Financial jargon can be tough to get your head around. Even for adults. So if you’re teaching your kids about investing and at hedge funds, you’ve come unstuck, you’re not alone. Here’s how to explain hedge funds to kids in simple terms.
What is a hedge fund?
A hedge fund pools investors’ money to make high-risk investments with the aim of making huge returns. Hedge funds are regulated by the Financial Services and Markets Act and the Alternative Investment Fund Managers Directive (AIFMD) and implemented in the UK via the Alternative Investment Fund Managers Regulations. Unlike other investments, they use a wider range of investment strategies. For example, buying with borrowed money and trading what’s known as esoteric assets (assets that are not heavily trafficked and, therefore there is less competition) in an effort to get higher returns for clients.
Why is it called a hedge fund?
They’re called hedge funds because when they were first created, they used hedging strategies to protect investors from risk. In finance, to hedge is to reduce the risk you’ll lose money on your original position by taking an equal, opposite position.
In simple terms, when you hedge, you’re betting on both possible outcomes. If your original position turns out to be a dud, you’ll lose money on that one, but you’ll make money on the other.
It’s like hedging your bets in sports. Let’s say you’re at a football game and you’re pretty sure the team you support is going to win, so you place a bet. Play starts, and they don’t look so strong. To protect yourself from losing your money, you hedge by betting on the other team to win too.
Today, a hedge fund focuses less on minimising risk and more on maximising returns. Even so, the name’s stuck.
Who uses hedge funds?
Hedge fund investors need to have a lot of money to invest and understand the risks involved. For example, they’ll be professional investors who work for big corporations or pension funds.
They can also be accredited investors. Accredited investors are individuals who earn at least £100,000 per year or have net assets (excluding your property, pension rights and so on) of at least £250,000
What’s the difference between hedge funds and mutual funds?
Both hedge funds and mutual funds work by pooling a large number of investors’ money and investing it for a fee with the help of a fund manager. But that’s where the similarity ends.
The key difference is hedge funds are high risk, high reward. Mutual fund returns are smaller but more reliable.
There are other differences between the two:
| Hedge funds | Mutual funds |
| Private investments available only to high-net-worth, sophisticated investors. | Available to the public. |
| Not strictly regulated by FCA. | FCA-regulated. |
| Take 20% fee from the profit. | Take no share from the profit. |
| Charge a 2% management fee | Charge a 1-2% management fee. |
| Tend to perform better than mutual funds. | Tend to perform worse than hedge funds. |
| Lock up your money for a year to start with, and limit your opportunities to take it out afterward. | You can sell your shares at any time. |
What do hedge funds invest in?
Hedge funds can invest in pretty much anything they like. That’s because they’re not as regulated as mutual funds. While mutual funds have to stick to stocks or bonds, hedge funds can invest in real estate, stocks, currencies, coins, stamps, or even patents.
Hedge funds can use riskier investment strategies than mutual funds. They might use leverage – borrowing money to make bigger bets on the market.
Hedge funds can also short-sell stocks. Short-selling is when you sell stocks you don’t own because you intend to make a profit by buying them back later at a lower price. You borrow them from a broker for a fee.
Short-selling (also known as shorting or going short) is very risky.
Let’s say you think Spotify stock is going to go down. Seeing a chance to make a profit you borrow some Spotify shares from a broker and sell them straight away at their current market price. Then you sit tight and wait to see what happens.
If you’re right and Spotify’s stock price goes down, you can buy back the shares you sold for less money. And return them to your broker.
If you’re wrong and Spotify’s stock price goes up, it’ll cost you more to buy those shares back and return them to your broker. So you’ll lose money.
Fun fact: Alfred Winslow Jones is regarded as the father of the hedge fund. In 1949 he raised $100,000 and created a fund designed to reduce the risks of long-term investing by short-selling and leveraging.
Types of hedge funds
There are four common types of hedge funds:
Global macro hedge funds
These try to make money from market swings caused by political or economic events worldwide. Brexit is an example. Global macro hedge funds, confident Britain would vote to leave the EU, took long positions on safer assets, like gold, and short positions on European stocks and the British pound.
Equity hedge funds
An equity hedge fund can operate globally or in one country. They invest in attractive stocks but hedge by shorting overvalued stocks.
Relative value hedge funds
These types of hedge funds look closely at the market prices of stocks and bonds that are related to each other. They often do what’s called pairs trading. They use analysis to decide if a pair of related stocks are undervalued or overvalued and then take long and short positions to hedge their bets. They might also take advantage of stock mispricing – when there’s been a company takeover, merger, restructuring, or bankruptcy.
Activist hedge funds
Activist hedge funds invest in a company and then take action to boost its stock price. Like demanding it cuts costs, restructures, or makes changes to the board of directors.
How do hedge funds make money?
Most hedge funds make their money from fees using the ‘2 and 20 rule’. A 2% management fee plus a 20% performance fee.
The management fee is to cover the cost of operating the hedge fund and pay the fund manager. It’s based on the value of each investor’s shares. So an investment of £1 million will cost an investor a £20,000 management fee for a year.
The performance fee is based on profits. So if you make a £200,000 profit on an investment of £1 million in a year, £40,000 of your profit goes to the hedge fund.
What are the returns of hedge funds like?
Hedge funds aim to make high returns, but it doesn’t always happen. A high-risk investment can make you a huge profit. Or a huge loss. And if you do make a profit, the fees can eat into it.
How often can you take money out of hedge funds?
When you put your money into a hedge fund it’s usually locked up for a year or more. Even if the fund fails to perform. After that, the number of times you can take money out is limited. It might be monthly, quarterly, or annually.
Examples of hedge funds
Hedge funds have been a major force since the 1990s, attracting trillions of pounds of investment. Over the past ten years, however, they’ve underperformed. Several have shut up shop.
According to the latest Hedge Fund Research data, the top UK hedge funds are:
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Man Group – £112bn AUM (assets under management)
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Capula Investment Management LLP – £88bn AUM
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Lansdowne Partners – £26bn AUM
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Marshall Wace – £40bn AUM
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Brevan Howard Asset Management – £16.5bn AUM
How can my kids learn more about investing?
If you’re looking for ways for your kids to learn more about investing, GoHenry can help. A pre-paid kids' debit card for ages 6-18, that comes with our in-app Money Missions tool. Designed to accelerate your child’s financial literacy, as well as investing, they’ll learn about budgeting, saving, spending wisely, and more. All through a series of fun, bite-sized interactive games and quizzes.
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