The Traditional Structure of Hedge Funds

Introduction

Hedge Funds are investment funds that pool together resources from accredited or institutional investors and invest in a variety of assets with the goal of generating high returns. These funds are typically open to a limited number of investors and require a significant initial investment.  A unique feature of hedge fund managers is that they often align their personal interests with those of the investors by investing a significant amount of personal capital. In this insight, we want to analyze the funds’ structure and their high risk, high return strategies to shed light on the advantages and the problems related with this unique and exclusive investment vehicle.

The Hedge Fund’s Typical Structure

Most Hedge Funds are structured as limited partnerships. This organizational structure is chosen for specific reasons that align with the nature of hedge fund operation and the interest of both the fund managers and investors. Limited Partnerships consist of:

  • Limited Partners: These are the investors in the hedge fund. They have limited liability, meaning their losses are typically limited to the amount of their investment. Limited partners provide the capital for the fund and share the partnership’s income, expenses, gains and losses.
  • General Partner (Hedge Fund Manager): The general partner is typically the hedge fund management company or the fund manager. This entity has unlimited liability, meaning they are personally responsible for the fund’s debts and obligations. The Investment Manager determines strategies and makes investing decisions and allocations, as well as manages portfolio risk. The investment manager is also invested in the fund and is compensated via a management fee, as well as a performance fee based on the fund’s annual performance.

In the introduction, we noted how only accredited or institutional investors are allowed to become limited partners of the fund. To qualify as an accredited investor in the U.S, a high net individual should have a net worth that exceeds $1 million and a yearly income of $200.000 or higher in each of the two most recent years and have a reasonable expectation of the income level in the current year. The rationale behind this limitation must be read in terms of investors’ protection. Indeed, hedge funds often engage in non-diversified, high risk investment operations that, on the one hand can yield very high returns and, on the other hand, carry very high risks. 

Moreover, hedge funds differ from classical mutual or investment funds in the fee structure. They often exhibit higher than average fees and include a management fee as well as a performance-based one. Managers only collect the latter when the fund is profitable, exceeding the fund’s previous high-water mark.

The Hedge Fund’s Strategy

Before delving specifically into the strategy that a hedge fund can adopt, it is important to ask whether investors can truly benefit from active management. This is because hedge funds’ existence relies on the idea that, by adopting a certain strategy, they can consistently outperform the broad market. Is this the case?

On the one hand, proponents of the Efficient Market Hypothesis (EMH) contend that markets are efficient or semi-efficient, implying that all relevant information is already reflected in asset prices. According to this view, actively managed funds, including hedge funds, face a formidable challenge in consistently outperforming the broader market over the long term. The argument suggests that any potential advantage gained through active management is offset by the collective wisdom of the market participants, making it difficult for fund managers to consistently identify undervalued or overvalued assets. 

On the other hand, advocates for active management, particularly within the realm of hedge funds, emphasize the actively managed funds’ ability to more effectively and proactively manage risk. Unlike traditional mutual funds, hedge funds can employ not only long but also short positions, derivatives, and other complex financial instruments. This arsenal allows them to proactively manage risk, seize arbitrage opportunities, and adapt to changing market dynamics.

What appears is that hedge funds leverage the imperfection (or sub-efficiency) of financial markets to exploit market opportunities. They are versatile investment vehicles, often illiquid and less regulated than the more common and less risky mutual funds. When talking about strategies, hedge funds can invest by:

  • Going Long/Short in equity. This strategy involves taking long positions in winning stocks while simultaneously financing short positions in losing stocks of the same industry. 
  • Seeking Arbitrage Opportunities. Here, we present the example of Long-Term Capital Management. “The analysts at LTCM (Long-Term Capital Management) had identified that the price of a Treasury bond with a maturity of 29 years and 9 months was surprisingly ‘too’ low compared to a 30-year Treasury bond that, in three months, would become a 29-year and 9-month bond. The price difference was essentially attributed to a liquidity problem; in other words, the 30-year bond was much more expensive because everyone wanted to buy bonds with that maturity, making it less common to purchase a bond with a maturity of 29 years and 9 months. Exploiting this price gap, LTCM was able to easily make profits by buying the less liquid bond (29 years) and selling the more liquid one (30 years), anticipating the convergence of the two prices. For a certain period, the hedge fund amassed immense fortunes. They identified over 38,000 of these price misalignments, and in the initial years, the fund recorded impressive annual returns on capital of over 40%. However, in August 1998, the markets were deeply shaken by Russia’s default on its debt. In just a few months, LTCM suffered devastating losses, losing over $4.6 billion in less than four months. To prevent further damage to other involved banks, the Federal Reserve urged a consortium of banks to intervene, taking over the fund and saving it from an imminent collapse” (LUISS University, “When Genius Failed).

This example helps us understand risks and rewards related to the nature of hedge funds.

  • Invest in distressed companies: the interested reader can refer to our dedicated insight on Distressed Debt Hedge Funds.
  • Applying Event-Driven strategies

The Inherent Problem of Traditional Hedge Funds

The example of Long-Term Capital Management highlights what is one of the most notable issues associated with hedge funds: once speculative bets fail, or when market conditions unexpectedly shift, hedge funds may suffer immense losses. This is because many hedge funds take leveraged speculative positions to enhance returns and exploit market inefficiencies. However, these strategies also amplify risks and enhance the exposure to market movements. 

In this context, multistrategy hedge funds provide more protection by combining a set of different strategies. This type of hedge fund provides diversification across strategies and grants more flexibility by making it easier for managers to adapt to shifting market conditions.

Conclusion

In conclusion,  hedge funds represent a unique and exclusive investment vehicle that attracts accredited and institutional investors seeking high returns. While the debate over the efficacy of active management continues, hedge funds leverage the imperfections in financial markets to exploit opportunities. On the one hand, this sets the stage for potentially high returns, but on the other hand, exposes hedge funds to very high risks. In this context, multistrategy hedge funds have emerged as a viable option to combine different strategies and enhance protection and mitigate risks in times of unpredictable market conditions.

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