While many people might have a rough idea about what hedge funds are and what they do, it is probably safe to say that most would simply say they are firms that manage capital. Hedge funds fall into the so-called ‘buy side’ of finance.
The ‘buy side’ refers to institutional investors – or asset managers, such as mutual funds, private equity, and of course hedge funds. Historically, hedge funds, as the name implies, have been funds that devote part of their capital to place a bet opposite to the bets that make up the focus of the fund.
So, what differentiates hedge funds from other types of asset managers? Hedge funds are an alternative form of investment that seek to deliver absolute returns via unconventional and risky investments (Investopedia, 2021). For those keen on hedge funds strategies, you might know of various strategies such as long/short equity, otherwise known as hedging, and market neutral. The amount of capital to go around this sector is quite substantial too. From 1997 to 2020, the value of assets managed by hedge funds across the globe has risen from $118bn to close to ~ $4tn (Statista, 2021).
Where does this funding come from? While funding could come from any kind of asset owner, it could be individuals, banks, pension funds, insurance companies, as well as endowments, hedge funds exclude small investors. They typically set high minimum investments that make it prohibitive for small investors that are seeking to diversify their portfolio. In contrast to some of their peers in the ‘buy side’, for example mutual funds whose fees have fallen quite a bit in recent times, hedge funds follow their “2-and-20” fee structure (Investopedia, 2021). That is, they charge a 2% management fee for the asset that someone commits and an additional 20% from any profits they manage to make (Investopedia, 2021). Throughout the 90s and early 2000s, hedge funds were heralded for their ability to beat the market. Yet ever since the financial crisis they have largely underperformed. So it is with great interest that we are now seeing large funds, such as Citadel, be able to capitalize on the volatility the markets have experienced because of the pandemic to generate high levels of returns once more.
