Module VII·Article IV·~2 min read
Hedge Funds: Structure and Strategies
Types of Asset Management Institutions
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Hedge Funds: Alternative Asset Management
Hedge funds are private investment pools with broad freedom in the selection of strategies, instruments, and use of leverage. Despite the name, many hedge funds do not engage in hedging in the traditional sense—the term has historically become associated with the alternative investment industry.
Legal Structure
A typical hedge fund is organized as a limited partnership (LP) or offshore corporation (often in the Cayman Islands). Investors are limited partners with limited liability. The general partner (management company) makes investment decisions and receives compensation.
A master-feeder structure is used to pool capital from different jurisdictions. Feeder funds (onshore and offshore) invest in the master fund, where the actual management takes place. This ensures tax efficiency for various categories of investors.
Minimum investment usually ranges from $1 million to $25 million, limiting access to institutional investors and high-net-worth individuals. Lockup periods (1–3 years) and redemption gates restrict investment liquidity.
Fee Structure
The traditional “2 and 20” model includes: a management fee of 2% of AUM (assets under management) and a performance fee of 20% of profit above the high-water mark. The high-water mark means that the performance fee is charged only on new profits—the manager must first recover previous losses.
Pressure on fees: after weak industry performance, fees have been declining. Average rates are approaching “1.5 and 15” or lower. Large institutional investors negotiate individual terms.
Main Strategies
- Long/Short Equity — the basic strategy: buying undervalued stocks, short selling overvalued ones. Net exposure (the difference between long and short) determines market risk. Market neutral strategies keep net exposure close to zero.
- Global Macro — directional bets on macroeconomic trends through currencies, interest rates, commodities, indices. Legendary managers (Soros, Tudor Jones) became famous for macro trades.
- Event-Driven — investments based on corporate events: M&A arbitrage (betting on deal completion), distressed securities (debt of troubled companies), special situations.
- Quantitative/Systematic — algorithmic strategies based on statistical models. These include momentum, mean reversion, statistical arbitrage, high-frequency trading.
Due Diligence When Choosing a Hedge Fund
- Track record: analysis of historical returns, volatility, drawdowns. Not only return is important, but also Sharpe ratio, consistency, behavior in stress periods. Beware of results that are too good—they may indicate fraud or unsustainable risks.
- Investment process: understanding the sources of alpha, repeatability of the process, risk management.
- Red flags: lack of transparency in the strategy, dependence on one person, absence of clear stop-loss rules.
- Operational due diligence: independent administrator, quality auditor, segregation of duties, cybersecurity. Operational risk is no less important than investment risk—many fraud cases (Madoff) could have been detected through operational DD.
Role in the Portfolio
Hedge funds are positioned as a source of diversification and absolute returns. Low correlation with traditional assets promises improvement in the portfolio’s risk-adjusted returns. Reality is more complex. Correlations increase during crises. After accounting for fees, the average hedge fund does not outperform passive benchmarks. However, the best managers do create alpha—the problem is identifying them ex ante.
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