Hedge Funds and Smart Money

This post is based on Chapter 1 from Efficiently Inefficient: How smart money invests & market prices are determined by Lasse Heje Pedersen.

Firstly, what is a hedge fund? The first hedge fund was created in 1949 by Alfred Winslow Jones and due to his impressive returns, by 1968 there were over 140 hedge funds in the US (according to the Securities and Exchange Commission). Hedge funds, unlike other investment vehicles, are involved in investing a pool of money in both long and short positions. They have liberation when trading (they can use strategies such as leverage, short-selling, derivatives, incentive fees) but are restricted in how they are allowed to raise money; investors must have reached a standard of financial knowledge and/or wealth, making them an accredited investor, and hedge funds can't actively seek investors through advertising or approaching individuals, known as a non-solicitation agreement. Hedge funds depend upon the balance of long and short positions to survive any market environment (rather than, for example, aiming to beat the stock market) and profit from the overall outperformance of their long positions relative to the short positions, in the long run.

There is a typical fee structure for hedge funds, known widely as "2 and 20" which relates to a 2% management fee charged regardless of outcome, but an additional 20% performance fee of returns. Sometimes, the 20% fee will only be paid if the return on the investment exceeds a hurdle rate (e.g. Treasury Bill rate). On top of this, a hedge fund's performance fee is protected by a high water mark, ensuring that if the hedge fund was to incur a loss, performance fees are only charged after the losses are recovered. This differs from other active management strategies such as mutual funds, which are only subject to the initial management fee.

The reason why investors are willing to pay these additional fees is because hedge funds have a higher level of active risk (the measure of the level of effective management taking place), which is the "volatility of the deviation from the benchmark", also known as the tracking error. Sticking with the comparison to mutual funds, they have a lower level fo active risk because a large portion of their returns is earned by delivering the benchmark, not undertaking high levels of effective management.

Unfortunately, analysing the performance of hedge funds is surprisingly difficult. This is because hedge funds choose whether to report to a database provider, and are obviously more likely to do so if they have high returns, as a means of promotion. This creates two main types of bias: backfill bias, and survivorship bias. The former describes the situation where all the backfilled data in the database are from hedge funds that have had periods of good performance, as this is when they are most likely to start reporting. The latter is when hedge funds stop reporting their data if they experience a period of poor performance. On top of all of this, it often transpires the most successful hedge funds do not report their data at all, potentially because they have limited capacity and cannot take on new clients, or to maintain their privacy and autonomy.

The structure and organisation of hedge funds, on the whole, follows a "master-feeder structure". This structure depends on investors investing in a feeder fund, which exists purely to invest in the master fund, the place where the trades actually occur. This structure is advantageous and widely used because it enables a manager to concentrate on an individual master fund while simultaneously and continually creating other investment products - the feeder funds - which can be adjusted to meet the needs of different types of investors. This can be done by registering feeder funds in different tax territories, changing the currencies feeder funds are denominated in, or adjusting the risk levels and performance, all dependent on the individual groups of investors. Master funds are usually organised as a partnership with feeder funds being the limited partners and the management company, owned by the hedge funds managers, being the general partner.

Even if the logistics add up, there needs to be an overriding economic benefit of hedge funds to justify their existence. Firstly, they provide efficiency by researching and using information about businesses and wider industries and reflect this information through the prices in their trades. This benefits the economy as the allocation of resources within the economy (the driver of economic growth and reaching full potential output) is dependent on the efficiency and operation of the capital market. Secondly, hedge funds provide liquidity for investors. This interlinks with the first benefit, and supports the efficient operation of capital markets. Thirdly, hedge funds are an additional source and opportunity for investors to diversify their returns, which supports the first advantage also.