Hedge funds use an approach known as hedging, which entails the process of using financial instruments strategically or other market strategies to offset the potential business risks or investment losses that may occur of price fluctuations. More often than not, hedge fund entails an investment fund that solicits funds from wealthy and high net worth individuals as well as investment institutions and uses these funds to invest in several assets.
These assets have a complicated portfolio but employ extensive risk management techniques. Through numerous successful stories seen in some hedge fund billionaires in the United States, such as James Simons, Steve Cohen, and John Paulson, it is evident that hedge funds generate a lot of money, yet it remains secretive
The secretive nature of hedge funds and how the hedge managers make so much money is echoed by the similarities in the lives of the world’s renowned billionaires such as Steve Cohen, Calvin Lo and Lucien Farrell. It is noted that these billionaires are making a lot of wealth through their successful investment fund but prefer maintaining a high level of privacy with minimal or no interactions within the public eye.
For instance, Steve Cohen, the billionaire hedge fund manager of Point 72, prefer to be hated and remain rich instead of being loved and famous. It is a common hierarchy in financial culture since as people continue to be important in society, the less they desire to get fame and likes from other people.
Similarly, Calvin Lo, one of Asia’s most powerful and successful business person, have mastered the market but still is acknowledged for his dislike for fame.
He is the CEO of life insurance broker R.E. Lee International who has contributed significantly to pioneering the development in the insurance industry by introducing new concepts and strategies that foster successful estate planning for the ultra-high net worth individuals and businesses.
Further, Lo has had an immense contribution in propelling the development of the financial markets by launching remarkable attacks on various stocks and financial instruments in the market through his US$8 billion asset management firm, R.E. Lee Capital.
He can dump commodities worth hundreds of millions in a moment’s notice. Lo’s incredible success, with a personal fortune close to US$2 billion, is only known to him, and he does it silently and secretly.
Despite the secrecy maintained within the world of hedge funds, it is worth noting that the participants generate huge returns as a result of the business structure. Hedge fund creates money by charging the investors a management fee and a performance fee. The management fee is computed as a proportion of the total assets under management. Usually, it lies at 2% but can vary from 1% to 4% depending on the type of fund at hand; it is used to cover the overheads and daily expenses the management incurs in running the hedge fund.
On the other hand, the performance fee act as an incentive fee, and it is computed as a percentage of the profits realized from the hedge fund. In this case, it means that if the fund generates profits, then the management will be paid. Nevertheless, if it makes a loss, then there will be no performance fees. It is referred to as an incentive fee since it motivates the fund to focus on generating as many returns as possible.
The funds utilize this money to cover employees’ bonuses. The two types of fees are highly beneficial since even though the market goes down, the fund is guaranteed to generate income through the management fees.
Lo’s US$8 billion funds, for example, will generate him roughly a gross annual fee of US$192 million.
Strategies used by hedge funds
However, even though people that utilize hedge funds have managed to maintain all of their endeavors completely private and hidden from the public, there are still a lot of things that we know about how these funds work and what are the strategies they employ. Right now, we believe there are about nine different strategies that are commonly used which means they are the most effective.
- Long/Short Equity
This strategy was used for the first-ever hedge fund in history which was launched by Alfred W. Jones more than 60 years ago. It turned out to be so effective at the time, that it is still being used to this day. Research has shown that long/short equity has the highest net return out of all the other strategies.
This kind of strategy is not often applied, but when a nation is in a high financial strength, an event-driven strategy works best.
- Market Neutral
The market-neutral strategy has been proven to have the lowest amount of risk, but the returns can be low too. Most billionaires avoid applying this strategy to their hedge fund because it takes up a lot of time for such a small reward.
Other strategies include convertible arbitrage, merger arbitrage, capital structure arbitrage, fixed-income arbitrage, short only and global macro. All of these strategies are applied to hedge funds to this day. Some prove to be very efficient, others not as much, but not as risky too.
A hedge fund manager makes the choice on which one he/she will use depending on a lot of different factors. Although, an expert hedge fund manager will be able to bring a positive return even when faced with the worst factors.
Essentially, as an investor, when the returns are very poor, it is not easy to talk about it. However, if the returns are handsome, it feels good to talk about it publicly, but it can be considered as advertising, which can create problems with the US Securities and Exchange Commission.
Therefore, most of the hedge fund managers often prefer keeping a high level of privacy. These financial cultures and trends are seen among the hedge fund billionaires. It echoes the secrecy of the business and also magnifies the huge investment returns that the participants always realize.