to calculate management fees and report the NAV. In most cases, such side pockets are private placements. This will allow the fund manager to avoid vague valuations of these underlying instruments as the value of these securities may not necessarily be available.
• Such side – pockets can be useful when immediate liquidity is required at the time of redemption.

Hedge funds are of great importance given the nature of investments the institutional and qualified investors get exposed to.

Let us have a look at the advantages to understand in detail how does a hedge fund work:

Downside Protection

• Hedge funds seek to Protect Profits and Capital amount from declining hedging strategies.
• They can take advantage of falling market prices: By 'Short selling,' whereby they shall sell the securities with a promise to repurchase them later.
• Make use of trading strategies that are suitable for the given type of market situation.
• Reap the benefits of broader asset diversification and asset allocations.
• Hence, e.g., if a portfolio has shares of Pharmaceutical companies and the Automobile sector and if the government offers some benefits to the Pharmaceutical industry but poses additional charges on the automobile sector, then in such cases, the benefits can outshine the possible declines in the automobile sector.

Performance Consistency

• Generally, Managers do not have any restrictions on their choice of investment strategies and possess the ability to invest in any asset class or instrument.
• The fund manager's role is to maximize the capital as much as possible and not beat a particular benchmark level and be content.
• Their funds are also involved, which should act as a booster in this case.

Low Correlation

• The ability to make profits in volatile market conditions equips them to generate returns with little correlation to traditional investments.
• Hence, it is not essential that if the market is going in a downward direction, the portfolio would be making a loss and vice versa.

Understand how does a hedge funds work makes it important to learn about the fee charges that they are applicable to investors. These fees are compensation given to hedge fund managers to manage the funds and are popularly referred to as the "Two and Twenty" rule. The two-component charges a flat 2% management fee on the total asset value. Management fees are paid to the fund manager irrespective of the funds' performance and are required for the operational/regular functioning of the fund. If the fund's unsatisfactory performance, this can drop to 1.5% or 1.75%. E.g., a manager with $1 billion of Assets under Management earns $20 million as Management fees.

The 20% Performance fee is paid once the fund reaches a certain level of performance, generating positive returns. This fee is generally calculated as a Percentage of Investment profits, often both realized and unrealized.

Say an investor subscribes to shares worth $10 million in a hedge fund, and let’s assume that over the next year, the fund's NAV (Net Asset Value) increases by 10%, taking the investors' shares to $11 million. In this increase of $ 1 million, a 20% Performance fee ($20,000) will be paid to the Investment fund manager, thereby reducing the NAV of the fund by that amount, leaving the investor with shares worth $10.8 million, giving a return of 8% before any further deduction of expenses.

Beside the management fee and performance fees, the subscriptions, redemptions, and lockups aspects also need exploration to know how does a hedge fund work.

Subscriptions refer to the entry of capital into the fund by the Investors, and Redemptions refer to the Exit of Capital from the fund. Hedge funds do not have daily liquidity since the minimum requirement of investment is relatively large; hence, such subscriptions and redemptions can either be monthly or quarterly. The fund's term must be consistent with the strategy adopted by the fund manager. The more liquidity of the underlying investments, the more frequent the subscription/redemption shall be. The number of days shall also be specified, which ranges from 15 to 180 days.

Lock Up is an arrangement whereby a time commitment is stated within which the investor cannot remove his capital. Some funds require a two-year lock-in commitment, but the most common lock-up is one application for one year. In some instances, this could be a "hard lock," preventing the investor from withdrawing the funds for the full-time period. In contrast, in other cases, the investor can redeem his funds upon penalty payment, ranging from 2%-10%.

Some of the Top Hedge Funds are given below with their Assets Under Management (Q1'16). The chart below also lists the strategies adopted which gives an idea about how does a hedge fund work:

source: Octafinance.com

This has been a guide to How Does A Hedge Fund Work. Here, we explain the concept along with its structure, benefits, fees involved, and top hedge funds. You may also look at the following related articles for a better understanding of the topic.

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