What makes a hedge fund different

Defined by approach, not by assets

A hedge fund is a private investment pool, usually open only to institutions and accredited (high-net-worth) investors. It can hold shares, bonds, currencies, commodities, loans, derivatives and occasionally real estate, in one market or many, in one region or worldwide.

None of those assets is unusual. What sets the fund apart is the toolkit: leverage (borrowing or derivatives), short selling, derivatives and concentrated positions. That is why hedge funds are best seen as a collection of investment strategies, not a separate asset class.

The name is partly historical. The first funds paired long and short equity positions so that a broad market move hit both sides and roughly cancelled out. Today many funds hedge little, some do not short or borrow at all, and they simply exploit a niche skill. Leverage, shorting and derivatives each look risky alone; the point is to combine positions so that one part offsets risks in another.

Because the toolkit is so flexible, a traditional index is often a poor yardstick. Many hedge funds aim for absolute returns (positive returns whatever the market does) or a high return relative to their own volatility, and their returns tend to have low correlation with traditional assets.

Think of the hedge fund label as describing a kitchen, not the ingredients: the same eggs and flour as everyone else, cooked with very different tools.

How hedge funds compare with other vehicles

Mutual funds are offered to the public, so they are heavily regulated, give daily liquidity and pay their managers a fixed fee. Hedge fund managers usually earn a performance-based fee, often have their own money in the fund, and have wide discretion over what to trade. Some funds add a high-water mark, so the manager earns no incentive fee until the fund is above its previous peak.

ETFs trade on exchanges, are open to anyone, are highly regulated, report frequently and charge low fees. A hedge fund is a private partnership with restricted access, light regulation and much higher fees.

Private equity funds are also private partnerships, but they buy whole companies, often unlisted, and hold them for years. Hedge funds mostly trade public, marketable securities, have a shorter horizon and offer periodic redemption, whereas private equity requires a long commitment that is called over time.

Seven distinguishing characteristics

Compared with traditional funds, hedge funds typically show the following features. Expect exam items that ask which of them is, or is not, a hedge fund characteristic.

• Fewer legal and regulatory constraints, and lighter transparency requirements.
• Flexible mandates that allow short selling and derivatives.
• A larger investment universe: any asset class, region or instrument.
• Aggressive, concentrated positions that harvest credit, volatility and liquidity risk premiums.
• Relatively liberal use of leverage.
• Liquidity constraints: lockups, notice periods and gates.
• Relatively high fees: a management fee plus an incentive fee.

Many strategies (activist, distressed, arbitrage, concentrated long/short) take months to build and to unwind, especially in stressed markets. Restricting redemptions protects the remaining investors from forced selling.

Liquidity terms: lockups, notice periods, gates

A lockup period is an initial span during which the investor cannot redeem. After it, redemptions are usually allowed only at set dates and after a notice period. A gate caps the share of the fund that can be redeemed on one date, so that assets can be sold gradually; requests above the cap are scaled back.

A soft lockup allows early exit during the lockup, but only on payment of a redemption fee. The fee normally goes to the fund, not the manager, to compensate the investors who remain for the trading costs the leaver causes.

These terms are the price of the strategy's freedom: a mutual fund promising next-day cash could not hold the illiquid, slow-to-pay-off positions a hedge fund can.

Risks to check before investing

Lighter oversight and asymmetric information between manager and investor are why incentive fees exist: sharing profits is meant to align the manager with the investors. But the same opacity creates fraud risk (Ponzi schemes and false performance reports have occurred) and the risk that a complex strategy fails in market turmoil.

A hedge fund can be riskier from an oversight point of view yet carry less market risk than a long-only retail fund. Investors should keep regulatory, operational, illiquidity and market risk apart rather than lumping them together.

Due diligence covers the strategy, transparency, liquidity terms and reporting; the manager's track record, experience and alignment of interests; the fund's operations and risk management; and exactly how fees are calculated.