1.2.9 Hedge Funds

Welcome to On Judgement. Two funds both use the hedge-fund label. One holds credit positions; another trades currencies and rates. What information is missing before you can compare their risks? Take a first view. You can change it when you have considered the evidence.

Hedge funds can use varied strategies, including long/short equity, macro, event-driven, credit and combinations of strategies. Labels are broad and can overlap. A multi-strategy portfolio needs analysis of shared risk factors as well as the number of teams. Quantitative methods can operate across many horizons, not only rapid trading. The relevant regulation and eligibility depend on jurisdiction, vehicle and investor type. It is misleading to infer that a hedge fund faces no rules or that every other fund is unable to short. Read the actual mandate, permitted exposures, leverage, custody, valuation and reporting arrangements.

In a simple borrowed-share short, the investor borrows shares, sells them, later buys shares to return, and pays relevant costs. A lower repurchase price can create a gain. A rising price creates a loss; there is no finite upper bound on the price in the simple model, so potential loss is unbounded. Borrow fees, dividends owed to the lender, recalls and collateral requirements affect the outcome. Margin calls can require cash before the investment view is vindicated. A short position is not simply “buying the opposite share”, and an apparently offsetting long/short pair can retain market, sector, basis and funding risks.

Long/short equity asks which relative or outright business views are held. Macro strategies may express views on rates, currencies or economies. Event-driven strategies depend on events such as mergers or restructurings. Credit strategies hold debt-related exposures. Multi-strategy vehicles combine approaches, with allocation and risk management choices. For each, ask what causes gains, what causes losses, whether leverage or derivatives amplify exposure, and how positions can be funded or closed in stress. The word hedge does not guarantee downside protection. Concentration, leverage and margin can force sales even in a vehicle with limited investor redemptions.

Management and performance fees use stated bases and dates. A hard hurdle generally applies the specified performance share only above the threshold; a soft hurdle can apply differently once a threshold is crossed. High-water marks can limit fees on recovering prior losses, under terms that may depend on investor/share class and flows. Lock-ups, notice periods, gates and redemption frequency need to fit the owner’s cash needs and the fund’s assets. Less frequent redemption does not remove all funding risk. Compare net returns, exposures, drawdowns, valuation and governance. A quoted “2 and 20” is not a complete fee calculation.

Let's work through Short payoff and a fully specified teaching fee. Short 100 shares at £50 and repurchase at £40. Borrow and other stated costs total £150. Separately, a £1m teaching fund earns £100,000 gross, charges 1% of beginning assets, then 20% of the gain remaining after that fee; no hurdle/high-water mark applies. Pause here and try the calculation or reasoning before continuing.

Short gross gain = 100 × (£50 − £40) = £1,000. Net gain after stated costs = £850. If repurchase instead costs £70, gross loss is £2,000 before costs. Management fee = £10,000. Remaining gain = £90,000; performance fee = £18,000. Ending fund value = £1m + £100,000 − £10,000 − £18,000 = £1.072m; net return = 7.2%.

The short calculation is a cash payoff, not a return on an unspecified collateral amount. The fee example follows only its explicit teaching contract, not a universal industry formula.

Now try the choices in this lesson. If your answer changes, identify the reason. Compare strategy, leverage, liquidity and investor-protection terms. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.