HedgeAlytix Library and Blog

Types of hedge funds: A Primer

HedgeAlytix is a platform that allows an investor or investment analyst to search for, evaluate and compare investment opportunities from the somewhat ambiguous category of vehicles called “hedge funds”. In order to do this with any semblance of parity, we have to categorize these investment vehicles. This can be done in any number of ways depending on the individual investor’s goals and requirements – which is why we offer a robust Fund Query function that filters our database against several dozen criteria. The most obvious point of comparison is to look at funds operating under similar investment objectives and policies; this is best accomplished by examining their principal investment strategy.

Hedge Funds are for the most part unregistered private investment funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are NOT subject to the same regulatory requirements as mutual funds, including mutual fund requirements to provide certain periodic and standardized pricing and valuation information to investors. That said, investment advisors and managers usually have a well-articulated statement of objectives and policies that can be sorted into one or more identified strategies. While there still will be gross differences between a small fund (say, $12 million) and a large fund (north of $500 million is a good marker) in how they select, buy and sell investments within any given strategy (e.g., fixed income arbitrage), by comparing and contrasting all fixed income arb funds together as a group, important differences may be highlighted. Significant differences in a manager’s actions as implied or extrapolated from various measures of risk vs reward will show up under scrutiny. How well a manager handles very good markets or very bad markets differ from fund to fund. Policies may shift over time (style drift, to the pros). Direct comparisons help generate further questions leading to further analysis. That is, after all, why investors use the HedgeAlytix platform in the first place.

But there’s more to this discussion of risk and reward.

Alternative investments are evolving rapidly.

Much of the prior discussion can now be considered out of date due to various changes in the regulatory regimes under which they must operate, the markets in which they invest, the technology that they employ, and the expectations of investors and managers. Here are some game-changers:

Investors can now find hedge funds in the broad market.

US-Regulated 130/30 Funds: There are now regulated funds operating as “40-Act” funds that anyone can buy. They offer daily liquidity and (almost) all the protections of a mass market mutual fund. They are allowed to employ many of the same investment tricks used by hedge funds, but not to the highly risky degree as a private placement. The key tactic they can use is the “130/30” investment strategy, which allows an investment manager to invest 100% of the fund in securities identified as offering strong appreciation and then sell short up to 30% of the fund’s total assets in securities that are thought to offer strong depreciation. The cash gained from the short sales can then be reinvested in additional strong securities. The fund is then sitting on a portfolio effectively greater than the money contributed by investors; it has financial leverage of 130%.

European Regulated Alternatives: The most rapidly growing segment of the alternative investment industry – probably the fastest growing investment segment altogether – are the AIFMD-compliant funds in Europe. This relatively new regulatory regime created by the European agencies aims, like the US SEC’s approach, to allow tightly controlled use of leverage and hedging with diversification and risk controls appropriate for the upscale retail and institutional markets. They are also required to establish support and service relationships with vetted professional groups and maintain minimal levels of liquidity. Funds organized and offered within specific regulatory structures generally may be used by qualified investors throughout the EU and elsewhere but typically are forbidden from marketing outside their “home” territory.

There are a number of financial services organizations throughout Europe, UK and Ireland offering more or less turnkey support to investment advisors wishing to offer investment vehicles to the EU and to attract other investors who appreciate AIFMD compliance.