Hedging is a way to reduce risks and insure an asset against unwanted market trends in the future. The main goal of hedge funds, on the contrary, is to maximize profits at a given (by investors) level of risk. Either they aim to minimize risk at a certain level of return.

See a contradiction here? Well, it’s not so. The flip side of hedging is great returns for portfolio investors. Today, over 12 thousand hedge funds are registered in the world. The profitability of the best of them exceeds 100% per annum.

In its general meaning, asset management companies are a very wide range of firms that can be divided by their size and operations – from personal money managers that handle individual accounts and have a few hundred million dollars in AUM, to giant investment firms operating with larger sums.

Basically, asset management companies, like Morgan Stanley, allocate investors’ money to spread it between different stocks and mutual funds. They charge an annual fee which is a percentage of the net worth of assets managed.

The purpose of this article is to give you a better understanding of the principal difference between Hedge Fund operation and Asset Management.

The internal structure

Most U.S. hedge funds are established as limited partnerships between the fund manager and investors. While the specific structure can vary from fund to fund, there are a few characteristics that are applicable across the industry.

Key hedge fund players:

• Investors. The source of funds.
• The Board of Directors. The bridge between investors and managers. Supervises the activities of the management company and companies providing services, resolves controversial issues, determines personnel policy.
• The management company. Attracts investors, determines investment strategies, and provides general management. Includes:
• managing partners;
• analysts: the quality of predictive models depends on them;
• traders: the “core” of the fund that determines the profitability of investors.
• Administrator. Conducts an independent assessment of the value of net assets (minimization of risks). In some cases, prepares accounting and external reporting for investors, pays bills, deals with the distribution of profits, subscription and redemption of shares.
• Primary broker. Provides operational support and technical support for transactions in the local and foreign markets. Provides a range of financial services (clearing, depository, etc.). Must provide the fullest possible coverage of the markets where the management company operates, therefore, a large bank (Merrill Lynch, Goldman Sachs, Morgan Stanley) often acts as the primary broker.
• The guarantor bank. Ensures the inviolability of deposits, generates reports on transactions on the account, in some cases checks the activities of the management company. In most cases, a large bank with an excellent reputation.
• External auditor. Checks the statements for their accuracy and compliance with accounting and legal regulations. An auditor is a guarantor of reputation, which, given the volume of investments, is of paramount importance.
• Legal consultant (internal or external). Ensures the acquisition of licenses, manages all issues of concluding contracts in different jurisdictions.

Some proactive hedge funds apply the special automated infrastructure into their company structure. Basically, they use a hedge fund management software like SS&C Hedge Fund Software or MetaTrader 5.

SS&C Fund Services offers fund administration services for hedge funds, funds of funds, private equity funds and managed account managers. SS&C Ranked Top Fund Administrator for Single- and Multi-Manager Funds.

Launched in 2020, MetaTrader 5 is a hedge fund-oriented software built to ease fund management. The program supports different trading systems and allows for algorithmic trading and data analysis.

Entry Limitation

Hedge funds are limited to a small group of sophisticated investors. To enter as an investor to most hedge funds, you need to be an accredited investor and have a big enough sum of money, so to say.

This limitation is mainly due to the freedom of choice and a possible greater risk hedge funds usually take. Hedge funds have more flexibility and the ability to follow any investment strategy, including aggressive. Thus, the investor must qualify as a sophisticated partner to understand and agree with the risk for the sake of having a greater return.

Investment strategy

As mentioned above, hedge funds are likely to take a bigger risk while staying less regulated and freer to choose the investment strategy. Hedge funds use a wider variety of strategies, including short-selling, derivatives, alternative assets, and betting on events like mergers and spin-offs.

Hedge funds seek to provide returns that are non-correlated to traditional, long-only markets.

For example, in merger arbitrage, a hedge fund will take a long position in a company that is being acquired and a short position in an acquiring company, with the expectation that the price of the target company will move eventually to the price target of the sale.

If the merger were to fail, both stocks would take a hit by the market. The short position in this case would provide some hedge, but the long position would get hammered. With leverage involved, the losses would be magnified.

On the other hand, freedom of choice and expanded possibilities can give hedge funds an edge when the global financial market is going down for an unpredictable reason…such as COVID-19.

Atlantic Pacific Australian Equity posted a 23.6% return in March and April of 2020. When world markets crashed in March, Nicholas Brion, one of the fund’s managers, woke up every hour to check his positions and make deals. Brion said he monitors around the clock for any signs that the pandemic could shut down economies. This attentiveness, in particular, allowed him to timely buy and sell shares of the gaming giant Aristocrat Leisure Ltd., which fell 36% in March and rebounded 20% in April.

Bottom line

Hedge funds may be appropriate for certain types of sophisticated investors who desire to supplement their traditional investment portfolios and at the same time can bear the special risks associated with hedge funds. By the very high-level definition, a hedge fund is a form of the asset management company, differentiated by its structure, style, and investment strategy.

Anastasia Nesterova MS in Digital Marketing | Writer with a focus on finance and tech trends | Marketing lead at PARSIQ, a blockchain-to-everything automation platform