What are hedge funds? What do hedge fund managers do?

Hedge funds may not be as popular as mutual funds in India. Nevertheless, they are considered a powerful wealth-building tool for sophisticated investors. 

This article explains what hedge funds are, who hedge fund managers are, how they manage funds and earn their compensation.  

What are hedge funds?

The word “hedge” simply means protecting oneself against financial risk. Hedge funds were originally introduced to limit or reduce investment risks by using hedging techniques. 

Hedge funds are privately structured investment vehicles that pool capital from accredited or institutional investors. This pooled capital is invested across equities, currencies, commodities, and other asset classes using advanced strategies such as long/short positions, leverage, arbitrage and derivatives like swaps.  

In India, hedge funds operate under the Alternative Investment Fund (AIF) Category III structure regulated by the Securities and Exchange Board of India (SEBI). 

Who is a hedge fund manager?

A hedge fund manager is a professional responsible for actively managing a hedge fund and executing its overall investment strategy. 

Their routine responsibilities include: 

• Conducting in-depth market research and financial analysis 
• Identifying potential trade opportunities 
• Understanding client requirements and investment mandates
• Implementing strategies to hedge risks while optimising returns
• Monitoring market movements and portfolio performance 

A hedge fund manager is different from a hedge fund trader. While a hedge fund trader primarily focuses on executing trades, a hedge fund manager plays a broader role in the overall portfolio management and strategy oversight. 

Did you know: The United States is home to some of the world’s top hedge fund managers, including Kenneth Griffin and Ray Dalio.  

How hedge fund managers make money

For their active involvement in managing funds with complex hedge fund strategy approaches, hedge fund managers are typically compensated based on the “two and twenty” model, which is considered a standard industry practice. 

Under this model, managers charge two types of fees: 

Management fee

This is an annual fee charged as a percentage of Assets Under Management (AUM), generally around 2%. 

For example, if the fund manages ₹1 crore, a 2% management fee would amount to ₹2 lakh annually. This fee is paid regardless of the fund manager’s performance. 

Performance fee

This is an incentive fee charged on profits generated by the fund, usually 20% of gains above a predefined benchmark. 

For instance, if a fund earns a profit of ₹50 lakh in a year, the manager may receive ₹10 lakh, subject to conditions such as the high-water mark. This policy ensures that fees are paid only when the fund surpasses its previous peak value.

Popular hedge fund strategies used to generate profits

Top hedge fund managers deploy multiple hedge fund strategies depending on market conditions:  

• Long/short equity: This involves buying undervalued stocks to benefit from price appreciation and selling overvalued stocks to gain from price declines. 
• Market neutral: This aims to reduce overall market risk by balancing long and short positions. 
• Global macro: This involves taking positions based on macroeconomic factors such as geopolitical shifts, interest rate changes, or currency movements. 
• Arbitrage: This involves exploring price differences between related securities to generate profits. 
• Event-driven: This focuses on capitalising on specific corporate events such as mergers, acquisitions, or bankruptcies. 

How hedge fund managers use leverage

Leverage in finance refers to borrowing money to increase potential returns on investments. While leverage can amplify gains, it also increases the risk of losses if markets move unfavorably. 

There are several types of leverage that fund managers use. Here are some common ones: 

• Margin buying: Fund managers borrow from brokers to increase investment exposure.
• Credit lines: This is similar to margin buying, but instead of borrowing from brokers, fund managers may approach third parties or financial institutions for capital. 
• Derivatives: Fund managers use derivatives such as futures, options, forwards, or swaps to gain larger exposure with limited capital. Derivatives are financial contracts that derive value from the performance of an underlying asset. 

Role of risk management in hedge funds

Risk management is crucial for any investment vehicle, but it becomes even more important in hedge funds because of the use of aggressive techniques and large capital allocations. Effective risk management is essential for capital protection and ensuring long-term, consistent returns for institutional investors. 

Hedge fund managers use several techniques to control risk, including stress testing, trading limits, liquidity management and leverage controls. 

Difference between hedge fund managers and mutual fund managers

While a hedge fund manager oversees hedge funds that use complex investment strategies, a mutual fund manager manages traditional mutual fund schemes designed for retail investors. The key differences between the two investment options are as follows: 

Conclusion

Unlike traditional investment options, hedge funds involve higher risk and require significantly higher minimum investments. They are generally suited for experienced investors or accredited investors. 

A hedge fund manager aims to hedge risk while maximizing returns through multiple advanced and flexible investment strategies. In return, they earn compensation through management fees and performance-based fees.  

Also Read: Mutual Funds vs. Hedge Funds: Understanding the Key Differences | m.Stock