An Introduction to Hedge Funds for DevelopersApril 10, 2015 · 4 min read
When I joined Fundbase in 2013, I had no clue what a hedge fund was. As a developer, all I care about is programming languages, design patterns, and the new cool JS framework that came out two minutes ago. All this financial jargon has little or no interest to me, right? WRONG!
The first step in solving a problem is to understand it. Otherwise, you’re just a monkey coder. You can’t add anything to the project besides writing code that someone else planned.
The only way to escape this is to study.
I found it quite hard to understand hedge funds since I didn’t have any financial background. Even Hedge Funds for Dummies was too complicated for me and many resources out there are trying to help you invest in hedge funds rather than simply explain how they work. This document is the guide I needed two years ago and couldn’t find. I hope this can help others, maybe even future Fundbasers.
What is an Investment Fund?
Before explaining what a hedge fund is, there are some concepts we need to cover, starting with: “what a fund is”. The Cambridge Dictionary has a good definition for it:
noun – an amount of money saved, collected, or provided for a particular purpose: a pension/trust fund The hospital has set up a special fund to buy new equipment. Contributions are being sought for the disaster fund.
Think about the birthday fund you have in the office: money is collected, saved, and then spent/provided for the purpose of buying presents for your colleagues.
If you create a fund with the purpose to be invested in and earn a profit, you have an investment fund. Setting up an investment fund is not as easy as creating a birthday fund; there are laws that regulate how the fund should work and often those rules change depending on the country. Generally speaking you usually have these components:
- Fund Manager: The person who decides how to invest the fund’s assets. When people invest in a fund they trust that the fund manager will make the right choices to get a return. Therefore, fund managers must have a high level of education and professional credentials.
Fund Administrator: Usually a company to whom the fund manager outsources all the administrative tasks such as:
- Calculating the NAV (Net Asset Value)
- Preparing reports for shareholders
- Payment of fund expenses
- Preparation of fund’s prospectus
- The shareholders: Whomever owns at least one share of a fund’s stock.
- A board of directors or trustees: A group of individuals that are elected as, or elected to act as, representatives of the stockholders to establish corporate management related policies and to make decisions on major company issues. Such issues include the hiring/firing of executives, dividend policies, options policies and executive compensation.
- A “marketing” or “distribution” company to promote and sell shares/units of the fund.
Of course there’s more than one kind of investment fund. Probably the most common are mutual funds - let’s quickly see them before we head to hedge funds.
Let’s say that you want to invest some money but your budget is only $100. Also, you’re not very experienced in finance. Developing an investing strategy by yourself might be too hard if not impossible. That’s a typical use case for mutual funds.
With a mutual fund, you can invest your $100 and have them managed by a professional team that can set up a diversified portfolio. You’re not going to be the only one who invests in the fund; other people like you will invest $100, $1000, $10,000 or whatever amount they choose. Then you’ll gain or lose money proportionally to the gain or loss of the fund.
An important note is the fact that shares are usually issued and can be purchased or redeemed at any time. Let’s try to clarify this concept. When you invest in a mutual fund — or any other fund — new shares are created and you own some of them. The more money you invest the more shares you can get. Every share is a little part of the fund that you own. To get money you can sell those shares to someone else or redeem them i.e. return the shares to the fund owner. The money you get back depends on the fund’s NAV.
The idea behind hedge funds is similar to the one for mutual funds: many people collect their money in order to have investors. The main difference is that hedge funds are less regulated than normal funds.
Thanks to this, hedge funds can adopt unconventional strategies that can lead to high returns but also to high risks.
To avoid inexperienced people investing in hedge funds without understanding the risks, the law allows only qualified investors to invest in hedge funds. The definition of qualified investor depends on each country, but in general it’s an individual with sufficient investing experience or high net worth and income. Usually, investors in hedge funds are people with considerable family wealth and large institutional firms.
Another difference is how the fund manager gets compensated. For other investments, the managers get a percentage of the AUM (Assets Under Management), usually around the 0.2%. Hedge funds often follow the “2-and-20” model, meaning that the manager keeps 2% of the AUM plus 20% of the profits.
This is a very high fee but it’s not all: investors can’t withdraw money at will. When they invest in the fund, they also agree not to touch their capital for an agreed upon time period.
With all those limitations, you might expect hedge funds to perform extraordinarily well. The truth is that, on average, they don’t always beat the market — especially if you take into account the manager fee.
On the other hand, if you carefully choose and monitor the existing funds you can gain astonishing returns. In case you were asking, that’s exactly what Fundbase is for.