Hedge Funds: How To Identify The Best Ones And Key Insights For Investors

By
Peyman Khosravani

The hedge fund industry was up 6.1% for the first half of 2024 (on an asset-weighted basis). What are the best hedge funds that deliver high returns? Here are some of the key insights for investors, experienced or beginners, to identify the best hedge funds.

hedge fund

The biggest hedge funds on the market usually become that way through excellent performance, a strong track record, and effective risk management strategies. Field Street Capital Management held the title of largest hedge fund company in 2023, holding assets valued at nearly 298 billion dollars.

Hedge funds are among the various alternative investment options accessible to high-net-worth individuals and organisations. In addition to investing in a wide range of markets, such as stocks, bonds, and commodities, hedge fund managers also use advanced methods including taking both long and short positions to take advantage of price inefficiencies across various investment products and geographical areas. 

Wealthy individuals and institutions invest in hedge funds to increase their profits beyond what could be possible in the open stock and bond markets. However, investors may not have easy access to their money when they want to access it, and hedge fund managers have the power to charge high fees.

We’ll cover how hedge funds make money, how to find and assess the top performers, where to track their success rates, and what to know about entry requirements.

What are hedge funds?

Hedge funds pool investor capital and use it to purchase securities or make other kinds of investments to make a profit. Generally speaking, hedge funds have greater freedom to pursue assets and methods that raise the risk of investment losses than mutual funds because they are not subject to the same regulations. Hedge funds are primarily accessible to large investors, such as pension funds, and richer individuals who can afford the higher fees and risks associated with hedge fund investing. Key features of hedge funds include:

  • Wide investment strategies (equities, bonds, derivatives, commodities, etc.)
  • Private, less regulated funds
  • Flexible fee structures (performance-based fees)
  • Higher risk, higher reward potential

How hedge funds make money

Hedge funds generate profits through various strategies aimed at beating the market. Here are some common ways they make money:

  1. Long/Short Equity: This is a popular strategy where hedge funds buy stocks expected to rise (long) and sell short stocks predicted to fall. By balancing long and short positions, they aim to profit in both bull and bear markets.
  2. Arbitrage: Hedge funds exploit price differences between related securities. For example, they might buy and sell the same asset in different markets to capture small price discrepancies.
  3. Global Macro: This strategy focuses on macroeconomic trends, such as interest rates, political changes, and global events. Hedge funds make big bets on entire countries or markets rather than individual companies.
  4. Leverage: Hedge funds often borrow money to amplify their returns, allowing them to take larger positions than they could with their own capital. While leverage can significantly boost gains, it also increases risk.
  5. Derivatives: Hedge funds frequently use options, futures, and other derivatives to hedge against risk or speculate on market movements.
  6. Event-Driven Strategies: Hedge funds capitalise on corporate events like mergers, acquisitions, or bankruptcies. They invest in companies undergoing significant changes, hoping to profit from the volatility and price movements associated with these events.

Hedge funds typically charge two types of fees:

  • Management Fees: Hedge funds charge a fixed fee based on the assets they manage. This fee is usually around 2% of the total assets under management (AUM), regardless of how the fund performs. For example, if a hedge fund manages £100 million, it may charge £2 million annually as a management fee.
  • Performance Fees: These are typically 20% of the profits made by the hedge fund, also known as the “2 and 20” model. If the fund generates substantial profits above a certain benchmark (called a hurdle rate), the fund managers take 20% of those profits as a performance fee. This incentivises fund managers to pursue high returns.

How to identify the best hedge funds

Choosing the right hedge fund requires thorough research and consideration of various factors. Here’s what to look for:

Define your investment criteria: 

  • Risk tolerance: Consider your comfort level with risk. Hedge funds can range from relatively conservative to extremely aggressive.
  • Return expectations: Establish your desired return level compared to traditional investments like stocks or bonds.
  • Investment horizon: Determine whether you are looking for short-term gains or long-term growth.

Analyse fund performance

  • Track record: Look for hedge funds with a consistent performance history over several years. A minimum of 3-5 years of solid returns is typically a good indicator of the fund’s stability and effectiveness.
  • Risk-adjusted returns: Focus on metrics like the Sharpe Ratio (return per unit of risk), Sortino Ratio (downside risk), and Alpha (excess return over a benchmark).
  • Drawdown analysis: Examine the fund’s performance during market downturns to understand its resilience and risk management capabilities.

Evaluate fund management

  • Manager experience: Research the background and track record of the fund manager. Successful hedge funds often have experienced managers with a strong understanding of market dynamics and investment strategies.
  • Team expertise: A well-rounded team with diverse skills can indicate robust operational capability and strategic depth.

Assess strategy alignment: 

  • Strategy fit: Ensure the fund’s investment strategy matches your financial goals and risk tolerance. For example, a long/short equity fund may be suitable for those comfortable with market volatility, while a market-neutral fund may appeal to more conservative investors.

Check fees and costs: 

  • Management fees: Assess whether the management fee, typically 1-2%, is justified by the fund’s potential performance.
  • Performance fees: Understand the fund’s performance fee structure and any high-water mark provisions, which can protect investors from paying fees on underperformance.

Examine liquidity and lock-up periods: 

  • Liquidity terms: Review the fund’s redemption policies. Some hedge funds have lock-up periods during which investors cannot withdraw their capital.
  • Notice periods: Be aware of any notice periods required for redemptions, which can range from 30 days to several months.

Where to find hedge funds

Finding hedge funds that meet your criteria requires a combination of research and connections. Here are some ways to locate hedge funds:

Hedge fund databases: Subscription-based databases such as Hedge Fund Research (HFR), Preqin, and Eurekahedge provide comprehensive data on hedge fund performance, strategies, and AUM.

Financial advisors: Professional advisors often have access to hedge fund information that is not publicly available. They can recommend funds that align with your financial goals and risk tolerance.

Industry conferences and events: Attending industry conferences, such as the Sohn Investment Conference or SALT, provides opportunities to network with hedge fund managers and gain insights into their strategies and performance.

Networking and referrals: Personal and professional networks can be valuable in identifying high-quality hedge funds. Referrals from other investors or industry professionals often provide access to funds that may not be widely known.

Institutional platforms: Some online platforms, such as iCapital Network or CAIS, cater to accredited investors, offering access to a curated selection of hedge funds.

Tracking hedge fund success

Monitoring the performance of hedge funds is crucial for making informed investment decisions. Here are key ways to track their success:

  • Preqin: Offers detailed reports on hedge fund performance, including comparisons across different sectors.
  • Bloomberg Hedge Fund Indices: Tracks the performance of hedge funds across various strategies.
  • Hedge Fund Research (HFR): Provides indices and detailed data on hedge fund performance, strategies, and industry trends.
  • eVestment: A data analytics platform that tracks hedge fund performance globally, offering insights into fund returns and strategies.

Minimum entry requirements

Hedge funds often have high minimum investment requirements, making them accessible primarily to high-net-worth individuals or institutional investors. Typical minimum investments range from $100,000 to several million dollars, depending on the fund.

In most cases, hedge funds are only open to accredited investors, defined as individuals with:

  • A net worth exceeding $1 million (excluding primary residence), or
  • Annual income of $200,000 (or $300,000 combined with a spouse) for the last two years.

Useful facts and data about hedge funds

  • Global hedge fund market size: As of 2023, the global hedge fund industry manages over $4 trillion in assets.
  • Average hedge fund return: In 2022, the average hedge fund return was approximately 7.2%, according to HFR.
  • Top hedge fund locations: The majority of hedge funds are based in financial hubs like New York, London, and Hong Kong.
  • Regulations: Hedge funds operate under fewer restrictions than mutual funds, allowing them greater flexibility but also higher risk.

Conclusion

Hedge funds offer an intriguing investment opportunity with the potential for high returns. However, identifying the best hedge funds requires careful analysis of performance, strategy, and management. By leveraging databases, financial advisors, and industry events, you can find funds that align with your investment goals. Tracking success through platforms like Preqin and HFR can help you stay informed about fund performance while understanding the entry requirements ensures you know what’s needed to invest in this exclusive space.

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