Hedge Fund Investing Chapter 1 Part 1: What Are Alternative Investments?

Chapter 1 opens with a warning. If you’re new to hedge funds, you will get overwhelmed. There’s a lot of terminology. There’s a lot of moving pieces. But Mirabile does a good job laying the foundation here. Let’s walk through it.

What Counts as an Alternative Investment?

Traditional investments are the stuff you already know: stocks, bonds, commodities, foreign exchange. These markets are huge, liquid, transparent, and heavily regulated. Mutual funds have been around for over 100 years.

Alternative investments are everything else. Think real estate funds, private equity, venture capital, managed futures, and hedge funds. Sometimes even timber, land, or artwork.

The alternative investment industry is still young. Hedge funds really only started growing in the early 1990s. To give you some perspective: there’s over $25 trillion globally in traditional mutual funds versus about $2 trillion in hedge funds. That’s a big gap.

Here’s a quick breakdown of the main types:

• Real estate funds invest in commercial or residential properties or mortgages. They make money from rental income, interest, and property value going up.
• Private equity funds buy ownership in existing private companies, try to improve operations or management, and then cash out when the company goes public.
• Venture capital funds give early money to brand new businesses, hoping the company gets bought or eventually IPOs.
• Managed futures funds trade futures contracts using directional or trend-following models. They’re similar to hedge funds but limited to listed futures and regulated by the CFTC.
• Hedge funds are private investment partnerships that trade stocks, bonds, commodities, or derivatives. They use leverage, short selling, and other techniques to boost returns and reduce volatility.

What Makes Alternative Investments Special?

There are seven common features that set alternatives apart from traditional investing:

1. Expert management - The managers are usually specialists in a narrow area. A biotech hedge fund might literally have doctors as analysts.
2. Manager co-investment - The managers put their own money in the fund. This is supposed to align interests. If the fund tanks, they lose too.
3. Performance fees - On top of a flat management fee, managers get paid a percentage of the profits. No profits, no bonus.
4. Leverage - Funds borrow money to make bigger bets. This magnifies both wins and losses.
5. Illiquidity - Your money is locked up. You can’t just pull it out whenever you want.
6. Limited transparency - Don’t expect daily updates on what the fund is doing. Many managers are secretive about their positions because they’re afraid of being copied.
7. Hard to value - The stuff they own might not trade on any exchange. Pricing can be tricky.

That limited transparency part is interesting. Mirabile mentions that managers can be “quite secretive and at times even a bit paranoid about disclosure.” They expect investors to trust the incentive alignment rather than watch over their shoulder.

Hedge Fund Structure: How They’re Set Up

A hedge fund is basically a pool of money from qualified investors, managed by professionals who use leverage and short selling to generate returns.

There are two main structures:

Onshore funds are set up in the United States, usually in Delaware. They’re formed as limited partnerships (LP) or limited liability companies (LLC). The LP form is way more common. The manager acts as the general partner (GP).

Offshore funds are organized in tax-exempt places like the Cayman Islands, Bermuda, or Luxembourg. These exist mainly for international investors and U.S. tax-exempt investors. They usually have a board of directors that appoints a professional investment manager.

Most hedge funds launch with both an onshore and an offshore vehicle to attract the widest range of investors.

Who Runs These Things?

The management company is the real operation. It’s where the people work, the trades happen, and the decisions get made. The fund itself just owns the securities and liabilities.

How big is the team? It depends on size:

• A $50-100 million fund needs at least 3-5 people. The days of “two men and a dog” launching a successful fund are over.
• A $500 million to $5 billion fund probably has 10-20 people working from a single office.
• Anything above $5 billion likely has 100+ employees across multiple offices worldwide.

The key roles include a general partner (who’s often also the CIO and CEO), portfolio managers, a director of research, head trader, risk manager, COO, CFO, head of operations, and head of investor relations.

If a fund manages over $150 million in the U.S., it has to register with the SEC. Even smaller funds often set up compliance manuals and codes of conduct voluntarily.

Hedge Funds vs. Mutual Funds

Both hedge funds and mutual funds are collective investment vehicles run by professional managers. But that’s pretty much where the similarities end. Mirabile lists seven major differences:

1. Performance measurement - Mutual funds are measured against a benchmark like the S&P 500. Hedge funds aim for absolute returns, meaning positive gains regardless of what the market does.
2. Regulation - Mutual funds are heavily regulated. Hedge funds are lightly regulated and can do things mutual funds can’t.
3. Compensation - Mutual fund managers get a flat fee based on assets. Hedge fund managers get a flat fee plus a performance fee.
4. Downside protection - Mutual funds generally stay fully invested and ride the market down. Hedge funds can short sell and use derivatives to protect against declines.
5. Correlation - Mutual fund returns are tied to whether stocks or bonds go up or down. Hedge funds can have low or even negative correlation to traditional markets.
6. Tools available - Mutual funds are restricted from using leverage, short selling, and derivatives. Hedge funds use all of these extensively.
7. Liquidity - Mutual funds offer daily liquidity. Hedge funds? Monthly or quarterly redemptions. Sometimes you wait one or two years.

The Size of Each Industry

The mutual fund industry peaked at around 641 organizations managing $24.6 trillion in 2007. After the 2008 crash it contracted, but recovered and is now dominated by a few giants like Vanguard, Fidelity, and PIMCO.

The hedge fund industry peaked at about 11,000 organizations managing $2.4 trillion in 2007. It also crashed in 2008. By the time Mirabile was writing, assets had recovered past $2 trillion but the number of managers was still around 9,000. Many small funds closed and fewer new ones launched.

Here’s what’s wild: 60% of hedge funds manage less than $100 million, but the largest funds (over $1 billion) control almost 80% of all investor assets. It’s very top-heavy.

Despite being a fraction of the mutual fund world, hedge funds punch above their weight. They account for about 15% of daily NYSE volume. Combined with high-frequency trading (which includes some hedge fund operations), they dominate market activity.

That’s the foundation. In the next part, we’ll get into the actual strategies hedge funds use, how leverage and short selling work in practice, and how performance gets measured.

Previous: Series Intro | Next: Chapter 1 Part 2

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.