Hedge fund - what is it in simple words? Features and structure. How to invest?

A hedge fund is a type of investment fund.
Its distinctive features are the use of risky strategies to earn money and a special system of remuneration for managers. Let us explain what a hedge fund is in simple words, how it works, how to invest in it, and whether a novice investor should invest in it. From this article you will learn:

1. What is a hedge fund and how does it work?
2. Hedge fund structure
3. The history of hedge funds
4. Features of the functioning of hedge funds
5. Types of hedge funds
6. Hedge funds in Russia and in the world
7. How to invest in hedge funds?
8. Advantages and Disadvantages of Investing in Hedge Funds
9. How to choose a fund for investment?

What is a hedge fund and how does it work?

To understand what a hedge fund is , let's first understand the definition of "hedging". This is a strategy in which a trader opens two opposite positions in different markets in order to compensate for losses on one transaction with profits on another.

A classic example of hedging : a trader buys Sberbank shares on the stock market, counting on their growth, and at the same time buys a put option on the derivatives market, insuring against a fall in price. Next options:

• if the shares rise, the investor will profit from their purchase and lose the option premium;
• if the stock falls, the investor will close his long position in the stock market, recording a loss, and at the same time exercise the option, making a profit.

There are a lot of hedge strategies. They differ in one thing: a high “appetite” for risk. This is where hedge funds differ, for example, from mutual funds - the latter invest in a limited number of assets, usually stocks, bonds and real estate.

The number of instruments used by hedge fund traders is large:

• derivatives (derivatives);
• precious metals;
• real estate of all types;
• Forex market currency pairs;
• penny stocks;
• junk bonds, etc.

In their work, hedge funds can use a variety of non-limited strategies with margin leverage . On the one hand, this makes it possible to obtain practically unlimited profits, and on the other hand, it entails the emergence of additional risks. Therefore, such funds are intended for more experienced investors with significant capital.

Recommendations from the author

What can you recommend to a future hedge fund creator?

1. The entire preparation procedure and the first steps to open a fund should be thought out as much as possible in advance. Namely: jurisdiction, strategy, expected profitability, etc. Carefully study the legislation of the country in which you decide to register a hedge fund, the taxation system, and government regulation of investment activities.
2. When choosing a consulting company that will help you prepare the necessary documents, you need to approach it as responsibly as possible. Do not forget that any company seeks to make money on your ignorance or lack of experience. However, completing all the documents yourself will be difficult and time-consuming. Use the knowledge and experience of professionals, but keep your interests in mind. Having decided on the strategy and other key points, it is worth getting advice from a company specialist, then decide - perhaps you can perform some actions yourself, and entrust the rest to specialists.
3. When your first investors appear, be as honest as possible. You shouldn’t lower their expectations too much, but promising mountains of gold would be a mistake. Focus on the minimum return in the first year of the fund's operation. In subsequent periods, build a financial plan on the basis that your initial costs will pay off in the first year. All your forecasts must be supported by calculations - involve a financial planner for this.
4. Even if you decide to manage the fund through a third-party company, it would be a good idea to have a certificate as a stock market specialist. Or, at a minimum, take a training course on trading and the securities market. Even if you are well versed in the world of investments, any fresh knowledge can be useful to you when managing a fund.

Hedge fund structure

To understand how a hedge fund works, you need to understand its structure. A typical fund has the following infrastructure:

• investors - persons who make direct investments in the fund and receive profit through its activities;
• Board of Directors – carries out direct management of the fund, coordinates the work of managers, attracts managers;
• management company – a team that directly determines the investment strategy (analysts) and generates profits (traders);
• administrator - a member of the management company, assesses the value of the fund's net assets, manages risks, determines the fund's expenses and income, and maintains accounting;
• auditor – carries out external control of the fund’s activities, namely checks the correct reporting, compliance with standards, safety of funds, etc.;
• depository – stores information about investors and their deposits;
• custodian bank – provides clearing and execution of financial transactions, stores the fund’s funds, ensures the safety of reserves, etc.

Goldman Sachs or Morgan Stanley , is involved in the role of custodian bank . Sometimes he is called the “primary broker”, since it is through him that the fund conducts its transactions with assets.

Naturally, this structure allows variations. For example, tax and legal consultants and international representative offices are often connected to the infrastructure; subsidiaries and sub-funds are created within the fund, through which transactions are carried out. Complex organizational structures are a hallmark of large hedge funds .

It can be difficult for an unprepared investor to understand behind all these clutter how the fund actually works, so he may encounter scammers or invest his money in the wrong structure and, as a result, get an unexpected financial result.

How to open an investment fund: answers to your questions

In this section, we have collected the points that have accumulated over many years and arouse the greatest interest of our clients. But we ask you to remember that the information presented below should not be taken as a direct guide to action or a set of instructions in the How To format. If you need specific assistance, agree on the terms of an individual consultation with our experts.

Is it true that the main task of an investment fund is to invest funds in the most interesting and promising projects?

True, but only partially. In fact, any IF is built on an inextricable link between two tasks - investing in specific projects and extracting the maximum possible benefit in the context of collective investments. If someone tells you that the entire economy is based on IFs, do not believe it. The modern world order is much more complex.

What are the main benefits of group investing?

There are quite a lot of them, and they are obvious and indisputable. But – an important note – they are by no means universal. In other words, the pros in one case can easily turn into a bunch of disadvantages in another. It all depends on many individual characteristics and requires careful consideration at the planning stage.

General benefits:

• If you know how to open an investment fund, have a ready-made project and real goals, but lack financial resources, a common pool of funds will be very helpful.
• You can resort to the services of specialists and involve them in the work. The amount required to pay for their work will be divided among all participants.
• Slightly lower transaction costs (if the investment fund has a small effect, the effect will be particularly pronounced).
• An increased level of asset diversification, which allows you to reduce (but not reduce them to zero!) risks that cannot or are very difficult to predict.
• Attracting financial reserves from third parties (there are legal and organizational restrictions).
• Profit is calculated based on the invested funds.

What is the classification of investment funds?

To fully answer this question, you need a fairly large text with infographics, links to current regulations and a significant analytical block. We doubt that such information can be of practical use, so we will limit ourselves to only the most common options.

IF options:

• By format: mutual funds, ETFs, hedges.
• Where possible, third-party participation: open, closed (in the latter cases, shares are distributed only when the fund is created).
• By place of registration (reference): onshore, midshore and pure offshore.

How to open an investment fund and not make a mistake with the structure?

The worst thing you can do is really start guessing. Projects of this level, as we have said more than once, require calculation and analysis of all possible options. We strongly recommend that you involve our experts in this. At least at the preliminary stage. Regarding the question asked, we can say the following: each jurisdiction has its own special rules, but the general elements that are almost always present do not change.

"Required" persons:

• The beneficiary influences the IF . He is also called a promoter, owner or founder. Let us clarify that this role can be played by both legal entities and individuals.
• Shareholders , or investors . Based on their investments, a common financial pool is created.
• Management company or individual manager.
• Custodian , or depositary . Its functions include actual accounting of assets and maintaining the appropriate register. Most often, these tasks are performed by a legal entity that has a special license, or directly by the bank.
• Registrar . An organization tasked with actually carrying out transactions in IF shares.
• Lawyer (law firm) . In charge of maintaining documentation.
• Broker . Trades shares on the stock exchange.

I didn’t know how to open an investment fund, and they advised me to have a mutual fund. This is right?

You should stay as far away from such “advisers” as possible. Let's say there: the recommendation is not completely meaningless, and even moreover, it is probably correct. But without knowing your specific situation, it is unprofessional to give such advice. In other words, if you are recommended to buy, say, a solid Mercedes or Audi, but you need the car to transport potatoes from the dacha... Well, you understand.

Secondly, you were interested in the opening procedure, and not the legal form of the investment fund. And these are completely different things. Thirdly, in some cases it makes sense to consider other, alternative options not related to IF at all, and they will be a better choice. But, we repeat, in this specific situation. But in order not to end the answer to the reader’s question on a minor note, we will describe the most important points regarding mutual funds (unit funds / mutual investment funds). Which are indeed the most popular format, although far from the only possible one.

Note:

• Does not have the status of a legal entity.
• The right to dispose of assets belongs to the management structure, the work of which, in turn, is controlled by the owner of the fund.
• The supervisory authority is the national financial regulator of the jurisdiction where the mutual fund is registered.
• To create a mutual fund, you definitely need “your own” investors.
• Structures for managing the fund can be registered independently.
• Placement of shares in the depository is mandatory.

What goals and benefits are pursued when creating private investment funds? Just making a profit?

Of course not. The general informal rule is: if you know how to open an investment fund, then you understand why it is actually needed. But quite often there is a situation when it is necessary to solve a specific problem, and the question arises of choosing the appropriate means to achieve this. And in this case, talking about the features and purposes of IF will be quite appropriate.

Problems that an investment fund can solve:

• Attracting additional financial resources.
• Safe (with certain reservations) investment with a minimum of risk. The legal structure of the mutual fund itself should be thanked for this.
• Optimization of the tax burden.
• Merger (integration) of the fund and other existing business.

We will separately highlight the benefits for beneficiaries:

• An effective collective investment tool. It should be considered first if you are planning a large and complex project that requires extended financing.
• A certain status component.
• Significant reduction of the distance between the owners of funds (investors), persons who need financing and beneficiaries of the fund.
• Formalization and legitimization of legal relations with investors.
• Increased asset protection.
• Preliminary approval of the details of the transaction before its actual execution.
• Significant tax savings.

How to open an investment fund?

It is pointless to talk about specifics without knowing the type of fund, the jurisdiction where it will be located, the assigned tasks and the amount, at least approximately, of financial resources. Therefore, we will talk about the main, basic stages that are almost always present.

Creation stages:

• Adaptation of a standard project for a specific fund.
• Development of management principles and rules.
• State registration.
• Direct formation of a financial pool.

What are they - index or commodity funds?

In fact, it is a good, although not universal, alternative to traditional investment funds. Index (or ETF - Exchange Traded Fund) “live” on stock indices, or on any raw materials. Compared to classic mutual funds, they have two undoubted advantages: profitability and investment attractiveness, since ETF shares are traded on exchanges.

The history of hedge funds

The first hedge fund was created, oddly enough, not by an investor, but by sociologist Alfred Jones in 1949 . Trading on the stock exchange, namely, technical analysis was his hobby. He noticed that when some stocks rise, others tend to fall. While preparing an article for Fortune magazine, where Jones outlined his observations, he came up with the idea of ​​​​making money on this. AW Jones & Co fund was born .

Jones' investment strategy was to buy one stock while shorting stocks that were expected to fall. Thus, he could make money both on a rising and falling market, and even on sideways movements.

Alfred Jones

From 1960 to 1965, his fund returned 325%, which was 100 percentage points higher than that of mutual fund managers who used only growth strategies and looked for undervalued stocks. Over the next 5 years, the fund earned another 670%.

Seeing such success, first friends and relatives, and then third-party investors, began to actively invest in the fund. For his services, Jones charged a fixed rate: 20% of profits.

Other funds began to copy Jones’ strategy, and by 1968, more than 140 similar funds had appeared in the United States. The US SEC classified a new category of investment partnerships as hedge funds (from the word “hedge” - insurance).

A new type of fund began to actively develop in the late 80s; the main “haven” for hedges is Britain (about 30% of the total number of funds is registered in London), followed by the United States, where 25% of all funds are located.

Strategies

Even a small hedge fund in the USA brings its investors 10–20% per annum (in foreign currency, of course). The profitability of top organizations exceeds 100%. How do hedge funds make money?

A variety of investment strategies, methods and methods of hedging can be conditionally combined into several groups.

Fair Value or Long Position is a long-term investment in undervalued or discounted securities. Let us recall from the article “Shares” that be undervalued if its estimated fair value exceeds the market value. This is the main strategy of any long-term portfolio and venture investors. Reliably estimating fair value is not easy, which is why hedge funds require the services of professional appraisers.

Short position - a trader sells short positions, making money on a falling market.

Example 1. A trader borrows 1000 shares of company A from a broker. Price: $100. Broker's commission: $1 thousand. Debt: $101 thousand. The trader sells securities on the market. A month later, the spot price dropped by 25% to $75. The fund buys the shares, returns them to the broker, and makes a profit of $24,000.

Long/Short position is the most popular hedging strategy, usually applied to half of the assets. It involves the acquisition of undervalued assets (long position) and the sale of overvalued ones (short position). The strategy can be diversified, but most often the fund uses it in relation to firms competing in the same industry.

Example 2. A trader uses his own funds to buy 1,000 undervalued shares of automaker A at a price of $100. Broker's commission: $1,000. To hedge risks, under the same conditions, the trader opens a short position with the broker for 100 shares of automaker B. If the trader is not mistaken in the degree of undervaluation of the shares of manufacturer A, then:

• In a growing market, for example, shares of company A will increase by 30%, company B - by 20%. Profit on a long position: 130 – 100 – 1 = 29 thousand dollars. Loss on a short position: 100 – 120 – 1 = 21 thousand dollars. Total profit: 29 – 21 = 8 thousand dollars.
• In a falling market, for example, shares of company A will fall by 20%, company B - by 30%. Loss on a long position: 100 – 120 – 1 = 21 thousand dollars Profit on a short position: 130 – 100 – 1 = 29 thousand dollars Total profit: 29 – 21 = 8 thousand dollars

Thus, the strategy will allow you to make money both when the market rises and when it falls. A loss is possible only if the change in the price of company B’s shares exceeds company A’s absolute value, which signals the trader’s incorrect assumptions.

Market Neutral Arbitrage - a trader makes money on the difference in prices (spot and futures) of the underlying asset on different exchanges.

Event Driven - a trader quickly reacts to short-term unfair changes in the price of shares of a particular issuer caused by significant events (acquisition, merger, reorganization, etc.). The essence of the strategy: buy or sell securities in time before the price levels off. The strategy is most effective if managers have insider information or hold leadership positions in the investee.

Distressed Securities - the acquisition at a large discount of the assets and liabilities of a company on the verge of restructuring or bankruptcy. The essence of the strategy: hope for the revival of the company as a result of internal changes and capital injections.

Global Macro is a hedging method that involves profiting from major macroeconomic and political changes in specific countries. Bonds, interest rates and currency pairs are used as the underlying asset (hedging currency risks).

Features of the functioning of hedge funds

The work of hedge funds is characterized by two main features. First, managers can use leverage to conduct speculative transactions. Pension or classic investment funds do not have such a right - this is carefully controlled by the regulator. Hedge funds do not have such control and therefore can essentially do whatever they want with their clients' money.

This approach allows you to make profits significantly higher than the market, but carries increased risks . Thus, in 2008, many hedge funds suffered colossal losses due to their risky strategies and simply went bankrupt.

The second feature is the reward scheme . The manager receives payment in the form of a fixed percentage for managing funds + a large reward in case of profit. Typically, the fixed remuneration is 1% of NAV, and the bonus for performance is from 5% to 20% of net profit.

Example of work and remuneration calculation

Let's look at an episode of a hypothetical hedge fund called, say, Plushkin & Co Fund. The rules of this fund stipulate the following points regulating the amount of the manager’s remuneration:

1. The commission charged by the fund from each of its clients for managing their funds is 2% per year;
2. If the fund's return exceeds 10% per annum, the manager receives a performance bonus in the amount of 20% of the total income for the year.

Let's assume that this fund attracted 20 investors, each of whom made a minimum contribution of $5,000,000. Thus, our fund managed an amount of $100,000,000.

All this money was placed in the accounts of the custodian bank and subsequently, by decision of the fund manager, was invested in the stock market (stocks and bonds). And a year later, the fund’s profit amounted to $30,000,000 (or 30% per annum).

According to the terms of the agreement with investors, since the threshold return of 10% per annum was exceeded, the manager receives a bonus in the amount of 20% of the total income. In addition, under the same agreement, the fund charges 2% for financial management.

Thus, the fund's income will be divided as follows:

• The fund will receive 22% of $30,000,000 (20% bonus + 2% commission), this will amount to (300,000,000/100)x22=$6,600,000;
• The fund's clients (investors) will receive the remaining profit in the amount of 30000000-6600000=$23400000. Since in our example the deposits of all clients were equal, the profit received by each of them will be an equal share in the amount of 23,400,000/20 = 1,170,000 dollars for each.

Types of hedge funds

The IMF identifies the following types of hedge funds:

• relative value - operate in certain markets according to the classical hedging scheme, which involves opening transactions in the opposite direction (for example, on spot and futures);
• global – they operate in the markets of all countries and use the widest range of assets in their work;
• macro funds – invest in the assets and instruments of a specific country or community of countries.

In addition, hedge funds are usually classified by size, country of origin, strategy used, etc.

Criteria for relative fund performance

To make it easier for an investor to find high-quality funds that not only meet initial return and risk requirements, but also meet the filters of a particular strategy, the next step is to identify a set of relative benchmarks and filters. Relative performance measures should always be based on specific categories or strategies. For example, it would be unfair to compare a global leveraged macro fund with a market-neutral fund that combines long and short equity positions.

To establish benchmarks for a particular strategy, an investor can use an analytics software package (such as Morningstar) to first identify a universe of funds that use similar strategies. Peer analysis will then reveal a variety of statistics broken down into quartiles or deciles for that population.

The threshold for each filter can be a result for each score that meets or exceeds the 50th percentile. An investor can relax the filter using the 60th percentile or tighten it using the 40th percentile. Using the 50th percentile for all metrics will typically filter out all but a few hedge funds for additional consideration. Additionally, setting the benchmark in this way allows for flexibility in adjusting the filters, as the economic environment may affect the absolute returns of some strategies.

Some hedge fund proponents use the following filters:

• Five-year average annual return
• Standard deviation
• Months until recovery or maximum drawdown
• Lower Deviation (DD)

These filters will help you filter out many hedge funds and determine a workable number of funds for further analysis.

Hedge funds in Russia and in the world

Today, there are more than 12 thousand hedge funds of various sizes in the world, with more than $3.5 trillion under management. The world's largest funds are AHL, which manages $26 billion, and GLG, which manages $30 billion. Both funds are headquartered in London.

One of the most famous (but not the largest) is the Quantum hedge fund led by George Soros. In 1992, the British pound was devalued, and the fund earned about $1 billion from its fall.

George Soros

Another well-known, this time scandalous, is the Bernard Madoff Foundation. In 1995, the fund suffered major losses and actually turned into a financial pyramid, which stood right up until the 2008 crisis. As a result, after the bankruptcy of the fund, Madoff went to prison for 150 years.

Hedge funds in Russia appeared in 2008, when changes were made to Federal Law No. 156-FZ “On Investment Funds ,” when Russian hedge funds were separated into a separate mutual fund.

There are few “pure” hedge funds in Russia, which is due to the complex procedure for registration and management of such an organization. There are only a few management companies that form such funds: VTB Capital, Gazprombank Asset Management, Aurora Capital Management, April Investments, Investment Manager Center, etc. As of the end of 2022, there were only 10 such funds in Russia. All of them are either closed or interval, investments in them are available only to qualified investors.

In addition to hedge funds directly in their classical sense, in Russia there are their closest analogues - general funds of bank management (abbreviated as OFBU). The management company of such a fund is the founding bank itself. At the same time, the assets and property of the bank and OFBU are separated from each other, they are managed by different teams.

This form of organization provides several advantages for the investor:

• capital management is carried out by experienced employees who most likely come from the banking environment;
• OFBU uses banking infrastructure to conduct transactions, which reduces overhead costs;
• the authority of the bank allows you to carry out expensive and especially profitable transactions and gives access to a wide variety of instruments;
• high reliability and transparency of work - it is not profitable for the bank to lose face due to several dubious transactions and deceiving clients.

The scheme of participation in the OFBU is somewhat different from the usual procedures. The investor does not participate with his own capital and does not buy shares. He exchanges funds for a special certificate of equity participation, which is not a security, like a share or share, but gives the right to receive part of the property (as a percentage).

When the certificate is redeemed, the investor receives his reward. The larger the fund's assets, the higher the percentage of income.

How much profit do they get?

Hedge funds, especially those that work with wealthy clients (family foundations, trusts), are fairly closed organizations. Even through research into their financial statements, it is difficult to find the ultimate beneficiary of the investment.

This also applies to the issue of profit. According to experts, on average, the HF is able to exceed the risk-free rate of return or bank loan interest set by the Central Bank by a multiple. For the USA and Western European countries this is 2-3%, for Russia - 7-8%.

Accordingly, American ones have a profit of no less than 10–12% per annum. Those. their returns are comparable to the SP500 stock index. Russian ones have a profit of at least 20–30% per annum, since they have to factor country risks into their investment strategy. Those. risks of doing business in a specific territory.

Hedge Fund Incentive Fees

In addition to the main payment in the form of a share of the profit received by the fund for the reporting period, investors receive incentive payments or bonuses:

• options to purchase a share or certificate of participation in the HF at a preferential price;
• if the amount of the investment portfolio exceeds a given threshold, the asset manager’s commission is reduced;
• preferential services from lawyers when executing investment transactions, including distribution of shares among the final beneficiaries of an investment project or portfolio;
• preferential lending rate to fund investors through its partner banks.

How to invest in hedge funds?

Investments in hedge funds look quite attractive, but, unfortunately, they are available only to a limited number of investors. qualified (professional) investors can act as shareholders of a hedge fund .

In Russia, a qualified investor must meet any of the following requirements:

• have capital invested in securities, derivatives or represented by money in the amount of at least 6 million rubles;
• have at least 3 years of experience in companies that make transactions on the stock market;
• make transactions on the market for 6 million rubles over the last year, carry out at least 10 transactions per quarter;
• obtain a specialized higher education (for example, MBA).

The barrier to entry into hedge funds is quite high. For Russia this is at least 3 million rubles , for US funds - from 500 thousand dollars.

Another challenge of investing in hedge funds: finding an entry point. Most funds are closed-end and interval funds. If the fund is closed, then you can become a participant only at the time of formation. If the fund is interval, it means that a certain time “window” opens for entry and exit from it: for example, you can make investments and withdraw money only from September 1 to October 1. This reduces the liquidity of shares and limits investors' ability to manage capital.

Income distribution

The profit received by the fund, minus remuneration and other administrative expenses, is distributed among investors according to their shares. Payment amounts to investors are calculated monthly, the payment date is fixed in the partnership agreement. The amounts received can be reinvested, i.e. the investor does not withdraw his profit every month or quarter, but increases the amount of his share. This can be effective in the long run.

When deciding to leave the partnership, the investor is required to notify the management of the hedge fund 2-3 months in advance. After payment of his share, the size of the shares of other participants is subject to revision.

Advantages and Disadvantages of Investing in Hedge Funds

The significant advantages of investing in hedge funds are:

• potentially unlimited profits;
• certain capital protection - large funds value their reputation, so they will not deceive clients;
• A share in a hedge fund can be inherited or transferred to a third party.

In short, a hedge fund is the best way to invest large capital when it is necessary to simultaneously protect funds and receive excess income. But this option is only suitable for wealthy clients. For everyone else, entry into a hedge fund is simply closed. And this is not the only disadvantage of hedge funds, here are other disadvantages:

• high risks - during crisis years, many hedge funds are forced to go bankrupt;
• funds have to be invested for a long time;
• limited capital liquidity – exiting hedge funds is not easy;
• lack of proper government control over funds;
• lack of insurance.

In Russia, the structure of hedge funds is not yet so developed, and often an elemental financial pyramid is hidden behind the façade of an investment company. So you need to carefully choose the fund to invest your funds in.

Other fund selection criteria

The investor can also select other filters that can either further reduce the number of funds to analyze or identify funds that meet additional criteria that are relevant to the investor and his preferences. Here are some examples of other filters and criteria:

• Fund Size : The size criterion can be minimum or maximum depending on the preference of the investor. For example, institutional investors often invest such large amounts that the fund or company must have a certain minimum size to make a large investment. For other investors, a fund that is too large may face future challenges by using the same strategy that has been successful in the past. This may be the case for hedge funds investing in small-cap stocks.
• Track Record : If an investor wants a fund to have a minimum track record of 24 or 36 months, then the filter excludes any new funds. However, sometimes a fund manager leaves to start his own fund, and although the fund is new, the manager's performance can be tracked over a much longer period of time.
• Minimum Investment : This criterion is very important for small investors as many funds have minimum investment requirements which can make it difficult to properly diversify. A fund's minimum investment can also provide insight into the types of investors in the fund. Higher lows may indicate a higher proportion of institutional investors, while lower lows may indicate a higher proportion of individual investors.
• Redemption terms : These terms have implications for liquidity and become very important when the overall portfolio is highly illiquid. Longer lock-ups are more difficult to incorporate into a portfolio, and redemption periods longer than a month can create some challenges in the portfolio management process. This criterion can be implemented to eliminate funds that have lock-up periods when the portfolio is no longer liquid. When the portfolio has adequate liquidity, this criterion can be weakened.

How to choose a fund for investment?

Investments in hedge funds look attractive, but the investor first needs to understand all the details - understand how the fund works, how it makes a profit, how it manages risks. And only then can you invest.

Here is a checklist for checking a hedge fund:

1. Find out how long the fund has been operating . It would be best if the fund has been operating for several years, has survived a couple of crises and emerged from them with dignity.
2. Look who the founder is . If there is a large bank or commercial organization behind the hedge fund, then this is a plus. But do not confuse the primary broker, the custodian and the management company. A fund can hide behind a big name, but it itself turns out to be a dud.
3. Find out where the fund is registered. Most hedge funds are registered in London and US cities. But now many companies are transferring their funds offshore to reduce taxes. On the one hand, this is a plus - the investor will receive more money, on the other hand, this is a risk. It is easier to liquidate a company in an offshore environment without consequences than in an official jurisdiction.

4. Look at the infrastructure of the fund and its partners . As a rule, large banks and brokers deal only with professional managers.
5. Study the reporting. Pay special attention to the profitability of the structure. Of course, past performance does not guarantee that there will be the same results in the future, but this benchmark is better than the absence of at least some criteria. It is important to look at profitability not only in “well-fed” years, but also in a crisis. If a hedge fund has lost less than its peers and the market as a whole, then it is a good fund. However, it should be taken into account that long-established structures, as a rule, are not among the leaders in profitability, since they are forced to reckon with risk and distribute risks more carefully. It is better if the fund has been operating for a long time and receives a stable profit, for example, 5-20% per year, than in one year it “makes” +100% of the capital, and the next year it loses 50%.
6. Review the fund's strategy . Look at what assets are used in work, in which countries traders operate, and what risks arise in connection with this. For example, now is not the best time to invest in funds operating in South America or China due to political risks.
7. Find out who directly works with your money . Namely, who is an analyst, trader, manager, administrator, etc. The final profitability of the fund will depend on the activities of these people. If there are dubious individuals among the fund’s employees, it is better not to have anything to do with such a structure.

And finally. Be sure to read the contract before signing it. It is worth paying special attention to the following things:

• how the manager’s remuneration is determined, including if the fund suffers losses;
• how can you withdraw from the fund;
• how a share in the fund is inherited;
• how to obtain compensation in the event of bankruptcy or dissolution of the fund;
• how controversial issues and force majeure are resolved.

If you are satisfied with everything, only then sign the agreement and invest your own funds in hedge funds.

Criteria for absolute fund efficiency

The first benchmark an investor should set when choosing a fund is the annual rate of return. Let's say we want to find funds with five-year annualized returns that beat the Citigroup World Government Bond Index (WGBI) by 1%. This filter will eliminate any funds that underperform the index over long periods of time and can be adjusted based on the index's performance over time.

This filter will also highlight funds with much higher expected returns, such as global macro funds, long-short mix funds, and others. But if these are not the types of funds an investor is looking for, they should also set benchmarks for the standard deviation. Once again, we will use the WGBI to calculate the standard deviation of the index over the previous five years. Let's say we set 1% as a reference value for the standard deviation. Funds with a standard deviation greater than the normative value may also be excluded from further consideration.

Unfortunately, a high yield does not necessarily help identify an attractive fund. In some cases, a hedge fund may have used a favorable strategy that resulted in returns that were higher than typical for its category. Therefore, once certain funds have been identified as high-yield, it is important to determine the fund's strategy and compare its returns with those of other funds in the same category. To do this, an investor can establish benchmarks by first performing an expert analysis of similar funds. For example, you can set the 50th percentile (less than or equal to 50%) as a benchmark for filtering funds.

The investor now has two rules that all funds must meet for further consideration. However, applying these two recommendations leaves too many hedge funds to evaluate in a reasonable time frame. Additional filters need to be set, but they will not necessarily apply to all other funds. For example, the filters for a fund that specializes in merger arbitrage will be different from the filters for a market-neutral hedge fund that combines long and short positions.