Hedge Funds
Hedge funds are largely unconstrained pools of capital designed to generate absolute return, regardless of market direction, primarily by employing leverage and short selling.
The Illusion of the "Hedge"
The term "hedge fund" is an outdated catch-all. Today, it simply refers to a fee structure (typically 2 and 20) and a regulatory exemption (available only to accredited/qualified purchasers). The actual strategies deployed range from perfectly hedged (market neutral) to massively leveraged directional bets.
Core Strategies
- Long/Short Equity: Buying undervalued stocks and shorting overvalued ones. A "130/30" fund is 130% long and 30% short, leaving a net 100% market exposure but magnifying stock-picking alpha.
- Market Neutral: Balancing longs and shorts exactly so net market exposure (Beta) is zero. Returns rely entirely on Alpha.
- Global Macro: Top-down directional bets on currencies, interest rates, and indices based on geopolitical and macroeconomic analysis.
- Arbitrage: Exploiting pricing inefficiencies between related instruments (e.g., Convertible Bond Arbitrage, Merger Arbitrage).
The Reality of Returns
Over the last decade, the average hedge fund has drastically underperformed a simple S&P 500 index fund. Why do institutions still allocate to them? Non-correlation. A pension fund needs assets that don't collapse when equities do.
Performance Fees & High Water Marks
The 20% performance fee is the primary driver of GP wealth. However, institutional LPs demand a "High Water Mark."
If a fund drops from $100M to $80M, it must claw its way back above $100M (the high water mark) before the GP can charge performance fees again. This creates a moral hazard: a manager down 20% might take massive risks to get back to the high water mark, or simply shut down the fund and start a new one to reset the mark.
High Water Mark Visualizer
See how drawdowns impact a manager's ability to collect performance fees.
FAQ
What is a prime broker?
The investment bank that provides leverage, executes trades, and handles stock lending for short selling to the hedge fund (e.g., Goldman Sachs, Morgan Stanley).
Why don't retail investors have access?
Regulatory protection. The SEC assumes that if you don't have $1M in net worth, you cannot financially withstand the total loss of capital that leveraged strategies can incur.