How Do Hedge Funds Work?

In the past few years, the topic of hedge funds has been common in financial news and commentary spaces. While the word is thrown around quite often, not everyone knows the basics. In this episode we look to explain foundational topics of how a hedge fund works.

Summary – Cents of Security Podcasts Ep. 62

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement 

Welcome back to the Cents of Security podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers. And today I’m your host for our podcast. Our guest is Lincoln Archibald. He’s the CFO of Fund Launch and the CIO and Co-Founder of Fund Launch Partners. 

In the past few years, the topic of hedge funds is very popular in financial news and commentary spaces, and it’s a very common one that you usually will hear about when talking with other people in the financial space. But the word is thrown around pretty often, and not everybody knows the basics. 

So in this episode, we’re going to try to explain the foundational concepts and try to give a beginner’s idea to how a hedge fund works. So, welcome to the program, Lincoln. 

Lincoln Archibald 

Thank you. Happy to be here. 

Cassidy Clement 

Sure, so since this is your first episode, why don’t you tell the listeners a little bit about yourself? How’d you get started in the industry? 

Lincoln Archibald 

Yeah, I wore a lot of different hats in the alt space. I started at private bank J.P. Morgan on their private banking side for venture and private equity funds. I was a venture capital analyst for a number of years. 

I started doing my own ground up mixed-use commercial developments and then actually about five years ago we started an educational platform helping incubate first time fund managers. So, I’ve been advising first time emerging fund managers for the past five years and then subsequently partner and invest with them. 

Cassidy Clement 

Great. So then you seem like the perfect person for this podcast, seeing all the different versions of these alternative investment funds and hedge funds in general. So to kick it off, what exactly is a hedge fund? And is that something that uses strategies that regular investors would be familiar with or is it something that’s a larger scale of an investment strategy? 

Lincoln Archibald 

So I think in the 1950s, it was called a hedged fund. None of this is investment advice, but, investment managers or individuals would build a portfolio of, primarily long only, a combination of stocks or bonds or some sort of security. 

And at the end of the day, they’re looking for uncorrelated returns, right? They’re looking for maybe higher returns on a risk adjusted basis. And that’s where kind of the principle of a hedged fund came out, where utilizing the use of leverage, we can either increase exposure to certain positions or we can short various positions. 

So a combination of long or short and there’s a bunch of different hedge fund strategies out there. There’s global macro, there’s tradng on political wins. There’s trading on event-driven basis. So there’s all these different hedge fund strategies, but at the end of the day, they derive from investors seeking uncorrelated returns on their investments. 

And I’ll note that hedge funds, principally, they’re open ended vehicles. So you’re primarily trading on the public markets. So either stocks, public bonds things of that nature. Maybe forex or commodities. Anything that has a liquid secondaries market is what’s classified today as a hedge fund. 

Cassidy Clement 

So with that, we’re talking about several different things that are deriving from other investments, like you said. Can anybody invest in hedge funds? Because I know different types of like derivatives have certain type of investor criteria, or if there’s an eligibility criteria specific to this type of investment. 

Lincoln Archibald 

From the investor perspective, yes, obviously, the private markets are heavily regulated by the SEC. Depending on your structure, there’s like a 506B and I’m not an attorney. This isn’t legal advice either.  

But a 506B structure, you can take on up to 35 non-accredited investors into your fund, but primarily most funds are privy only to accredited investors. So a net worth of $1.2 million or more or, annual income of $200,000 or more for an individual or $300,000 or more for a married couple. 

And the reason that the SEC has these mandates is to protect the investor. Obviously hedge funds you can, as you’re taking on different concentrated positions, it’s increasing the perceived risk, right? And so the SEC says, hey, in order for people to invest in these products, you need to meet a certain income threshold.  

There’s also other accredited investor verifications, such as if you hold a Series 65 license or you’re an employee of the firm and you’ve demonstrated that, hey, I understand what I’m getting into and I know this market. 

So yeah, it’s all there. It’s privy primarily, and it tiers up, there’s different types of funds. I won’t get too deep into the details, but there’s also qualified clients and qualified purchasers and other exemptions. Like depending on how you structure your fund, you’re limited to certain types of investors. 

Cassidy Clement 

Since you’re talking about the limitation with certain investors, obviously, this type of business may, as most of us know, have different types of fees or ways that they make money. So from a broad perspective, are there certain types of fees, or compensation even, that is associated to a hedge fund company? 

Lincoln Archibald 

Look, at the end of the day, hedge funds are active managers, right? 

So there’s the primary structure on a fund is a GPLP structure. The general partnership, which is the managing partners of the team, the people that are doing the trading. And then investors invest into the limited partnership, and the general partners oversee that limited partnership. 

Now, common fee structures is the standard blanket is a 2 in 20. Meaning a 2% management fee on all assets under management and then a 20% performance fee. So if I make, 20%, then I’m going to give 80% to the limited partners, those investors, and as the manager I’m going to take 20%. 

Now there’s some various structures you can add in there. One primary specific to hedge funds, is either a hurdle rate and/or a high watermark. So a hurdle rate is where, hey, look, I have to hit let’s call it an 8% return before I’m going to start taking some of the performance fee. Why do you do that?  

It’s because most investors right now, they can go out and they can invest in a T bill and get over five. So you have to set a hurdle rate for these managers before the manager actually gets to start participating on the performance fee. 

And then a high watermark is basically a very important clause in hedge funds because if one year I make 50% and then the next year I go down 50%, I am in the negative right from the original principle. And I have to get back up to the highest aggregate account balance before I can start taking a performance fee again. 

So there’s rules and structures like that, but simply put, a 2 in 20. It’s an extremely lucrative business for managers, right? As a hedge fund manager, at the end of the day, you need to make your investors money, and if you don’t do that, you’re going to go out of business. 

Cassidy Clement 

Yeah, that actually is something that I think a lot of people don’t always realize with hedge funds, even though it does have a specific type of clientele, the risk tolerance is also way different than just a standard issue I’m going to go out and buy a share of a stock.  

That’s why, as you mentioned, there is some eligibility criteria for the different type of investors, whether it’s two people together, whether they’re spouses or a group, because, as you said, there are times where the math doesn’t necessarily allow for the performance to be totally seen for several years even, especially if it’s a newer fund. 

So to go into some of the makeup of these funds from a staff perspective, you talked a lot about general partners, but what type of staff make up a hedge fund? Because in finance, when you’re reading about the makeup of it in commentary or even in classes, you’ll hear the words of quants, traders, floor traders the programmers, who or what group of people really are making up the staff that go into these funds? 

Lincoln Archibald 

At the end of the day, there’s no one shoe fits all, right? It really depends on the characteristics of your firm. To put it simply though, there are three primary responsibilities to run a fund. There is your expert investor, either they’re called the CIO or just the lead investor, lead partner, managing partner, whatever, but somebody needs to manage the money, right? 

That’s a core responsibility.  

Additionally, somebody needs to raise the money, so that your capital raiser or your director of capital markets. And again, it can be a shared role or they can be two separate individuals. And then additionally, you need a fund manager. Somebody that’s actually going to run the business. 

A lot of people don’t forget, but in investment management business, it’s still a business and you’re going to have HR and payroll and compliance and accounting and all of your back-office infrastructure. You still need somebody to run that. So three primary roles: the expert investor, the capital raiser and the fund manager. 

And I’ve seen shops where that’s one person fulfilling all three of those. I’ve seen shops where there’s three different individuals serving those buckets, but principally what outside looking in when we’re looking at a hedge fund, we’re really looking at that expert investor spot, right? That somebody who’s making the investment decisions. 

And again, a myriad of ways you can structure that team. An amalgamation of PMs: Portfolio Managers. If you raise a hundred-million-dollar fund, you might be a multi-strat fund where you’re trading ten different strategies and you might have ten different portfolio managers managing those. 

Let’s call you a “long only” hedge fund where you’re choosing eight concentrated positions. You’re probably going to have a smaller team that’s making the investment decisions, but you’re going to have several research analysts beneath you that are doing in-depth analysis on various companies. 

So at the end of the day, it goes back to your strategy and, what people do you need to execute on that investment strategy?  

Cassidy Clement 

Since you’re mentioning strategy to staff size in some ways, or, the person who wears all the hats, et cetera, when we talk about hedge funds in abstract, I think for the most part, at least in American finance, a lot of times they’re looked at as some pillar that has just arisen. 

And that’s how they got there. Not everybody understands. From your perspective as somebody who’s been in this industry, what is like the average timing of this stuff? It can’t happen overnight. They have to establish funds, they have to establish investors, what are some examples or some ideas that you can give to our listeners to say hey, this is why it’s not just a show up and the next day you make $100 million. It takes time. 

Lincoln Archibald

Oh yeah. I mean, I always tell managers like, look, if you’re trying to retire off of fund one, you’re doing it all wrong. At the end of the day, it’s the LPs that are taking the risk and you need to act in their best interest. When you’re a fund manager, you actually have a fiduciary responsibility to act in the best interest of the fund. And so timing yeah, look, there’s a lot of different ways to get into this business. 

I would say there’s two primary profiles I see of emerging managers. I’ve worked with thousands at this point. A: you go to an Ivy League school, you get an institutional background, you go into banking, you are working on Wall Street for a decade, maybe two, and then you spin out and you start your own shop, right? 

And it’s typically more of an institutional fundraise. What I mean by that is look, you’ve got big names from your service provider perspective. You are probably trying to raise more than $200 million or more on fund one, and you’re going out and raising from institutional grade investors, meaning endowments or pensions or, ultra-high net worth family offices. 

On the contrary, though, most people don’t fit the bill. There’s what I call the untraditional manager, which is somebody that just starts trading and they start making money. And backgrounds galore. I worked with a guy last year.He was a pharmacist for several years, and he started making more money trading than he was as a pharmacist. 

And he quit his day job and started a hedge fund, and he now manages tens of millions of dollars. That untraditional mold, what you need is track record, right? You need to demonstrate that you can manage money, and you can do it consistently. Now, not to get too deep in the weeds here, but if you take your retail account out to market and say, hey, look what I’ve been doing in my retail account. I want to raise a fund and be a fund manager now.  

It’s not going to be worth anything.  

Most investors won’t value or give accreditation to trading in an individual retail account. What I might suggest, again, not legal advice or any sort of advice here, but I think where I’ve seen the most successful people is you launch what’s called a hedge fund incubator which not a lot of people know about, but essentially it’s where you’re setting up your LP and your GP structure. 

You’re setting up a fund, but at the end of the day, you don’t have to set up, you don’t have to have a private placement memorandum. You don’t have to have a limited partnership agreement, a PPM or an LPA. It’s a fraction of the cost. And at the end of the day, the general partner is the sole LP into the fund. 

So basically, you take your own money and you put it in the fund and then you start trading out of that fund. And then what you can do is you can go take that limited partnership and you go get an audit because that’s what a lot of investors want to see, especially in the public markets, is that I want to see an audited track record before I even touch this thing. 

And so take that hedge fund incubator, go get an audit, and now you’re ready to go launch a hedge fund. And look, that could be as soon as twelve months down the road from now. That can be twenty four months down the road. As long as you need to really fine tune your strategy, make sure you’ve got your risks dialed in and you’re reducing your drawdowns and you’ve really fine-tuned your strategy and you feel confident to go start trading that strategy with other people’s money. 

Cassidy Clement 

So I’m glad that you actually brought up some of the other, we’ll say not as well known institutions that would invest in the hedge fund. That was just something that surprised me a little bit in my research. I was a little bit aware, but not totally, which is something like endowments and pensions and so on and so forth that are within some of these funds.  

Speak a little bit to that of how exactly that happens or other surprising factors about hedge funds or hedge fund investors that our listeners might not know. 

Lincoln Archibald 

Yeah, look running a hedge fund is hard. It is a lot of work and it is a stressful business. Yes, it is an extremely lucrative one, but it’s extremely demanding. Look, as you develop and you build out your firm I would say it’s a lot of firms’ objective to become an institutional grade investor. 

And basically, what I mean by that is you’re deserving of institutional grade capital. So to add some color there. As you go out and you’re raising from your friends and family, it’s relatively unsophisticated dollars, right? Like, it might be a doctor or a lawyer or somebody who has wealth or a business owner. They don’t know a ton about investing. 

They’re probably investing because of you. And they might see a flashy number that’s better than what they’re getting with their financial advisor. And they say that seems interesting. Let’s try it out. But usually, an individual that you’re convincing to invest in your fund. 

When I talk about institutional money, it’s almost always there’s walls you have to go through to get that money. Meaning, there’s usually a Chief Investment Officer of that money that probably has a structured investment committee that’s going to underwrite you as a potential manager. That’s going to look at the risks, potential reward, your team, your track record, your background, where are you domiciled? 

How are you structured? What’s your load cost? Like all these things where they’re truly underwriting you as a potential investment. And to qualify for that sort of money is you need to become an institutional grade manager. You’ve got to be clean cut. 

You got to check all the boxes. If you want a taste of what I’m talking about, there’s actually, it’s primarily for private equity funds, but the Institutional Limited Partnership Association, ILPA. It’s a nonprofit that publishes content on behalf of institutional allocators of how they should think about their investment decisions. 

And they’ve got a DD questionnaire, due diligence questionnaire on there, that has hundreds of questions that these LPs will ask you. So when I say, hey, if you want to qualify for this pension money or institutional money, you need to become an institutional grade investor. 

Now when looking at bigger money, insights into that, there’s very different needs, right? I talked about that high-net-worth investor. Like at the end of the day, it’s very short term. They’re like, hey, I’m not thinking about money for the next decades, but an endowment, a pension, an insurance company, they have strict thresholds of a return criteria that they need to hit. 

So they’re very tactful about their asset allocation. As you walk into one of these institutional allocators, they already know what % of their portfolio they’re comfortable investing in the hedge funds, whatever % that may be.  

And so you are fighting for a piece of that pie. And then really the conversation, is, hey, why you instead of the other guy, right? 

You’ve got to assume that when you’re going after bigger money, that they are looking at hundreds of funds that look almost exactly like yours. And so in the investment management world everyone’s always fighting. The question is often posed, what is your edge, right? What is your Alpha? What makes you better than the next person? Than the next manager that’s managing money? So, maybe that’s some insight that you’re looking for.  

Cassidy Clement 

Yeah, totally, because it leads me into my next question. Since hedge funds are for specific investors, what should those investors ask themselves if they are considering a hedge fund? 

Lincoln Archibald 

A lot of emerging managers don’t quite have what’s called an investment policy statement, but I think it’s a very insightful document. 

That’s kind of part of becoming an institutional grade investor. And part of that investment policy statement is you’re basically codifying your strategy and you’re saying, hey, these are my objectives, right? There’s a lot of different investment objectives you could have as a manager. You could have the objective to generate yield. 

Maybe it’s a monthly coupon, right, that you’re paying out to your investors. It could be maximized return at all costs, right? Where you’re shooting for the moon on these things. It can be, principally, hedge driven strategies, right? It can be growth. It can be value. There’s a lot of different.. maybe it’s tax driven, right? 

You’re conscious about your tax consequences in these funds. And so I would say as an investor, choosing what funds to invest in, you need to choose one that matches your investment objectives, right?  

Ask yourself, hey, is this really something that I want to have in my portfolio? Am I comfortable with the associated risks of this investment? Historically, hedge funds have like higher drawdowns than other asset classes like real estate or venture capital or private equity that have maybe more collateralized business behind them. 

And I would make sure I have a thorough understanding of the use of leverage that manager is utilizing in their strategy. And what are the risks associated with that?  

So I underwrite hedge funds all the time, and something I look at, having been doing this for a while, I am really conscious of load cost. 

Hedge funds can be expensive to run and especially smaller funds. If you’re managing $20 million. This is a fund I underwrote a couple months ago. It was a $20 million hedge fund. But he had almost a million dollars a year in load cost, meaning it was costing about a million dollars to run that business. 

What does that tell me? That’s a 5% catch up before we’re even in the money, right? Like he’s got to make 5% before he’s break even. And that was just on load costs. That didn’t include management fees, which bumped it up to 7 % in the hole before I’m going to make any more money with this hedge fund than I am investing in the public markets or something like that. 

So you really have to ask yourself, hey, does this manager, does he really have an Alpha there? So those are some of the things I would think about. Did I answer your question? 

Cassidy Clement 

Yeah, totally. I only have one other follow up to that, which is day to day investor, right? You bought one share of ABC Company, a week goes by, you’re like, I don’t want it anymore. You sell the share of ABC company.  

How does it work with a hedge fund? Meaning you invest in the hedge fund, and then you want to sell your shares. 

How does that work? Are there limitations? Are there different types of Redeem share costs, things like that. 

Lincoln Archibald 

It’s a great question. Typically in hedge funds, they are what we call open ended vehicles, meaning that there’s really not a term date, right? 

On real estate or private equity, there’s a term associated with the investment. It’s usually five, seven, or ten years, meaning that an investor invests in that, your capital is going to be locked up for ten years. You’re not going to be able to touch it until the end of the fund. So it’s an extremely illiquid investment. 

In hedge funds, it’s open ended, meaning it’s a liquid vehicle. Now, there’s typically a lot of asterisks there. One being that there’s usually like an initial one-year lockup on your money. So if an investor invests in a hedge fund, it’s usually, hey, look, at the end of the day, you can’t touch this. You can’t redeem your principal for one year. 

And the reason managers do that is just because there can be a lot of volatility in hedge funds, right? And if you’re constantly having managers come in and out of your fund, it becomes costly and time-consuming for the fund manager. And so there’s usually a initial one year lockup period on the money. 

So an investor can’t redeem their capital. And then after that, I’ve seen several different ways. It’s all written in their prospectus, their private placement memorandum and their limited partnership agreement, on how they manage liquidity. And I’ve seen rolling one year redemption windows with a 90-day notice, meaning hey, look, you can get your money out of a hedge fund, but only on this certain day every year.  

And I’ve seen the same thing quarterly, and I’ve seen the same thing monthly, or I’ve seen just at any given time you can file a redemption, but usually there’s like a delay. It’s going to take us 30, 60, or 90 days to get your money back. 

And the reason being is because, again, the fund manager has a fiduciary responsibility to the fund and not to any individual limited partner. That’s important, right? It’s not to any single investor, so if investor A wants their money back, I’m like, hey, look, at the end of the day, I’ve got to execute on this trade efficiently, or I’ve got to close out these positions properly. 

I’ll get you your money, but it can’t be at the cost of other limited partners in the fund. And really, you can write the rules however you want, right? That’s the beauty about private markets. You can write the terms of your investment. 

You can write the agreements. That’s what’s beautiful about the private markets is that you dictate the terms. Whatever fits your strategy the best. So you see everything, so whatever the terms are of that specific fund that you invest in is what you’re given. Now a common question that’s asked is, okay what if I’m subject to lockup and I still need my money, right? 

What if I invest in a hedge fund and six months later, it’s got a one-year lockup, I need my money. Usually in PPMs, there are extremely harsh penalties if an investor wants to redeem outside of a traditional redemption window. Like I’ve seen anywhere between a 10% penalty up to I’ve seen north of 50% penalties, meaning, yeah, you can have your money back, but I’m only going to pay you back 50 cents on the dollar just because it’s so costly. 

I’ve seen as small as 3%. But again, it really depends on the strategy that manager has and how consequential a redemption can be on the fund as a whole. 

Cassidy Clement 

Yeah, that’s probably one of the biggest points here to drive home is that, like you said, they have a duty to the whole fund, not necessarily just one of the people who put money in. So that dictates a lot of how the redemption, the strategy, the way they go about things as a company or a fund. It’s not as easy as, like I said, just going out and saying, I bought this share two days ago and I want to sell it now. 

It doesn’t totally work that way. But you covered a lot of great points. Thank you for joining us, Lincoln. 

Lincoln Archibald 

Hey, happy to. Happy to chat. 

Cassidy Clement 

Yeah, thanks. So as always, listeners can learn more about an array of topics for free at IBKR Campus and interactivebrokers.com. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening, everyone.  

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