Hedge Funds, broadly speaking, are investment funds that have less regulation and more flexibility relative to other, “classic” investment funds, such as mutual funds (more on this distinction is written below). A Hedge Fund will have an investment manager, and will typically be open to a limited range of investors who pay a performance fee to the fund’s manager on profits earned by the fund. Each Hedge Fund has its own investment philosophy that determines the type of investments and strategies it employs.
In general, the Hedge Fund community undertakes a much wider range of investment and trading activities than do traditional investment funds. Hedge Funds can employ high-risk or exotic trading, such as investing with borrowed money or selling securities for short sale, in hopes of realizing large capital gains. Additionally Hedge Funds invest in a broader range of assets, including long and short positions in Equities, Fixed Income, Foreign Exchange, Commodities and illiquid hard assets, such as Real Estate.
The first hedge funds were thought to have existed prior to the Great Depression in the 1920s, though they did not gain in popularity until the 1980s, with funds managed by legendary investors including Julian Robertson, Michael Steinhardt and George Soros. Soros gained widespread notoriety in 1992 when his Quantum Investment Fund correctly bet against the Bank of England by predicting that the pound would be devalued, having been pushed into the European Rate Mechanism at too high a rate. Soros’ bet paid off to the tune of $1 billion, and set the stage for future hedge fund entrants, who speculated on markets based on fundamental and quantitative factors.
Similar to Hedge Funds, mutual funds are pools of investment capital. However, there are many differences between the two, including the following:
Hedge funds charge both a management fee and a performance fee. While this varies by fund, typical management fees consist of 1-2% of assets under management and performance or incentive fees of approximately 20% taken from gross profits. The performance fee is a key defining characteristic of a hedge fund, motivating the hedge fund manager to generate superior returns by aligning his interests with those of the investors. In contrast, mutual funds and long-only managers usually charge only a management fee.
Total investor capital inflow allocated to hedge funds in Q1 2012 exceeded $16 billion, with the number of funds having increased for 9 consecutive quarters to reach 7,477 total funds as of Q3 2011. Asset growth has risen faster than growth in the number of new funds, implying investor preference for allocation to the industry’s largest firms. As of Q4 2011, assets under management across all hedge fund strategies was estimated at $1.641 trillion (with an additional $315 billion residing with managed futures/CTA accounts), reflecting a drop of more than $200 billion from Q2 2011.
A Quantitative Hedge Fund is any Hedge Fund that relies upon algorithmic or systematic strategies for implementing its trading decisions. Quant trading strategies may focus on any asset class (equities, derivatives, fixed income, foreign exchange, commodities, etc.), with trades that are based on systematic strategies, rather than discretionary decisions. In other words, at least to some degree Quantitative Hedge Funds employ “automatic” trading rules rather than ones that employees at the fund identify and evaluate. Of course, these two strategies can be mixed, but nearly all Hedge Funds are either primarily a Quant Hedge Fund or primarily a non-Quant Hedge Fund.
For the rest of this discussion, we will refer to non-Quant Hedge Funds as “Fundamental Hedge Funds”—in other words, funds whose investment style is largely or entirely driven by fundamental research that attempts to value securities in the marketplace and identify “undervalued” and “overvalued” assets.
Both Fundamental and Quantitative Hedge Funds may use fundamental information, such as economic data, accounting/financial data as well as governmental, demographic and industry measures of supply and demand. However, the primary difference is that Quantitative Analysts will look to use this data in a systematic, automated way. Often, the Quantitative Analyst will use tens if not hundreds of different types of data to predict a single output (rules about which assets to buy and sell); these analyses will then be used to identify attractive long and short positions. Much of this data will take the form of time-series information (for example, Ten-Year Treasury yield over time), or cross-sectional information (for example, different Price/Earnings ratios for companies in a given industry). Quantitative Analysts will not perform detailed, “bottom-up” fundamental analysis of stocks or other individual securities; rather they may try to get a sense of the relative attractiveness of dozens or hundreds of different assets simultaneously.