Wait, so what exactly is a hedge fund?

My good friends and family know I’m not a good sleeper! I always find myself waking up in the middle of the night with my head spinning with ideas and ticking through to-do lists. Aside from realizing that I should probably work on fixing this… its nights like these that helped me find my love for writing. I’ve been wanting to expand my content for a while out of just talking about work style to also incorporating work advice and maybe even some markets commentary. I’m going to be writing a lot more about my own personal work experiences trying to share mistakes I’ve made, funny work stories, and lessons I’ve learned. This is a somewhat embarrassing story, but stresses the need to ask questions early on in and even throughout your career. Let me know what you think at thatpencilskirt@gmail.com. I would love to hear from you if there are any other “back to basics” topics that would be helpful for me to cover!

Wait, so what exactly is a hedge fund?

When you work in Private Wealth Management there are some clients who make your heart skip a beat when they call. There are some you dread speaking to, some who’s questions you can anticipate before you hear their voice, and some who inspire you. There was one client I worked with who did more than inspire me. He saw that I was young, eager and not afraid to participate in conversations, so he challenged me. This particular client had senior people from all different parts of the bank doting over him, but for some reason, he always turned to me and asked questions. Usually they were simple: “How is your day going?” or “Have you ever been to Southeast Asia?” But one day, he asked me something completely unexpected.

We were in a heated markets conversation discussing when, if ever, active management will have a comeback (I always thought it would… for the record) and we started talking about hedge funds.

“Everyone is redeeming out of hedge funds saying the fees don’t justify the returns, but the second the stock market crashes – if it ever does – anyone left with these smart managers will be grateful” I proudly stated.

“Maybe… but let’s talk about Hedge Funds” he continued “What are they?”

I realized – In my mind I thought I knew what a hedge fund was, but when I was asked the question dead on, I didn’t know how to respond. Cue the laughter. I know it is pretty ridiculous that I’m sharing that I didn’t know what a hedge fund truly was after scoring a job on Wall Street… Sure, I could name a bunch of hedge funds and tell you how they invest and what their biggest positions were, but I couldn’t define what made a hedge fund, a hedge fund. The truth was, they all seemed so different. Some just invested in public stocks, some invested in stocks and bonds, some ran a short book, and some made bets on currencies. What was the common thread?

So what is it…

As explained to me by this very wise client, a hedge fund is a legal structure for investing. Nothing more, nothing less. They are typically structured as Limited Partnerships (LPs) where the investors (think really rich people, pension funds, endowment and foundations…) contribute to a pool of assets invested by the General Partner – aka the hedge fund manager. The hedge fund manager has flexibility to invest the funds within guidelines that they set for themselves and outline in an agreement. In exchange for managing the money, they get paid. Hedge funds are typically evergreen. Meaning, they can invest the pool of money indefinitely and are not forced to exit positions within a specific period of time. Investors, however, have the ability to redeem their money out of the fund monthly, quarterly, or annually (typically.)

How do they get paid?

You may have heard of the “2% and 20% fee structure.” What this means is that the hedge fund manager charges a 2% annual management fee on the total pool of assets (this is typically used to “keep the lights on” and cover office expenses, salaries… etc.). The “20%” is the “carried interest” which is a percentage of the upside that is paid out to the manager. Think of this as their incentive to perform. The more profits they return to their investors at the end of the year, the more carried interest they receive.

Although industry speak has dubbed 2% and 20% as “typical” hedge fund fees, there is a wide range of how these fees are structured. For example, I’ve seen larger investors pay under 1% in management fees. One other complicated, but important, nuance with hedge fund fees is the addition of a high watermark. Many funds will offer to their investors that they do not receive carried interest after fund performance is down, if it is not back up to a certain “watermark.” Let’s talk through an example: If a hedge fund was down 10% in a given year, the hedge fund managers would not receive any carried interest. If the following year, if the portfolio is up 10%, they still may not receive carried interest depending on what their watermark is. Think about it, would you want the manager charging you for the “upside” he earned to get your investment back to the amount you initially put in? Probably not.

Back to the original question

So you have to ask yourself, are hedge funds good, bad or indifferent? Will they have a “comeback” on Wall St.? This question is difficult to answer because in keeping to the essence of what a hedge fund really is, it depends. It depends on the manager, the investment thesis and strategy and the fund’s performance.

What I learned more than anything else, though, is how important it is to ask questions, and understand topics at their most basic level. It’s not difficult to rattle off stats about the markets and use big words. But it is difficult to explain a complex topic using simple language.

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