👋🏼 everyone,
I used to work with someone a few years ago who went to work at a hedge fund and the reaction internally was a bit like ‘he sold his sold to the devil’.
That got me thinking though - why did I feel the same, I had a pretty strong disliking for a sector I knew next to nothing about and it left me intrigued. Would I like to work for a hedge fund if I ever got the opportunity?
Who knows, I might have hated the environment, drowned in the workload, despised the nature of the work. Maybe all of the above.
What I do know is that this viewpoint is not unique to me. I've spoken to countless people, both personally and professionally, who feel that the world of hedge funds is so secretive and opaque that they have no idea how it works.
So I want to share what I’ve learnt over the last few years. Today I’m going to cover:
🔎 What exactly is a hedge fund?
A step-by-step guide on how hedge funds operates
📹 explanation
Long vs short selling strategies (with a simple example)
A day in the life of a Hedge Fund Analyst
🙈 Why Hedge Fund Managers are so often disliked
Can you as an individual investor gain access to a hedge fund?
Get a job in a hedge fund and retire by 35 - does that actually happen?
(Quickly) Explained…
A hedge fund is a privately managed fund typically consisting of a small group of large investors whose money is managed by a manager and (sometimes) a team of analysts/investors.
They can use a variety of strategies (see below) and generally are marked by a diverse series of investments. They typically are designed to provide an absolute return, meaning a positive return regardless of the direction of the market.
Some hedge funds get a reputation for being very aggressive in order to ensure absolute return.
The hedge fund is designed to take the money provided by the investors and through professional management provide a good-to-high rate of return.
They are not available to the general public. They have a more limited audience, and less regulation historically.
A step by step guide of how hedge funds work:
Fund formation: The hedge fund is created by a fund manager, who establishes a legal entity. The fund manager defines the fund's investment strategy, objectives, and terms, including fees and investor eligibility criteria
📧 Investor solicitation: The fund manager seeks out potential investors who may be interested in allocating capital to the hedge fund. This can include high net worth individuals, institutions, family offices, or other eligible investors
🕵🏼 Investor due diligence and onboarding: Interested investors conduct due diligence on the hedge fund, which involves evaluating its investment strategy, track record, risk management processes, and fees.
👩🏻💼 Fund management: The fund manager is responsible for making investment decisions and managing the fund's assets. They analyze market conditions, identify investment opportunities, and determine the appropriate allocation of the fund's capital across various assets and strategies
Investment execution: Based on the fund's investment strategy, the fund manager executes trades, such as buying or selling stocks, bonds, derivatives, commodities, or other financial instruments
⚠️ Risk management: Hedge funds employ risk management techniques to protect capital and mitigate potential losses. This can include setting position limits, diversifying investments, using hedging strategies, and monitoring market and portfolio risks. Risk management practices vary among hedge funds and are tailored to their specific strategies
Performance monitoring: The fund manager continuously monitors the fund's performance, tracking the returns generated by the portfolio. They assess the performance relative to benchmarks and evaluate the success of the investment decisions and strategies employed
🗃️ Investor reporting: The fund manager provides periodic reports to investors, typically on a quarterly basis, detailing the fund's performance, portfolio holdings, and other relevant information. These reports help investors assess the progress of their investments and make informed decisions
🤑 Fee collection: Hedge funds typically charge management fees, calculated as a percentage of the fund's assets under management, and performance fees, which are a portion of the profits generated. The fund manager collects these fees to cover operational costs and compensation
Hedge funds…in 60 seconds:
🎰 Long vs short selling strategies
Short selling and long selling are investment strategies commonly employed by hedge funds to potentially profit from both rising and falling markets. Here's a brief explanation of each strategy:
Long Selling:
When a hedge fund takes a "long" position, it means they are buying an asset with the expectation that its value will increase over time. For example, if a hedge fund believes a particular stock will appreciate in value, they will buy shares of that stock, aiming to sell them at a higher price in the future. Long positions are typically taken in bullish market conditions when the fund anticipates upward price movement.
Short Selling:
In contrast, short selling involves taking a "short" position. This strategy allows a hedge fund to potentially profit from a decline in the price of an asset. To execute a short sale, the hedge fund borrows the asset (often from a broker or another investor) and immediately sells it in the market. The fund aims to buy back the asset at a lower price in the future to repay the loaned shares, thus profiting from the price difference.
Short selling can be a little be confusing, so let me break it down a little further.
Let's use a common item like bicycles 🚲 for this example:
Imagine you have a friend named Sarah who owns a brand new bicycle. You believe that the price of bicycles will decrease in the near future due to an oversupply in the market.
With Sarah's permission, you borrow her bicycle and immediately sell it to someone else who is willing to buy it at the current market price.
As time goes by, your prediction comes true, and the price of bicycles drops. Now, you decide to buy back the same type bicycle at the lower price.
You return the borrowed bicycle to Sarah, completing the transaction.
By short selling the bicycle, you were able to profit from the price decrease. You borrowed the bicycle, sold it at a higher price, and then bought it back at a lower price, allowing you to keep the price difference as your profit.
But what are the borrowing terms? What if Sarah wants the bike back before the prices drop?
Well, that’s where the loan (borrowing) agreement comes into play: the agreement will outline the duration for which, the bike in this example, but generally known as ‘securities’, are borrowed.
This period may be fixed or subject to termination by either party with prior notice.
Also it’s important to know that some agreements also have a ‘Conditions for recall or termination’ clause - so the agreement may include provisions that allow the lender to recall the borrowed securities before the agreed loan period expires. Important to know as it adds further risk.
A day in the life of a Hedge Fund Analyst 🧵
Why are Hedge Fund Managers so often disliked? 🙈
I think I should point out at this stage, there are over 15,000 active hedge funds in the world and like any profession or industry there are good eggs 🥚and not so good eggs when it comes to people.
But here are some of the reasons why hedge fund managers tend to get a tough time:
Lack of transparency: originally, the term "hedge fund" meant just that. A fund of money that was "hedged" (protected) against violent swings in the market. The term later evolved to mean any conventional or unconventional investment strategy with little or no government regulation. Because only investors who meet certain standards of wealth are usually allowed to invest, governments do not closely monitor these funds - although regulation has increased in recent years.
This lack of transparency is one major reason why hedge funds are vilified. They are often accused of trading on insider information, profiting at the expense of ordinary investors. This is sometimes true and sometimes not.
Profiting from hard times: George Soros infamously bet against the British £ so heavily that it moved exchange rates and harmed the Bank of England. Several hedge fund managers made a lot of money betting against subpar American mortgages when the rest of America was suffering a financial crisis. And unsurprisingly people generally don't tend to like other people who seemingly reap the greatest rewards when others are suffering the most.
Ripple effects their investment strategies can have on the rest of the market: One common characteristic is a high degree of leverage. Meaning, for every $1,000 in stocks a hedge fund owns, they may have borrowed $950 of it from a creditor. With this much leverage, it only takes a small degree of loss for a fund to burn up their own $50 and be wiped out. When this happens, the bank often steps in and usually dumps all the stocks and the bonds in the market at heavily discounted prices. When many funds collapsed in 2008 and 2009, everyone was dumping things in the market at majorly discounted prices. This made the investments that every day Americans own quickly lose their value as well.
Can individual investors gain access to a hedge fund?
It is possible to invest in hedge funds, but there are some restrictions on the types of investors who comprise a hedge fund's investor pool.
In general, it is extremely difficult for individual investors to gain access to a quality hedge fund.
Why?
Hedge fund General Partners and Managers often create high minimum investment requirements. It is not uncommon for a hedge fund to require at least $100,000 or even as much as $1 million to participate.
Unlike mutual funds, hedge funds avoid many of the regulations and requirements within the Securities Act of 1933.
In exchange, the Securities and Exchange Commission (SEC) requires a majority of hedge fund investors to be accredited, which means possessing a net worth of more than $1 million and a sophisticated understanding of personal finance, investing and trading.
These requirements exclude the vast majority of the investing public.
🏝️ Retire by 35 - possible?
I started this post by reflecting on whether I would have pursued a career in hedge funds if I’d be more acquainted with the sector when leaving college, but the environment and sometimes ethical questions that are raised may have put me off.
It’s also worth noting that the whole ‘get in, make your money, and get out’ philosophy that is so often attributed to the world of hedge funds isn’t strictly based on reality.
Megan Tobias Neely spent years studying what hedge fund managers say about their careers, and then interrogating the gap between those claims and reality (which can be found in her book).
Neely’s been told that it used to be possible to get out by the age of 35, now it's more like 55 or beyond. And if you do get out, you might not like what you find - one of Neely's interviewees sold his firm with $200m in assets under management and then returned to work after finding himself bored.
One thing seems true from her research, though, and that is that making the big bucks 💵 is becoming harder than ever.
Thank you very much for reading 🙏 if you found this helpful and enjoyed the post, I’d be super grateful if you could hit the ❤️ below - thank you!
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.
Keep it up Jason, I love this!