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Are hedge funds “mysterious” and “controversial?” Are they “inherently evil?”

Periodically, stories bubble up in the mainstream press that paints these funds in a poor light. Unfortunately, both critics and champions of alternative funds attempt to reduce complex financial transactions into simple language. In doing so, important details are inevitably lost and the search for meaningful insights is thwarted.

A quick perusal of recent newspaper headlines makes clear that hedge funds are squarely on the radar of a wider cross-section of society than ever before. They present hedge funds as an opportunity (“Good at Chess? A Hedge Fund May Want to Hire You” or “Pitching the Hedge Fund Masters”) or a threat (“Big British Hedge Fund Takes Aim at the States”), as a potential force for good (“Hedge Fund Chief Takes Major Role in Philanthropy”) or a potential force for evil (“Hedge Fund Manger Gets 60 Years for Fraud”), or simply as a odd source of humour and diversion (“Hedge Fund Hippies”).

But what does an actual, real life hedge fund really do?

Hedge funds have been described as “mutual funds on steroids.” This is not an entirely unhelpful first impression. If mutual funds take risks on what stocks will go up and currency exchange rates will go down, hedge funds take very, very big risks.

The roll call of great hedge fund managers includes many names that are becoming more familiar to casual readers of mainstream newspapers and magazines: Arthur Samberg, Paul Tudor Jones, Philip Falcone, Steve Cohen, Paul Singer.

Are hedge fund managers really the smartest people around? This is an alluring, but obvious quite futile, question. Regardless of whether they are or aren’t, they are still human. They are capable of making mistakes, and many do. Interestingly, like professional athletes, often the heights reached early in a career will not be seen again as the years go by.

Each year, many new hedge funds are launched in the hopes of attaining the success and recognition of the giants in the industry. In 2012, for example, new start-up hedge funds came to market focusing on a diverse range of investment strategies, including FMG Mongolia Fund (emerging markets), Context BH Partners LP (equity long/short), Citizen Entertainment Fund Ltd (fixed income), Ancora Merger Arbitrage Fund LP (merger arbitrage) and 36 South Black Eyrar Fund (volatility trading). There are now even firms which are dedicated solely to identifying new managers and backing them in their early days with significant early investments. Known as “seeders”, firms such as IMQubator and Reservoir Capital have had great success at picking the next generation of star hedge fund managers. Notably, IMQubator is ultimately backed by APG, the Dutch pension fund, a significant institutional investor.

In addition to single strategy hedge funds that may invest in Japanese equities or high-yield bonds of technology stocks, there are even funds whose sole purpose is to invest in other funds. Known as funds-of-funds, firms such as Financial Risk Management and Synergy Fund Management have received billions of dollars from investors in order to assemble diversified portfolios of underlying hedge funds. Their clients simply need to write a single check to gain access to a collection of funds selected and overseen by their teams of experts. Taking the first step towards including hedge funds in your multibillion investment portfolio couldn’t be easier for the institutional investor with the courage and wherewithal to embrace alternative investments. Or so it would seem at first.

The actual term “hedge fund” is notoriously difficult to define with any precision.

In part, this is due to the derogatory manner in which the phrase is now used. At its broadest, “hedge fund” can refer to all unregulated investment vehicles not otherwise categorizable as “private equity funds” or “real estate funds”. An overly narrow definition might settle on those funds that engage in highly leveraged trading strategies which utilises short selling or complex derivatives. Neither approach is particularly helpful for the informed layperson eager to learn more about their motivations and activities.

It would be more useful, perhaps, to simply describe certain of their key features and establish a working definition from there. Hedge funds constitute private pools of capital, with investors meeting certain net worth or sophistication requirements. Unregulated by the US Securities and Exchange Commission (SEC), the UK Financial Conduct Authority (FCA) or other relevant regulators, hedge funds are not subject to the limitations and restrictions imposed on their public fund brethren, such as retail mutual funds in the United States or authorised unit trusts in the United Kingdom.

These funds generally invest in publically listed securities and derivative instruments based on such securities. The strategies followed by hedge funds can be categorised in a number of ways. One possible set of groupings would include: “long/short,” which combines long positions with short sales; “event driven,” which seeks to identify the likelihood of certain corporate transactions; “relative value,” which seeks to exploit pricing discrepancies that arise between securities; and “tactical trading,” which identifies and follows macro-economic and other trends in various markets. Importantly, new strategies are being conceived of every day, as bright young men and women discover unique trading opportunities that arise from the day’s headlines.

A few generalizations can also be made about the economics of a hedge fund. It is common for these funds to charge a performance fee, based on the success they have pursuing their investment strategy, in addition to an asset-based management fee, based on the amount of money provided by investors. Also, the capacity constraints imposed by certain investment strategies mean a limit may exist on how much capital can be employed by a particular hedge fund without negatively impacting its returns and, thereby, the lucrative performance fee accruing to the fund manager. They typically conduct their investment activity through a prime broker, which is often a team within a large Wall Street investment bank, such as Goldman Sachs and JP Morgan and Bank of America Merrill Lynch and Credit Suisse.

Structurally, hedge funds may be set up either onshore (i.e. in the market in which the investors are located) or offshore (i.e. in a different market). They make use of either tax transparent entities, such as limited partnerships, or tax exempt entities, such as companies established in jurisdictions where broad tax derogations are possible. The most common offshore jurisdictions is no doubt the Cayman Islands, located in the warm waters of the Caribbean. Hedge funds are typically open-ended. This means that they issue and redeem units or shares directly with investors on a regular basis, based on the net asset value of the units or shares on a particular day. The mutual funds and unit trusts sold to Uncle Edgar and Aunt Edna are also open-ended, allowing retail investors to move money in and out when needed. By contrast, the units or shares of closed-ended funds (such as a private equity fund) are not eligible for interim liquidity. As a result, they must either be held until liquidation or traded from investor to investor in secondary transactions.

Currently (and for the foreseeable future) the primary investor market for hedge funds is the United States, consisting of US tax-exempt investors, such as public and private pension funds and university endowments, and US high net worth investors. However, the significant growth in United Kingdom and European based fund managers over the past 15 years has meant that structuring hedge funds has become an increasingly multi-national endeavour.

Importantly, hedge funds have evolved in recent decades as a natural result of long-term changes in the structure and operation of the financial markets. The simple facts about what they do can help demystify these alternative investment vehicles for investors and savers. Calling them “shadowy” and “evil” does little to address the real issues that arise when things occasionally go very, very wrong.

The above is an excerpt from the forthcoming book, “ONE STEP AHEAD – Private Equity and Hedge Funds After the Global Financial Crisis ,” which will be published by Oneworld in the fall. Click here for more information.