Analytics Stories

CHAPTER 51How Do Hedge Funds Work?

As I'm writing this chapter in March 2020, the market lost nearly 8% in one day due to fears about the spread of the coronavirus (specifically, COVID-19). As we all know, market volatility can result in wild market swings. Investment strategies that greatly decrease the risk of exposure to market volatility and result in slightly lower than average returns appeal to many (particularly wealthy) investors. Hedge funds use trading strategies that are supposed to reduce risk (mainly due to the volatility in equities) and hopefully even increase average returns.

In this chapter, we will give brief explanations of several commonly used hedge fund strategies:

• Long/short and market-neutral equity strategies
• Convertible arbitrage
• Risk arbitrage
• Global macro

We will also look at the performance of hedge funds during the years 2007–2017, which was analyzed by Nicola Metzger and Vijay Shenai (see “Hedge Fund Performance during and after the Crisis: A Comparative Analysis of Strategies 2007–2017,” International Journal of Financial Studies, vol. 7, no. 1, March 2019, pages 1–31).

Growth in Hedge Funds and Hedge Fund Fee Structure

Most hedge funds require the investor to put in at least $500,000. The most common fee structure is 2 and 20, which means that the hedge fund takes a flat fee of 2% plus a 20% performance fee on profits above a set target. For example, if the target is an 8% annual return and the hedge fund earns a 15% return, then the hedge ...