Types of Hedge Funds, Managers, and Fees West Lafayette IN

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Despite the ambiguities involved in describing hedge funds, you can sort them into two basic categories: absolute-return funds and directional funds. I look at the differences between the two in the following sections. Because hedge funds are small, private partnerships, I can’t recommend any funds or fund families to you. And because hedge fund managers can use a wide range of strategies to meet their risk and return goals (see the chapters of Part III), I can’t tell you that any one strategy will be appropriate for any one type of investment. That’s the downside of being a sophisticated, accredited investor: You have to do a lot of work on your own!

Absolute-return funds
Sometimes called a “non-directional fund,” an absolute-return fund is designed to generate a steady return no matter what the market is doing. Alfred Winslow Jones managed his pioneering hedge fund with this goal, although the longshort strategy that he used was just one of several methods that snagged him consistent returns (see the section “Alfred Winslow Jones and the first hedge fund”). Although absolute-return funds are close to the true spirit of the original hedge fund, some consultants and fund managers prefer to stick with the label absolute-return fund rather than “hedge fund.” The thought is that hedge funds are too wild and aggressive, and absolute-return funds are designed to be slow and steady. In truth, the label is just a matter of personal preference. An absolute-return strategy is most appropriate for a conservative investor who wants low risk and is willing to give up some return in exchange. Some say that absolute-return funds generate a bond-like return, because like bonds, absolute-return funds have relatively steady but relatively low returns. The return target on an absolute-return fund is usually higher than the longterm rate of return on bonds, though. A typical absolute-return fund target is 8 percent to 10 percent, which is above the long-term rate of return on bonds and below the long-term rate of return on stock.

Directional funds
Directional funds are hedge funds that don’t hedge — at least not fully (see the section “Hedging: The heart of the hedge-fund matter” for more on hedging). Managers of directional funds maintain some exposure to the market, but they try to get higher-than-expected returns for the amount of risk that they take. Because directional funds maintain some exposure to the stock market, they’re said to have a stock-like return. A fund’s returns may not be steady from year to year, but they’re likely to be higher over the long run than the returns on an absolute-return fund. Directional funds are the glamorous funds that grab headlines for posting double or triple returns compared to those of the stock market. The fund managers may not do much hedging, but they have the numbers that get potential investors excited about hedge funds. A directional strategy is most appropriate for aggressive investors willing to take some risk in exchange for potentially higher returns.

Hedge Fund Neighborhoods
Many different people work for, with, and around hedge funds. The following sections give you a little who’s who so you understand the roles of the people you may come into contact with and of people who play a large role in your hedge fund.

Managers
The person who organizes the hedge fund and oversees its investment process is the fund manager — often called the portfolio manager or even PM for short. The fund manager may make all the investment decisions, handling all the trades and research himself, or he may opt to oversee a staff of people who give him advice A fund manager who relies on other people to work his magic usually has two important types of employees:

Traders: The traders are the people who execute the buy-and-sell decisions. They sit in front of computer screens, connected to other traders all over the world, and they punch in commands and yell in the phones. Traders need to act quickly as news events happen. They have to be alert to the information that comes across their screens, because they’re the people who make things happen with the fund.

Analysts: Traders operate in real time, seeing what’s happening in the market and reacting to all occurrences; analysts take a longer view of the world. They crunch the numbers that companies and governments report, ask the necessary questions, and make projections about the future value of securities.

Lawyers
Although hedge funds face little to no regulation, they have to follow a lot of rules in order to maintain that status. Hedge funds need lawyers to help them navigate the regulation exemptions and other compliance responsibilities they face, and hedge fund investors need lawyers to ensure that the partnership agreements are in order and to assist with due diligence.

Consultants
Because big dollars are involved, many hedge fund investors work closely with outside consultants to advise them on their investment decisions. Hedge fund managers also work with consultants — both to find accredited investors through marketing and to make sure that they’re meeting their investors’ needs. A consultant can take a fee from an investor or from a hedge fund, but not from both. That way, the consultant stays clear of any conflicts of interest.

Advising investors
A key role for consultants is helping investors make sound investment decisions. Staff members who oversee large institutional accounts — like pensions, foundations, or endowments — rely heavily on outside advisors to ensure that they act appropriately, because these types of accounts hinge on the best interests of those who benefit from the money. Consultants not only ensure that investors follow the law, but also advise investors on the proper structure of their portfolios in order to help them meet their investment objectives. A consultant analyzes how the investor divides the money among stocks, bonds, and other assets and then recommends alternative allocations that may result in less risk, higher return, or both.

Monitoring performance
Investment consultants track the performance of their clients, of course, but
they also build relationships with hedge fund managers and collect data on
the risk, return, and investment styles of different funds and fund managers.
They use the information they collect to advise their clients on investment
alternatives. Because you can find only a few central repositories for hedgefund
performance information, and because hedge funds don’t have to make
their return data public, this is an important service.

Marketing fund managers
Many hedge funds are small organizations. In some cases, the fund managers work alone. These funds have a small number of investors, and they may not allow their investors to take money out for a year or two, so they don’t need to do constant marketing. It rarely makes sense for a hedge fund to have a dedicated marketing person on staff. But that doesn’t mean hedge funds don’t need to find other investors. When the fund is new or when current investors want to withdraw their money, marketing becomes important. To help find new investors, many hedge funds work with consultants, who bring together investors looking for suitable hedge funds and hedge funds looking for suitable investors.

Hedge Fund Fees
Hedge funds are expensive, for a variety of reasons. If a fund manager figures out a way to get an increased return for a given level of risk, he deserves to be paid for the value he creates. And, one reason hedge funds have become so popular is that money managers want to keep the money that they earn instead of getting bonuses only after they meet big corporate overhead. Face it — a good trader would rather keep his gains than share them with an overpaid CEO who doesn’t know a teenie from a tick. A teenie is 1⁄16 of a dollar. A tick is a price change. If the next trade takes a security up in price, it’s an uptick; if it takes the security down, it’s a downtick. In the olden days, when everything traded in eighths or teenies, ticks were printed on strips of paper called ticker tape. If a person did something notable, like win a World Series or land on the moon, he or she would receive a parade, and everyone at the brokerage firms would open their windows and throw out their used ticker tape (hence, ticker-tape parade). Almost all hedge fund managers receive two types of fees: management fees and performance fees. More than anything else, this business model, not the investment style, distinguishes hedge funds from other types of investments.

Management fees
A management fee is a fee that the fund manager receives each year for running the money in the fund. Usually set at 1 percent to 2 percent of assets in a fund, the management fee covers certain operating expenses, salaries for the fund manager and staff, and other costs of doing business. The fund pays other expenses in addition to the management fee, such as trading commissions and interest. For example, say a hedge fund has $100,000,000 in assets. It charges a 2-percent management fee, which is $2,000,000. The fund has an additional $1,750,000 in trading expenses and interest. The fund investors have to pay fees from the assets whether the fund makes money or bombs. If the fund’s management fee is too low, the fund manager won’t be able to run the business effectively or hire the necessary staff. If the fee is too high, the fund manager will make such a nice living that he or she will have little incentive to pursue a performance bonus.

Performance fees
Most hedge funds take a percentage of the profits as a performance fee — also called the incentive fee or sometimes the carry. The industry standard is 20 percent, although some funds take a bigger cut and some take less. You need to read the offering documents you receive from a fund to find out what the fund charges and whether the fund’s potential performance justifies the fee. If the fund loses money, the fund manager gets no performance fee. In most funds, the fund managers can’t collect performance fees after losing years until the funds’ assets return to their previous high levels, sometimes called the high-water marks. The performance fee means that the fund manager’s incentives are closely aligned with those of the fund’s investors. As folks on Wall Street say, hedge fund managers eat what they kill. The big problem with the performance fee is that if a fund has a negative year, the fund manager has an incentive to close the fund and start over instead of losing the performance fee. And every fund will have a bad year once in a while. In many cases, a hedge fund’s outstanding performance disappears after the performance fee hits the manager’s pocket. You may find that you’re paying a lot of money and dealing with many complications to be in a hedge fund when you could get the same net return through a different type of investment, like a mutual fund.

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For Dummies is a registered trademark of Wiley Publishing, Inc. in the United States and other countries. Used here by license.