Market Insights: Why Do People Invest In Hedge Funds? [Part 1]

In today’s Market Insight blog, I’m writing to you to explain all about hedge funds! Now, the reason I’m writing this post is because there are a ton of misconceptions out there about what a hedge fund is, what it means, and why anyone would pay so much to invest in a fund.

First, let’s establish what a hedge fund is NOT. A hedge fund is not anyone that manages someone else’s money. So, your buddy who was given money by his aunt to trade stocks for her is not a hedge fund, no matter how much he calls himself one. Managing someone else’s money does not make you a hedge fund.

A real hedge fund has five distinct characteristics:

  1. Offshore registered fund
  2. Onshore management company
  3. Third-party administrator
  4. Prime brokerage agreement
  5. Strong track record

#1 and #2 describe the structure of the hedge fund. A hedge fund has a very specific setup. It is comprised of two parts: the offshore registered fund and the onshore management company.

The registered fund is kept somewhere offshore in a tax haven jurisdiction, such as the Cayman Islands, in order to reduce expenses for the investors so that the fund can grow more quickly. This is not illegal; it’s all above board and perfectly acceptable under the law, as long as the fund is appropriately registered with the SEC.

The second half is the onshore management company. This is the part that actually manages the money. So the offshore fund contracts the management company to manage all the assets in the fund. All in all, to set this structure up typically costs about a million bucks.

#3 is the third-party administrator. Their job every day is to make sure that the management company is implementing the fund’s investment mandate. The administrator provides a sort of checks and balances system to ensure that the management company is doing its job correctly.

#4 is an agreement with a prime brokerage. A prime brokerage is one of the big investment banks such as Goldman Sachs, UBS, Morgan Stanley, etc., which provides services such as access to research, securities lending, leveraged trade execution, and more. In order to get an agreement with a prime brokerage, a hedge fund needs a minimum of around $30 million of investor capital, although requirements are different from each prime brokerage. This is because the large investment banks deal with massive trades and transactions, so if the hedge fund is not a big enough fund, then it’s not worth the bank’s time to deal with the fund.

The last characteristic of a hedge fund is a strong track record of trades. This means at least 3-5 years of fund management, audited by one of the big four accounting firms. The prime brokerage just needs to see that the fund managers know what they’re doing.

Whew! That’s enough technical talk for one day. Next week, we’ll pick up where we left off and take a look at why hedge funds exist and what makes them special. Until next time!