Hedge funds – what are they and why are they in the news?

Written by: Charlie Hancox
February 1, 2021
  • Hedge funds have been heavily featured in the news this week due to the GameStop situation
  • We explain what hedge funds are and how hedge funds work
  • We explore why hedge funds have lost money on GameStop

If you have been following the financial markets in the last week, you will have noticed that hedge funds have been all over the news. In this article, we will break down what they are, how they work, how this affects you, and why they have been all over the news this week.

What are hedge funds? The basics

What is a hedge fund in simple terms?

Hedge funds are groups that bring the funds of investors together into a pool and carry out complex, risk-mitigating investment strategies with the aim of making investors money.

How do hedge funds work?

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Hedge funds employ an experienced team of financial experts to analyse trends, examine fundamentals, and conduct detailed due diligence.

They will employ different strategies, such as trying to remain market neutral by going long on some stocks and short on others to mitigate the impact of broad market movements.

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How does a hedge fund make money?

A hedge fund makes its investors money by making a variety of good investments, and the employees of the hedge fund are remunerated via profits. The fee structure paid by fund investors is broadly based on AUM.

What does hedge mean?

To hedge is to protect yourself from financial loss and other adverse circumstances. Hedge funds do this by mitigating risk through a variety of investing strategies and protocols.

What is the most successful hedge fund?

The best performing hedge funds vary each year, but the top 10 are generally ranked by assets under management (AUM). Based on this metric, the world’s most successful hedge fund is Bridgewater Associates based in Westport, Connecticut. Co-chairman/co-chief investment officer Ray Dalio founded Bridgewater in 1975. It has around $138 billion under its management.

Can anyone start a hedge fund?

Technically, yes, anyone can start a hedge fund. However, once you consider the practicalities, it seems a less viable possibility. If you want to pay yourself anything, hire employees, or cover administrative costs, scalability is key. You need a very large amount of capital to start a hedge fund, and that is without factoring in the significant level of risk and need for expertise.

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The morality and legality of hedge funds

Why are hedge funds bad?

Hedge funds wouldn’t necessarily be bad if they played by the same rules as regular retail investors, but unfortunately, they don’t. This was demonstrated during the 2007-2008 global financial crisis, and most recently by their collusion with major American stockbroker, Robinhood, after a gamma squeeze instigated by WallStreetBets. Robinhood first suspended purchases and then sold the shares of its users without consent in an effort to protect the short positions of certain hedge funds.

Though many investors view short selling as a component of the stock market that enables it to function healthily, the brand of shorting employed by hedge funds leaves a sour taste in the mouths of retail investors.

Hedge funds will sometimes take up large short positions in companies and feed negative information about the company to the public to drive its value down. This can be damaging to the shorted company and its employees, and it can also harm the investors who have gone long on a stock in the hope it will rise in value.

Many investors claim that some hedge funds carry out the illegal practice that is naked shorting: shorting a stock without owning it, as well as short ladder attacks: hedge funds selling stocks back and forth to each other at increasingly low prices.

Are hedge funds legal?

Hedge funds are legal. The financial authorities state that hedge funds operate on a legal, transparent basis. Many hedge funds are well-operated, ethical organisations, but there are those out there that are more reckless, with allegations of insider trading being a common accusation.

Are hedge funds high risk?

Many hedge funds successfully balance a high risk of capital loss with a high potential for capital growth. All investments carry inherent risk, and this is also true of hedge funds. However, investors can find some comfort in the expertise of those investing their money.

Why are hedge fund managers so rich?

Hedge fund managers are so rich because of the business structure of hedge funds. Management and performance fees combine to produce a lucrative remuneration package. Essentially, hedge fund managers receive a flat management fee alongside a percentage of the hedge fund’s profits. Many hedge fund managers are responsible for billions of dollars of capital, and their remuneration is proportionate to this.

The GameStop situation

Why did hedge funds lose on GameStop?

The hedge funds lost on GameStop because they left themselves massively vulnerable to a gamma squeeze on GameStop stock thanks to WallStreetBets. Either through overconfidence or mismanagement, hedge funds like Melvin Capital and Citron Capital opened up huge short positions on GameStop in the belief that the stock price would go down.

Chewy.com owner Ryan Cohen acquired a stake in GameStop last year for $76 million. He wanted to transform GameStop away from its bricks-and-mortar roots into an online game-selling platform to rival Amazon. The hedge funds believed this would fail miserably, so opened up massive short positions. When retail investors got wind of this, they bumped the price of the stock from an initial $20 to a peak of around $350.

How much money has Wall Street lost?

Reports suggest that Wall Street has lost around $70 billion so far. It has been reported that the hedge funds are doubling down this week in the hope that the price bubble will burst.

Hedge funds are big news right now, and some of their tactics have been exposed due to pressure from amateur investors. However, this week promises to be a vicious battle for market supremacy. Make sure you stay up to date with the latest news as the story develops.