Hedge Funds can turn millionaires into Multi-millionaire and Billionaires. They invest big money in the market from borrowed capital and client funds. Then, how do these Hedge funds earn so much money that the fund managers themselves become a billionaire? Let’s know How Do Hedge Funds Make Money?
Hedge funds are a game-changer in the stock market. In the US alone, Hedge funds have assets under management amounting to $2.7trillion as of 2019. The money comes from high net worth individuals and corporations who are accredited, Investors. Hedge funds charge a high commission fee from their clients whose sum they use to play with the stocks, ensuring higher returns and minimal risk.
The basic structure of a Hedge fund
A hedge fund is generally a financial institution that collects money from wealthy investors and loans, then uses the collected amount for market investments in such a way that assures them of minimum risk and high ROI(Return On Investment).
Hedge means to protect, and the fund is the pool of money. That’s what hedge funds did initially in the market, but their role has evolved. Today they invest money that involves taking high risks. Hence it’s a game where there is a big win or heavy loss.
Generally, A Hedge fund is operated by a professional fund manager who is also the General manager of the hedge fund and wealthy accredited investors called limited partners. Their main objective is to invest money such that there are always high returns even when the market fluctuates.
Who invests in a Hedge fund?
The investments in a hedge fund depend upon the performance of the fund manager, who is also the General Partner of the firm. A track record of higher returns on previous investments helps Hedge funds attract valuable assets to manage and invest. A Hedge fund is regulated minimally by the Securities and Exchange Commission hence gives them greater autonomy to invest and take leverage.
A common man cannot invest in a hedge fund because you need to be an accredited investor to invest in Hedge funds, but if you are a family member of the fund manager then, you might get an opportunity. So, who is an accredited investor..?
- A person or a corporation who is allowed to trade unregistered securities by the securities and exchange commission.
- An individual who does not require protection in the market.
- Any individual who has an annual income of $200,000 or more or a net worth of $1Million.
- A corporation with assets exceeding $5million can be considered an accredited investor who is a registered trader with limited market regulations.
The fee structure of a Hedge fund
Hedge funds do not solely rely on accredited assets for the investments they make, they also borrow capital from various institutions to pool money which allows them to invest anywhere in the market, earning high profits even when the market is not in a good shape.
Generally, Hedge funds run a fee structure of 2, and 20 i.e. a 2% commission fee on the assets under their management and 20% of the total return on investments annually.
Various Capital investments of a Hedge fund
Hedge funds invest their pooled money in almost everything that assures them of high profits. These includes:
- Real Estate
- Land
- Stocks
- Bonds
- Currencies
- Derivatives etc.,
They get money from corporations, High net worth individuals, pension funds, endowments, which allows them to take risks and earn high returns.
Capital sources of Hedge funds:- Basically, Hedge funds earn from the commission fee but other sources also allow them to make money and gain high returns.
- Management Charges – Hedge funds earn annually on the assets of the accredited investors they manage. They take 2% of Assets under management(AUM) So, if your assets are worth $8 Million in a hedge fund then, the Hedge fund will typically charge $160,000 per annum for managing your assets i.e. investing them further for higher returns Hence, even if the profits are low Hedge funds will keep getting asset management fees. This fee reduces once the size of assets increases to make sure that the investors get their promised returns. Sometimes this fee varies from 1% to 4% subject to the amount under management.
- Return on Investment Charges – This is typically 20% of the total return on your assets called an incentive fee. Let’s say your assets generated $200 million in a year, then the Hedge funds will take 20% i.e. $40 million. The Hedge funds ensure higher profits to make money for themselves, Hence building a balance between the accredited investor and the hedge fund.
- Threshold on Charges – It is reasonable for Hedge funds to charge the investors on asset returns but what if the profit generated is low and minimal, in such cases a 20% incentive is improbable hence a Hurdle rate is agreed upon if the Hedge fund can earn above the threshold then only the incentive fee is applicable otherwise ignored. It is called High-watermark that ensures that a fund manager is not paid for poor performance.
- Divestment Charges – If a particular accreditor wants to withdraw their funds due to low returns then, they can choose to surrender such meetings are held monthly to discuss returns and investments. Single disinvestment will lead to the modification of the whole investment model of a hedge fund reducing the pooled money, hence investors need to pay a surrender fee. Generally, this amount is charged to discourage divestments in the funds.
- Refunds- Imagine an asset earning high returns increasing the total value of the funds and after a few days or months the asset is undervalued due to market volatility in such cases the Hedge funds pay Retrospective fees i.e. they return their incentives, This is done to gain investor’s trust.
- Leverage Charges – Hedge funds rely heavily on leverage which is to be returned with interest to pay back huge amounts of leverage. accreditors are charged with a financing fee, it usually depends on the debt incurred by the Hedge fund and is subject to certain terms and conditions.
- Market Neutral – Hedge funds operate in a market-neutral environment that assures big returns and minimal risks. Hedge funds invest big money hence losing is less of an option for them, they operate in long-term and short-term investments at the same time to steer clear of market volatility.
- Long/Short Equity strategy – This is one of the high-return investment strategies of hedge funds, They purchase stocks that will appreciate and sell stocks that might depreciate. This is called taking long positions in underpriced stocks and short positions in overvalued stocks ensuring low market exposure and profitable returns.
- Life Insurance strategy – This is one of the popular money-making strategies of Hedge funds called ‘Life settlement plans’ to understand this imagine you own a life insurance policy and that is bought by a hedge fund, and you will be paid less than the death benefit but more than what you paid as an insurer this imposes the liability to pay premiums on the hedge funds and once the insurer dies the whole insured amount is paid to the Hedge fund. This is an emerging strategy that proves that Hedge funds can do anything for big money.
- Litigation strategy – As said earlier Hedge funds do not only depend on stocks and derivatives to make money they employ in out-of-the-market dealings to ensure their targeted High watermark profit and litigation is one such strategy. Litigations always credit high returns and involve lower investment( from the perspective of a hedge fund) and minimal to zero risk. Imagine you are a litigant in a dispute and you are funded by a hedge fund. Once the litigant wins the lawsuit the hedge funds gain higher amounts of litigation returns as your investor because they will earn a part of the settlement.
Now, Hedge funds do not invest in single litigants but invest in litigation investment
Firms that save them from the hassle and ensures high returns apart from these Hedge
Funds also earn from investing in low-performance bonds, investments in wine, antiques
And at times manipulating the market using short squeeze. Hedge funds can invest in
Anything and everything that one can imagine making them prone to market volatility.
Concluding the money-making strategies of a Hedge fund
The biggest advantage of a Hedge fund lies in its limited regulations, which is why countries like China or India do not host large and profitable Hedge funds. Hedge funds are kings of wall street like Machiavelli advises the king to follow any method to ensure his superiority and to protect the state the king must not hesitate to commit evils because he must focus on the larger good of the nation-state. In the very same way, Hedge funds do not hesitate in adopting weird strategies to achieve their goals of higher returns.
Countries like the US, UK, or Hong Kong host the world’s largest Hedge funds due to free-market policies followed in these countries. In the long period, the Hedge fund managers end up making bigger money compared to their clients so, it would not be incorrect to say that Hedge funds are great marketers they know your preference and what exactly you want to buy.
Frequently asked questions
- What are derivatives..?
A derivative is a financial instrument whose value is determined by the asset or group of commodities underlying. The value changes based on the agreement between the two parties.
- Are there any Hedge funds in India..?
Yes, there are Hedge funds in India for example India Capital fund, Fair Value, India deep value fund, etc. these funds are regulated by SEBI hence they are under obligation to play by the market rules.
- How can I become a Hedge fund manager..?
To become a Hedge fund manager is not an easy task but not impossible. Hedge funds employ few highly qualified people. They hold PhDs in mathematics from top universities like Stanford or Yale because you need to learn the market rules through analysis to make the best bets. Hence become a good seller to start yourself in the Hedge fund industry.
- Which is the world’s profitable Hedge fund..?
Bridge water associates and Renaissance technologies have dominated the Hedge fund industry for a long time but other players are not behind in terms of generating profits like Black rock advisors or AQR Capital management.
