Hedge funds: long-short equity, global macro, CTA and arbitrage strategies, fee terms, lock-ups and what UCITS liquid alternatives change

What you will learn

• What the four main hedge fund strategy families try to earn and what can go wrong in each
• How gross and net exposure describe a long-short book
• How management fees, performance fees, hurdles and high-water marks interact over several years
• What liquidity terms mean and which features a UCITS "liquid alternative" keeps or loses

Explanation

A hedge fund is a lightly regulated pooled fund for professional or wealthy investors that may use short selling, leverage and derivatives. The word "hedge" is historical; many are not hedged at all. What defines them is flexibility and performance-based fees.

Strategy families

Two measures describe a long-short book. Gross exposure = longs + shorts as a percentage of capital; it shows how much market risk and leverage are at work. Net exposure = longs − shorts; it shows the directional bet. A "130/30" fund has 160% gross and 100% net exposure, so it is fully exposed to the market plus active bets. A market-neutral fund targets net exposure near zero, but if its longs have a beta of 1.1 and its shorts a beta of 0.9, equal euro amounts still leave a net beta of 0.2, a hidden long position.

Fee terms

The traditional structure was "2 and 20": a 2% management fee on assets and a 20% performance fee on gains. Levels have fallen for many funds, but the mechanics matter more:

• Hurdle rate: performance fee is charged only on returns above a threshold (a fixed percentage or a money-market rate).
• High-water mark (HWM): performance fee is charged only when the net asset value exceeds its previous peak, so investors do not pay twice for the same gain after a loss.
• Crystallisation: how often the performance fee is locked in (quarterly, annually). More frequent crystallisation favours the manager.

Liquidity terms

A lock-up is the initial period (often one to two years) during which you cannot redeem. After that, redemptions are allowed at set dealing dates (monthly, quarterly) with a notice period (30 to 90 days). A gate limits total redemptions per dealing date, for example 10 or 25% of fund assets, and a side pocket separates illiquid holdings so remaining investors are not disadvantaged.

UCITS liquid alternatives

Many hedge fund strategies are also offered as UCITS funds (Undertakings for Collective Investment in Transferable Securities), the EU retail fund framework used by ordinary ETFs. The UCITS rules impose, among other things, issuer diversification limits (commonly summarised as the 5/10/40 rule), redemption at least twice a month, limits on global exposure from derivatives, and a ban on uncovered physical short sales, so shorts are implemented synthetically through swaps and futures. The investor gets a regulated, usually daily-dealing fund with a Key Information Document. What is lost: strategies needing illiquid assets, concentration or high leverage cannot be copied faithfully, so the UCITS version is often a diluted copy at a similar fee. Check the current UCITS rules, which are updated from time to time.

Worked example

Hypothetical example: you invest €100,000 in a fund with a 2% management fee and a 20% performance fee, no hurdle, high-water mark, fees calculated at each year end. Gross returns: year 1 +20%, year 2 −10%, year 3 +15%.

1. Year 1: gross value €120,000. Management fee 2% × 120,000 = €2,400, leaving €117,600. Gain above HWM (€100,000) is €17,600; performance fee 20% = €3,520. Net value €114,080. New HWM €114,080.
2. Year 2: gross value 114,080 × 0.90 = €102,672. Management fee €2,053 (rounded), leaving €100,619. Below the HWM, so no performance fee. HWM stays at €114,080.
3. Year 3: gross value 100,619 × 1.15 = €115,711. Management fee €2,314, leaving €113,397. Still below the HWM of €114,080, so again no performance fee. Net value €113,397.

Gross compounded return: 1.20 × 0.90 × 1.15 − 1 = +24.2%. Net return to you: +13.4%. €3,520 of performance fee was paid on a year-1 gain that was partly given back. Without a high-water mark you would have paid a further 20% × (113,397 − 100,619) ≈ €2,556 in year 3. Entry charges, fund expenses beyond the management fee and taxes are excluded.

Common mistake

Practice activity

On paper: a fund has €100 million capital, €180 million in long positions and €120 million in short positions. The longs have an average beta of 1.0 and the shorts 1.2. Calculate gross exposure, net exposure and net beta exposure in millions of euros.

Key takeaways

• Hedge fund families differ in return source and failure mode; gross and net exposure reveal the real risk.
• Performance fees with a high-water mark protect you from paying twice, but fees on a volatile path can still consume a large share of gains.
• Lock-ups, notice periods, gates and side pockets decide when you actually get your money.
• UCITS liquid alternatives add regulation and liquidity but often deliver a diluted version of the strategy at a similar fee.

Next step

The next lesson turns to private credit and direct lending, where floating rates, covenants and recovery assumptions determine what a lender really earns.