David Einhorn is one of the best-known hedge fund managers in the world. According to Forbes, he has a net worth of more than $700 million. He has made most of this money as a hedge fund manager, running Greenlight Capital.

 

In his book, fooling some of the people all of the time, he narrated about how he started his fund as a 30-year old man with less than $1 million. Today, he has seen his fund grow to have assets worth more than $5 billion. This is the story of many hedge fund managers like Bill Ackman, Ray Dalio, and Stan Druckenmiller. In this article, we will look at the hedge fund industry and how you can invest in one.

“Hedge funds have made massive leveraged credit bets, knowing that their upside is billions in fees and their downside is millions in fees.”

What is a Hedge Fund?

A hedge fund is a company that manages money for other investors. These investors can be high net-worth individuals or institutions. The hedge funds make money by charging a fee on these total investments. The most common fee structure for hedge funds is the 2-20. In this, the manager takes a 2% cut of all funds put by his investors. This is known as a management fee and is used to pay the lease, investment software, and the salaries of staff. The 20 is known as the incentive fee. This is usually a cut of all the profits that the manager generates.

For example, if a hedge fund has $10 million in assets under management, he will make $200k through the administrative fee. If the fund returns 10% in a given year, the manager will have a gross income of $1 million. From this, he will take a 20% cut of $200k. Therefore, the total earnings for the year will be $400k. As such, it is easy to see why hedge fund managers make all this money.

What is the History of Hedge Funds?

The origin of the hedge fund industry can be traced to 1949 when Alfred Winslow Jones started his fund after raising more than $400k. He was running an experiment on whether an individual can outperform the overall market. To do this, he decided to invest in companies he believed in and shorting those that he did not believe in. He also used leverage as a way of making more money. This model caught the attention of Wall Street. Today, the industry has changed and various types of hedge funds have been started. Recent data show that hedge funds have more than $3 trillion in assets under management.

 

Types of Hedge Funds

There are more than 10 types of hedge funds. In this part, we will look at these funds and the amount of money that they manage.

  • Balanced funds. These are funds that invest in both stocks and bonds. As of the first quarter of 2019, these funds managed more than $299 billion.
  • Convertible arbitrage. These are funds that invest in special situations, with the goal of benefiting from the price differentials. For example, in merger arbitrage, the funds seek to benefit from the movement in price between the acquire and the company being acquired. These funds have more than $19 billion in AUM.
  • Distressed securities. These are funds that invest in companies that are going through financial distress. Their goal is to engineer a turnaround of these companies. They have $61 billion in AUM.
  • Emerging markets. These are funds that invest in the various emerging market countries like South Africa, Brazil, and Russia. These can be divided into their various geographies such as Asia, Eastern Europe, Global, and Latin America. They have more than $550 billion in AUM.
  • Equity Long Bias. These are funds that invest in stocks only. They don’t short the stocks. They have $332 billion.
  • Equity Long/Short. These funds invest in stocks they believe in and short those they believe will decline. They have $209 billion in assets.
  • Mult-strategy. These are funds that employ various types of strategies. Some combine the strategies mentioned above. These have $313 billion.
  • Fixed income. These are funds that invest in fixed income securities like bonds. They have $581 billion in assets. Other types of hedge funds are macro, options strategies, market neutral, and event driven funds.

How to Start a Hedge Fund

Octopus is a great book by Guy Lawson, in which he describes how Sam Israel started his own hedge fund. It is an interesting read. In it, he explains all the steps that one needs to follow when starting a hedge fund. These steps are summarized below.

  1. Have a background in finance and investment. A good way is to start by taking a course in finance and then working at a reputable financial institution.
  2. Register your fund. It is essential for you to register your fund to ensure that you are operating legally. Get all the certifications needed to manage other people’s money.
  3. Raise money from family and friends. In this, you should raise money from trusted family and friends. At this stage, it will be difficult for you to find any big investors.
  4. Invest the funds. Give yourself at least one year managing these funds. Ensure that you document everything. If your performance is good, go to the next step.
  5. Start raising money. The easiest way of raising money is by talking to big companies like JP Morgan and Goldman Sachs. If you have a good performance, these funds will help you raise money.
  6. Invest the funds. Use your investment strategy to invest these funds. It is always recommended that you always keep your investors on the loops. This means writing them periodic letters updating them about the performance of the fund.

Should You Invest in a Hedge Fund?

The question many investors ask is whether it makes sense investing in a hedge fund. To be frank, we don’t recommend you investing in hedge funds, unless when you are the manager. This is because of three main reasons. First, most hedge funds accept a minimum amount of millions of dollars. This is why only the wealthy people and institutions invest in these funds. Second, the performance of most hedge funds is not all that good. In fact, the average hedge fund has underperformed the market in the past decade. Third, the fees they charge are enormous and not worth it.

Final Thoughts on Hedge Funds

Hedge funds have made their managers very wealthy. These managers are not afraid of showing their wealth. For example, Bill Ackman recently purchased an apartment for $100 million ‘for the sake of it’. Ken Griffin recently paid more than $235 million for an apartment. Disgraced fund manager, Jeffrey Epstein lived in a 7-storey building. On the other hand, most investors in hedge funds have not shared in this success. After buying the apartment, Bill Ackman lost more than $4.4 billion in the following year when his investment in Valeant Pharmaceutical tanked. Instead of trusting a manager, we recommend that you invest in quality index funds.