Hedge Fund Investing: Understanding Investor Motivation, Manager Profits and Fund Performance, Third Edition

By Kevin R. Mirabile

Kevin Mirabile provides the unique perspective of a 35 year practitioner turned academic on hedge fund investing. Using plain language explanations of complex topics and strategies, you'll be able to use the knowledge in this book whether you're a financial advisor, an academic, a student or a beginner. This is a useful tool for anyone who wants to better understand who invests in hedge funds, why they invest, and how to evaluate the performance and risk.

This book covers everything from the the basics to exploring new, exotic investment strategies. "Hedge Fund Investing" provides an excellent foundation for anyone who is a potential hedge fund investor. Examining hedge funds from commercial and academic perspectives sheds light on many aspects of hedge fund investing that many investors don't fully understand.

• Language: English
• Publisher: BookBaby
• Release date: Sep 16, 2020
• ISBN: 9781098324650

Book preview

What Are Alternative Investments and Hedge Funds?

Introduction

A newcomer to hedge fund investing can easily get overwhelmed by the complex terminology and unique characteristics associated with this type of investing. There is a lot to know and not always a lot of time to learn it. This chapter is meant to present the basics of hedge fund investing (including defining alternative investments) by discussing the characteristics and structures of hedge funds on a standalone basis and relative to mutual funds. The chapter is intended to be a means of providing an introduction to some performance and risk measurement terminology and phrases. This chapter also lays the foundation for the rest of the book. Let’s get started.

What Are Alternative Investments?

Alternative investments is a term used to describe investments in nontraditional asset classes. Traditional asset classes include stocks and bonds and sometimes commodities, as well as foreign exchange. Alternative investments include hard assets, collectables, real estate funds, private equity, venture capital, managed futures funds, hedge funds and sometimes structured products like collateralized debt and loan obligations. Every institution seems to have its own set of rules for what is and is not an alternative investment.

Investors obtain alternative exposure by investing in vehicles such as private limited partnerships and alternative mutual funds. Alternatives may offer attractive portfolio benefits to investors, although on a stand-alone basis they can be more volatile or less liquid than traditional investments.

The more established and better understood traditional asset classes can be described as having large global markets, significant pools of liquidity, a high degree of price transparency and regulation, along with well-established market microstructures. Stocks and bonds have been available to investors for centuries. Even mutual funds have existed in various shapes and sizes for well over 100 years. By even the broadest measures, on the other hand, alternatives and hedge funds began as recently as the late 1960s and really only began to grow in the early 1990s.

By its 2020 peak, the market value of publicly traded equity had reached almost $100 trillion. The current value of the public bond market is near $150 trillion. In the beginning of 2020, prior to the market crash and recovery, the combination of these two asset classes was over $250 trillion. At the end of 2019, there were more than $20 trillion of investments in traditional stock and bond mutual funds in the United States and over $30 trillion globally. This compares to about $3.2 trillion invested globally in hedge funds at the end of 2019. ¹

Alternative investing is a far less mature industry that traditional asset management or mutual fund investing. Alternative investments are considered relatively young in terms of life cycle and track records. Hedge funds are perhaps the newest form of alternatives and as such, may also be the least understood. Their business models are not as stable, well-developed or mature as those associated with traditional investing or even earlier forms of alternatives, such as real estate and private equity.

So, what exactly constitutes an alternative as opposed to a traditional investment? There are a few broad categories that most professionals would agree make up the universe of alternative investment opportunities.

Real estate investing includes direct investments or funds that invest in commercial or residential real estate or mortgages that produce rental income, interest income and capital appreciation. Most funds are organized in specific regions or by specific types of properties.

Private equity investing includes direct investment or funds that take equity ownership in existing private companies in the hope of streamlining or improving management, negotiating favorable leverage terms with banks and improving performance so that the fund may ultimately profit from an initial public offering of the company’s shares.

Venture capital investing includes direct investment or funds that provide day-one capital to fund new business ideas. These early-stage investors hope to profit by sale of the company to a strategic investor or perhaps to a private equity fund that ultimately will help the company go public.

Hedge fund investing includes investments in either private investment partnerships, mutual funds or Undertakings for Collective Investing in Tradable Securities (UCITS) that trade stocks, bonds, commodities or derivatives using leverage, short selling and other techniques designed to enhance performance and reduce the volatility of traditional asset classes and investments.

All alternative investment managers are experts in their area of investment and are typically large investors in the fund they manage. These managers get paid both a management and an incentive fee for their work. Many also use leverage to enhance returns, while some create portfolios that are very illiquid at times, and most only provide limited transparency to investors. Some alternative investments can be difficult to value.

When thinking about an alternative investment, here are many things to consider:

The need for expert management. Does the manager of the investments have significant experience in a specific market segment, industry or area of investment? This extra level of skill and focus can allow the manager to identify unique values or opportunities not readily seen by the investor community at large.

The existence of manager co-investment can serve to align manager and investor interests. Does the manager and many of the partners or employees of the management company have a significant investment in the fund? This serves to align the interests of the investors with those of the manager.

The use of performance fees can serve to incentivize manager behavior. Does the manager get paid a percentage of the profits from the investments, in addition to any flat fees for managing the fund? The widespread use of an incentive fee is based on the principle that it further aligns the interest of the manager with that of the investor.

There are both a positive and negative consequences associated with leverage. How much money or securities does the fund borrow to make investments? The use of a fund’s investor capital, plus leverage obtained from banks or derivatives, allows the fund to magnify gains or losses from each investment and achieve higher rates of return.

The portfolio positions may be illiquid. How long does an investor need to lock-up money in the fund before they can sell or redeem? Many times, funds require investors to lock-up their money for an extended period of time before being they can redeem their investment.

There is often limited transparency provided to investors. Does the fund disclose its investments to its investors on a daily basis? Many times, a manager may restrict the amount of periodic information provided to investors related to positions, strategy, leverage or risk.

It may be difficult to value many investments. Can the investment or the underlying instruments owned in the portfolio be valued on an exchange or do they require an over-the-counter quotation or price, a model price or an independent valuation to determine the value? An illiquid market, third party valuations or the use of model price for an instrument can lead to more subjective portfolio pricing and less accurate fund valuations.

Alternative investment managers are usually trying to generate an absolute return and not managing money to beat a benchmark. This gives them the freedom to focus on narrow opportunities with significant barriers to entry, thus requiring a high level of expertise. A commercial real estate fund might employ a property manager who is an expert on shopping malls in Chicago. A private equity fund may focus on infrastructure projects or telecommunications and may employ former industry executives and engineers to evaluate potential investments. A hedge fund that invests in equities related to the biotech industry may have doctors on staff that work as consultants or research analysts who recommend companies to the portfolio manager.

Many professional managers who start a private equity or hedge fund also invest the majority of their personal net worth in the fund. Managers do this to align interests and to signal confidence to investors that they believe in what they are doing and that they are not merely managing other people’s money.

Managers of alternative investments usually command a performance fee in addition to a fixed fee for managing assets. Managers getting an incentive or performance fee share in the upside when they produce positive results and generally do not get paid when they produce negative results. The effect of the performance fee is to give the manager a tangible incentive to generate the highest possible absolute level of return and to minimize variation and volatility over a complete business cycle.

Alternative investments are generally less regulated than traditional investments. This opens the door to the use of leverage, short selling and derivatives on a much grander scale. Leverage is a powerful tool for magnifying winning outcomes and enhancing returns. Short selling is another form of leverage that particularly applies to managed futures and hedge funds and allows managers to make money when prices fall and to magnify outcomes. It also enables managers to mitigate volatility and reduce risk. Derivatives can be used by real estate funds to hedge interest rate risk or hedge funds to place bets on the market.

Managers of alternatives can be quite secretive about disclosure. They do not routinely provide much information to their investors and, rather, expect investors to rely on incentives and co-investment to align interests rather than the active monitoring of positions. Some institutions struggle with this limited transparency. Managers are also often concerned about their particular investment strategies being leaked and replicated if they provide too many details, thus adding another incentive for this limited transparency

More recently we have seen original emergent or exotic alternative strategies that use hedge fund, private and public equity, ETF and mutual fund structures to offer new and unique exposures to investments like life settlements, farmland, weather derivatives, or collectables such as artwork, comic books, vintage automobiles, litigation finance, life settlements, aircraft leasing, farmland, collectable stamps and coins and Bitcoins.

Many of these exotic alternative investments still lack liquidity, infrastructure and transparency and are subject to greater fraud and valuation risks. These investments tend to remain in the domain of pure speculators, hobbyists and those who are equal parts product enthusiasts and investors. Some of these exotic alternative investments share at least a few common attributes or qualities with hedge funds, private equity and real estate investments. Many of them use hedge fund styles and structures to invest.

Hedge Fund Characteristics and Structures

Hedge funds use a wide range of legal entities and domiciles to gather assets from investors. Each entity is designed for a specific purpose and a specific type of investor. Domestic funds in the United States tend to be organized as limited partnerships (LPs) or limited liability companies (LLCs) and investors tend to be individuals. Offshore funds are generally organized in tax or regulatory advantaged locations such as the Cayman Islands, Bermuda, Luxembourg or Ireland. These funds cater to certain types of not-for-profit investors in the U.S. and international investors. Other structures, such as mutual funds, are designed for retail investors or institutions who want more regulation and surveillance of the structures offered. Regardless of the structure used, each fund must also appoint a manager to make decisions and run the day-to-day operations, either as the general partner or under a contract established by the fund board between the fund and the manager.

Structures and Domiciles

A hedge fund is a specific type of alternative investment. It is a legal entity, not an asset class per se. Generally, hedge funds are commingled vehicles that allow many investors who qualify to be aggregated and invested as a single pool of capital. A hedge fund is generally lightly regulated and combines leverage, short selling and derivatives with active security selection, macro views and advance portfolio construction methods to generate returns and manage risk.

Traditionally, hedge funds were limited in the structures they used to gather assets. They were generally organized as either onshore funds or offshore funds. Onshore funds are funds organized in the United States as either partnerships or limited liability companies. Offshore funds are investment companies organized outside the United States, typically in a tax haven such as the Cayman Islands or Luxembourg. Today, hedge fund strategies are also available to retail investors and are offered as mutual funds or unit trust products.

Onshore funds are U.S. entities that are formed as limited partnerships or limited liability companies. Onshore funds are typically formed in Delaware and managed by a general partner. The managing member or manager typically manages an LLC. Investors in a limited partnership are limited liability partners, and investors in an LLC are simply members. The GP or managing members are responsible for portfolio trading and taking actions on behalf of the fund.

Offshore funds are most typically offered to qualified U.S. taxable investors or investors located outside the United States. The vehicle used is normally a listed portfolio company. Funds are typically formed in jurisdictions that do not impose tax on fund income (e.g. Cayman Islands, Bermuda, British Virgin Islands). A board of directors is required to govern the company and appoint a professional investment manager to manage the portfolio. The manager is responsible for portfolio trading and takes actions on behalf of the fund.

Mutual funds are a type of U.S. investment company created under the Investment Company Act of 1940. Mutual funds are collective investment vehicles that invest in a wide array of products and instruments. An investment manager, who is generally also registered with the Securities and Exchange Commission is appointed to manage the portfolio on behalf of the fund. Mutual funds also have a board of directors to govern the fund and appoint service providers. Mutual funds are subject to a higher level of regulatory oversight than onshore or offshore funds, and in most cases, diversification, leverage, short selling and liquidity restrictions are imposed on the fund.

UCITS funds are similar to mutual funds. They are highly regulated collective investments that can be offered to either institutional or retail investors in Europe and elsewhere.

Management Company Responsibility and Organizational Design

A hedge fund manager is the company, individual or partnership that is empowered by the fund to manage its investments and bind the fund to legal obligations. The manager of the hedge fund or its general partner is at the center of all decision-making, transactions and business relationships. Under certain circumstances, particularly with offshore funds and mutual funds, a board of directors or group of advisors also has the authority to commit the fund to contracts or make decisions on behalf of the fund. In most cases, these decisions, if retained by a board, are in practice delegated to the manager and reviewed by the board or advisors. The fund manager is the entity that has staff, occupies space, pays bills, buys and sells stocks and manages risk. The fund owns the securities purchased and any liabilities in the form of loans, borrowed shares, derivative obligations or payables created on its behalf as a result of manager actions or omissions. Figure 1.1 shows the relationship between the fund manager, funds and investors.

Figure 1.1: Position of Hedge Fund Manager

Funds can be formed in a number of U.S. and offshore jurisdictions. Most funds create both a domestic onshore fund and an offshore fund when they launch to broaden their appeal and accessibility to the widest range of investors possible. The primary purposes of the offshore fund are to solicit international investors, create eligibility for certain investments whose sale is prohibited or restricted in the United States and to facilitate the needs of U.S. tax-exempt investors. Retail mutual funds or UCITS funds do not normally get established until after the manager has been in operation for one year or more and has established a track record.

The management company organizes the initial setup of the business and runs each fund investment vehicle under its domain on a day-to-day basis. The management company usually includes many people and teams responsible for executing trades, designing the portfolio, performing research and managing risk, in addition to those needed to run operations and accounting, market the firm and to offer the funds to investors.

Hedge fund management companies share a number of common organization design features; however, the specific organization of any management company is highly variable and dependent on its size, age, strategy, jurisdiction, product mix and the personality of the founding partner. A fund manager who launches with $50 to 100 million in a single fund would require at least three to five people to manage and run the business effectively today. The days of launching a fund with the proverbial two men and a dog and later becoming highly successful are no more. A management company responsible for managing one strategy and two funds (onshore and offshore) with similar or identical mandates and $500 million to $5 billion in assets could operate out of a single location or office and might only need to employ 10 to 20 people to run the business, build effective internal controls and provide reporting to investors. A fund that managed more than $5 billion would most likely employ over 100 people and operate in multiple offices and locations around the world with a well-defined business model and diverse functional responsibilities.

A private fund manager in the United States may be required to register with the Securities and Exchange Commission, depending on the assets under management of the organization. The rules today require managers to register with the Securities and Exchange Commission if they manage more than $150 million in assets. Managers with lesser amounts may be required to register with their state authorities under certain conditions.

A fund that is managed by a specific fund manager and offered for sale may also be exempt from registration as a security under the 1933 Act, if the fund is limited to fewer than 99 investors under safe harbor rule 501c3-1 or is limited to fewer than 499 investors under safe harbor rule 501c3-7 of Regulation D. Investors in the fund would need to meet certain qualifications based on income and net worth tests. This allows the fund to be classified as a private placement rather than as a public security, which has to follow more onerous regulatory specifications and restrictions similar to mutual funds. Historically, private funds could not be advertised and sales were limited to known investors. The JOBS Act of 2012 has provisions that allow managers of private funds to use more advertising and promotions, although few hedge funds have taken advantage of these provisions.

All mutual fund managers, including those using hedge fund strategies, are required to register with the Securities and Exchange Commission. All mutual funds must comply with the provisions of the Investment Company Act of 1940.

Typically, the general partner or management company hired to run a fund by the fund’s board is wholly owned by the founder or senior partners of the firm. The general partner or management company employs the functional experts such as the chief operating officer, chief financial officers, chief compliance officer, portfolio manager, trader, director of research, treasurer, risk manager, controller, head of information technology, head of human resources and head of operations. Each department head employs analysts and staff to support each function. Most organizations are relatively flat, with many direct reporting lines to the general partner, who is usually also the firm’s CIO. The management company earns a fee from the fund for carrying out its responsibilities.

The specific roles and responsibilities of each individual supporting a fund vary from firm to firm and from strategy to strategy, however most funds seek to establish a critical mass by filling certain roles needed to launch and grow the business in a controlled fashion. Without this critical mass, it is difficult for investors to take the fund seriously. When evaluating a fund, it is critical to note whether the following positions are in place, and if not, to ask why.

The General Partner or owner of the management company is usually the firm’s founder and sole equity owner. In smaller firms, the general partner may also be the Chief Investment Officer and/or the Chief Executive of the firm. This is usually the case in funds below $1 billion in assets under management. In larger firms, equity ownership may also be allocated to other members of the firm’s senior management team.

The Chief Investment Officer or Portfolio Manager is generally a partner or highly paid professional who manages all or a portion of the portfolio or a particular sector or strategy of the fund. They may also be responsible for approving all trade ideas and allocating capital within or between portfolios.

The Director of Research is usually a senior professional or partner responsible for economic, industry or quantitative research to support the process of idea generation and capital allocation among various opportunities. Several analysts will normally report to the Director of Research.

The Head Trader is the person who is responsible for efficiently and cost-effectively executing trades, based on instructions from the portfolio managers.

The Risk Manager is the person who is responsible for independently evaluating portfolio risk and monitoring risk limits and policies of the fund designed to mitigate losses.

The Head of Information Technology is responsible for the firm’s desktop, remote and telephonic environment as well as the development and maintenance of its software and hardware configuration and linkages to external service providers, brokers and investors.

The Chief Operating Officer is responsible for all non-investment-related activities and the day-to-day running of the firm.

The Chief Financial Officer or Controller is responsible for the fund’s financial statements, tax returns and all record keeping related to both the fund and the management company.

The Chief Compliance Officer is responsible for the design and effectiveness of the firm’s compliance program, employee training and regulatory reporting.

The Head of Operations is responsible for the day-to-day processing of securities purchases and sales, income collection or payment, fund expenses, borrowing money, reinvesting cash and reconciling positions with traders, administrators and brokers.

The General Counsel is the primary legal officer of the firm and is responsible for all internal and external legal matters, including the fund’s offering documents and the firm’s relationships with outside counsel.

The Head of Investor Relations is responsible for sales and service of the firm’s individual and institutional investors, as well as most of the firm’s communications and reporting to investors.

The Head of Human Resources or Talent Management is the person responsible for policies and procedures related to finding, onboarding and retaining talent at a firm.

The Treasurer is the person responsible for managing the fund’s cash flow, funding lines, credit facilities and liquidity.

A typical hedge fund organization chart is show in Figure 1.2. It shows the roles and reporting lines for a well-established hedge fund that is managing money on behalf of both high net worth individuals and institutional investors. Each of the functional heads will likely have several analysts working for them; headcount will increase as the firm grows. The number of analysts and the firmwide headcount will grow during the early stages of the firm’s life cycle, while assets under management are also growing. Increases in headcount should slow once the firm establishes some operating leverage and economy of scale. At that point head count will grow more gradually, as will other expenses. If assets grow, fees and profits will expand.

Figure 1.2: Hedge Fund Organizational Model

Many hedge fund operators will start small and add staff over time. Some of these roles are not essential on day one, and most will be added as the funds grow in size and complexity or as they attract more institutional investors. As a general rule, the larger the assets under management, the more robust the organizational model and number of employees. Larger and more established firms with billions under management, such as firms like Citadel or Bridgewater, for example, might have more than 1,000 individuals engaged in the fund, whereas a small startup with $10 million or less may only have a handful of individuals engaged at any given time

Hedge Funds Versus Mutual Funds

A mutual fund is a highly regulated investment vehicle managed by a professional investment manager. It aggregates smaller investors into larger pools that create economies of scale and efficiency related to research, commissions and diversification. Mutual funds have been available to investors in a wide range of asset classes since the mid-1970s and became increasingly popular in the 1980s and 1990s as a result of retail attention, product deregulation and solid returns. Mutual funds generally cannot use leverage or short selling and generally cannot use most derivatives. Collective investment products originated in the Netherlands in the 18th century, became popular in England and France, and first appeared in the United States in the 1890s. The creation of the Massachusetts Investors’ Trust in Boston heralded the arrival of the modern mutual fund in 1924. The fund went public in 1928, eventually spawning the mutual fund firm known today as MFS Investment Management. State Street Investors started its mutual fund product line in 1924 under the stewardship of Richard Paine, Richard Saltonstall and Paul Cabot. In 1928, Scudder, Stevens and Clark launched the first no-load fund.

The creation of the Securities and Exchange Commission and the passage of the Securities Act of 1933 and 1934 provided safeguards to protect investors in mutual funds. Mutual funds were required to register with the Securities and Exchange Commission and provide disclosure in the form of a prospectus. The Investment Company Act of 1940 put in place additional regulations that required more disclosures and sought to minimize conflicts of interest. At the beginning of the 1950s, the number of open-end funds topped 100. In 1954, the financial markets overcame their 1929 peak, and the mutual fund industry began to grow in earnest, adding some 50 new funds over the course of the decade. The 1960s saw more than 100 new funds established and billions of dollars in new investment inflows. The bear market of the late 1960s resulted in a temporary outflow and a minor reversal of the trend in growth. Later, in the 1970s, Wells Fargo Bank established the first passively managed index fund product, a concept used by John Bogle to found the Vanguard Group. Today, mutual funds manage more than $15 trillion on behalf of a wide range of investors.

Hedge funds only emerged as an investment product in the late 1960s. Alfred Winslow Jones is considered to have been the first hedge fund manager, in that he used leverage and short selling to modify portfolio returns and was paid an incentive fee. Hedge funds, however, provide investors with investment opportunities that are very different from those available from traditional investments such as mutual funds. Hedge funds are also regulated and structured differently from mutual funds and thus have certain unique properties, although both operate using expert managers on behalf of passive investors. Hedge funds are designed to offer investors an absolute return, less volatility and lower correlation to traditional investment benchmarks such as the S&P 500 and the various bond indices. Hedge funds offered as private onshore or offshore funds do share some common features with the more traditional mutual fund; however, they also have some very significant differences.

There are several major differences between a private hedge fund and a traditional stock or bond mutual fund that are worth noting.

Performance measurement. Mutual fund success or failure is based on relative performance versus some benchmark or index. Performance is compared to a particular index that is considered suitable to capture passive returns from a particular asset class. Equity mutual funds are commonly benchmarked against an index such as the S&P 500. Hedge funds, on the other hand, are designed to generate positive returns in all market conditions and as such are referred to as absolute return investments that can generate mostly alpha for their investors.

Regulation. The mutual fund industry is highly regulated in the United States, whereas regulation of the hedge fund industry is only just beginning to emerge in many markets, including the U.S. A mutual fund’s design, terms, liquidity, performance calculations and other features are prescribed by regulation. In addition, they are generally restricted from many types of transactions, including the amount of leverage, short selling and derivatives. Hedge funds, by contrast, are only lightly regulated and therefore much less restricted. They are allowed to short sell securities, use leverage, add derivatives to their portfolios and can use many techniques designed to enhance performance or reduce volatility.

Compensation model. Mutual funds are generally rewarded and compensated by a fixed management fee based on a percent of assets under management. The fee generally varies by asset class, with money markets and fixed income earning the lowest fees and active equity or credit strategies earning the highest. Hedge funds are generally compensated with both a fixed management fee and a variable performance fee based on the funds results.

Protection against declining markets. Most mutual funds are designed to track or outperform an index and as such generally need to stay close to 100 percent invested in a specific asset class. In some limited cases, they can use put options or short index futures for hedging. Mutual funds are not normally designed to protect investors against declining markets. Hedge funds, however, are almost always designed to offer some protection against declining markets.

Correlation to traditional asset classes. The performance of most mutual funds is dependent on the direction of the equity or bond markets. The performance of many hedge fund strategies has a low, perhaps even negative, correlation to the stock or bond market.

Leverage, short selling and derivatives. Most mutual funds are restricted by regulation from the use of leverage, short selling or derivatives. When permitted to use leverage, short sales or derivates, they can do so only in varying degrees and within strict limits. Even those that can use these options often do not, as the firm may lack the expertise and training to do so effectively. In contrast, almost every hedge fund can use some combination of leverage, short selling or derivatives to modify returns and lower volatility.

Liquidity. Most mutual funds offer daily liquidity. In cases where liquidity is restricted, investors most often can exit the fund by paying a penalty. Hedge fund investors usually can redeem only periodically, based on the strategy of the fund. Redemption is usually monthly or quarterly. In some cases, it may extend to one or two years.

Despite the differences noted above, some hedge fund strategies, such as global macro and long and short equity, previously offered only in private fund formats, are now offered as mutual funds. Many hedge fund managers now offer a combination of private and public funds using LPs, LLCs and mutual funds or UCITS products. Larger firms also offer managed accounts and customized portfolios to significant institutional investors.

Size and Scope of the Mutual Fund Industry

The global mutual fund industry and exchange traded fund industry assets under management amounted to approximately $60 trillion at the end of 2019. According to the year-end 2019 report by the International Investment Funds Association, the U.S. accounted for $28 trillion, Europe accounted for $18 trillion and Asia accounted for $8 trillion in global assets. There were over 125,000 funds in operation worldwide. Equity funds comprised approximately $25 trillion, bond funds $12 trillion and money market funds were approximately $7 trillion of the nearly $60 trillion in aggregate industry assets. The figures above include both open-ended funds and exchange traded funds. Exchange traded funds made up approximately $6 trillion of the total of nearly $60 trillion. ²

Size and Scope of the Hedge Fund Industry

The global hedge fund industry initially peaked at about $2.4 trillion in assets under management at the end of 2007. The number of managers and the assets under management declined dramatically in 2008 as asset values fell across the board and many funds experienced significant redemptions and liquidations. According to Preqin data, the industry had recovered all of its lost assets and increased its assets under management to more than $3.61 trillion by the end of 2019. During the first quarter of 2020, the industry likely saw more outflows and a loss of value due to the COVID-19 market meltdown and a decline in assets under management to less than $3 trillion. ³

According to Preqin data, there are estimated to be 16,256 active hedge funds in the market today, up from 12,639 in 2011. The number of new launches versus liquidations has declined steadily during this period. In fact, new launches were declining steadily each year from 2012 to 2019. It is anticipated that both the number of hedge funds and assets under management will decline further in 2020. Figure 1.3 shows new hedge fund launches and liquidations occurring each year, starting in 2012. The graph shows that there were only 519 hedge fund launches in 2019, down dramatically from 1,119 in 2018. For the first time since 2012, more funds were liquidated in 2019 than the number of funds that were launched. New launches are now likely in the eighth year of decline. ³

Figure 1.3: Hedge Launches and Liquidations

The hedge fund industry has consolidated quite a bit over the past decade. Today, a very small number of very large firms control the vast majority of industry assets under management. The top ten funds tracked by Preqin account for more than 25% of the industry assets under management. However, there are still many smaller funds managing less than $100 million. The number of smaller funds is expected to contract further but not disappear as the industry continues to consolidate. Some investors will continue to be attracted to the nimbleness, unique strategies and ability to generate higher returns offered by some of smaller funds dealing in limited capacity opportunities that are too small for the mega-funds that dominate the industry.

Mutual funds, pension plans, sovereign wealth funds, endowments and foundations and individual investors still allocate the majority of their investments in traditional stocks and bonds. Hedge funds and other alternative investments represent a relatively small percentage of all investments done by global investors today. Allocations to hedge funds and alternatives remain attractive because of their ability to preserve capital and their positive diversification effects when added to traditional portfolios.

Despite