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What is a Hedge Fund?

Hedge Funds – What You Need To Knowhedge fund image

A hedge fund can be considered as a form of partnership between an investor and a fund manager or general partner. The investor contributes money to the fund and the work of the fund manager is to manage the investment to fulfill the fund’s goal. A hedge fund, as the name suggests, is supposed to act as a hedge against market fluctuations. The fund is supposed to generate returns whether or not the market is declining.

One of the main characteristics of a hedge fund is that it is not open to every individual. In essence, only wealthy individuals are allowed to invest. To invest in a hedge fund, you’ll need to meet certain net worth requirements. This is currently set at a net worth of 1 million dollars excluding the investor’s primary residence. Because of this restriction in investment, if you have a large capital amount, but fall short of the requirement for a hedge fund, it may be worth considering investing in a gold IRA instead.

With a hedge fund, an investor is allowed to pull together a wide variety of securities. You can basically invest in anything from land to stocks, derivatives or even currency. However, mutual funds usually have a limit on what you can invest in and this is usually stocks and bonds only.

There are also a lot more fees involved when it comes to a hedge fund. Other than the expense ratio, you will also be charged a performance fee. The amount or type of fee structure will depend on the kind of hedge fund you choose to buy.

The other important thing about hedge funds is that they are controlled by private companies. The hedge fund is allowed to do pretty much whatever they want so long as the investors are notified beforehand. This kind of openness and flexibility may appear to be very risky which sometimes it is. But some people have obtained long-term returns because of investing in hedge funds.

When buying a hedge fund, you will be required to buy an operating agreement. This is basically a legal document that outlines how the fund works. For instance, it may state that in the agreement, you will receive 20% of any profits over 5% every year and that you can invest in anything anywhere in the world. This 5% is known as a hurdle rate because you are required to achieve that percentage before you start earning any performance compensation. Upon filling the form, this investment agreement is sent to the fund administrator which is basically an accounting firm that does all the administration work after which they can begin managing the money.

Why Invest in Hedge Funds

Hedge funds are supposed to give some good returns on investments because for one, you are allowed to use a wide range of strategies and also you pay a lot of fees to actively manage the money. But lately, this hasn’t been the case. A good number of high net worth individuals are claiming that it is difficult to invest in hedge funds. There could be some good reasons to explain this.

For a start, investing in hedge funds can be difficult because they are never advertised. Unless you have an affiliated broker who informs you when such opportunities arise, you will never get a chance to invest. The provision that bans advertising has been argued to be outdated even though it was put in place to protect investors.

The other issue that makes it difficult to invest in hedge funds is that the general partners can basically reject your offer even though you have the money to invest without giving a reason. It’s not like mutual funds where anyone is given an opportunity to invest so long as they have the money.

General partners may also set up certain minimal requirements for investing in hedge funds. You may not be able to meet all these minimum requirements especially the minimum amount of investment that you should make. And since there is always a limit to the total number of individuals who can invest, the general partners are likely to make that figure high. You can find hedge funds that require a minimum investment of $100,000 whereas others require a minimum of $10,000,000. If the minimum amount is too high for you, then you may want to consider a mutual fund, or if you have a minimum amount of $20,000 you may want to invest in gold.

When buying hedge funds, it’s best to remember what they do. The funds can take long and short positions and they often make big directional speculations on the markets. These funds seek to maximize profits in any kind of market and minimize or hedge risk. But hedge funds can be highly leveraged.

You also need to consider the management fees and the amount they require to take up in profits. There are certain factors that will affect hedge funds such as the low-interest rates and low volatility so you may want to consider this when buying. But across the board, hedge funds have had a good share of poor returns. Some investors have withdrawn their funds because of failing to see much value from them. But there are still others who have made a kill. The trick is to understand the kind of risk involved and returns you are likely to receive prior to buying.

How to Buy Hedge Funds

Hedge funds present far more flexibility than mutual funds mainly because they are designed to attract the sophisticated investors. There are a number of things you need to understand when buying a hedge fund.

For a start, you need to know that there are fees which have to be paid to the fund managers. Fund managers can receive one of these two forms of compensation: assets under management (AUM) fee and incentive fee. Thus, the fee structure will appear something like 2 and 20% which means the AUM fee is 2% of assets and the incentive fee is 20% of all profits. There are certain fee caps that may be put in place to prevent fund managers from taking too many risks. There is also a tax bill that you may have to settle. So, in general, hedge funds have hefty fees and taxes which you need to consider.

Secondly, you need to understand how leverage and short selling works. These two are great tools for hedge funds, but they may present a great risk. Hedge funds attempt to reduce risk but mainly maximize the return on investment. That is why fund managers will try to hedge against a low performing market by shorting the market.

Nowadays, there are so many strategies that have been used in hedge funds. Each hedge fund strategy is structured in such a way that it will take advantage of certain market opportunities when they arise. The strategy used will determine the risk attributes and investment opportunities that are available with the hedge fund. Because hedge funds are very diverse, the investors can have a wide range of choices as to what they want to invest in and how.

Hedge funds usually require a large initial minimum investment and they are only limited to a number of accredited investors. It’s also important to understand that the investments are illiquid which means that you will not be able to withdraw your money in the fund for at least one year which is known as the lock-up period. Withdrawals are not allowed whenever you please. They usually happen at certain intervals, which could be quarterly or bi-annually.

Hedge funds can be a suitable form of investment if you want to put away a sizeable amount of money and diversify your portfolio. A well-diversified portfolio will consist of hedge funds and this is one of the best ways to maximize ROI.

 

The Risks involved in Hedge Funds

Investing in a fund of hedge funds does have some potential risks. Even though it offers a lot of flexibility and diversification, there are certain risks that you need to be aware of. Let’s look at each one of them in the section below.

Unregistered investments

Since hedge funds are generally not subject to the SEC’s registration, it becomes difficult for the investor or even the fund manager to verify the information that has been reported or even analyze the performance of the hedge fund. It becomes easy for an unscrupulous fund manager to engage in fraudulent activities.

Too many investment strategies

Many of the investment strategies involved when investing in a hedge fund are just too risky. Most of the hedge funds present a high risk of capital loss especially when the wrong strategy is in use. It’s easy to wipe out your entire life’s investment. If you consider yourself a conservative investor who cannot afford to lose all you have then perhaps hedge funds are not for you.

Illiquidity

Hedge funds are very difficult to transfer or resale. This illiquidity is what makes them a suitable form of investing for wealthy individuals who want to put their money on a long term basis. You may want to sell your hedge fund units and get out of the investment but fail to get a market for it.

Pricing risk

The assets in which the hedge fund invests can also be quite complicated. It may be a challenge to price these securities appropriately which puts the investor at risk.

Settlement risk

If one or more parties involved in the transaction fail to deliver the securities then you risk losing all your investment. This is a kind of risk you cannot afford to take if you are not ready to deal with losing a lot of money.

The other issue is that hedge fund managers are simply trying to time the market and this can be very difficult to do. When an unexpected economic event occurs, you risk losing all your investment even though the fund had shown a positive long-term trend. In case the fund loses money, the managers do not get a percentage of that loss. This means that the fund managers are not exposed to the same level of risk as the investors. In turn hedge funds become very risky to investors who may lose all their money.

There are risks in all types of investments, be they stocks, mutual funds or hedge funds.

The Different Hedge Funds Available

Hedge funds can be broken down into any number of categories depending on the investment strategy that is being used. We are going to look at some common types of hedge funds and when you should consider buying them.

Directional funds

Fund managers of directional funds will take a very high risk in an attempt to obtain a higher than expected return. Directional funds are somehow exposed to the fluctuations in the stock market. Some people claim that they have stock-like returns which simply mean that the funds returns will not be steady all year round but will fluctuate from time to time. Directional funds are known to give very big returns in certain years and plummet terribly in others. But if you are a long term investor then this shouldn’t be a problem especially if there is a positive upward trend.

Non directional or absolute return funds

Regardless of what the market is doing, an absolute return will give you a steady flow of income. This happens because the fund manager has attempted to eliminate all the market risks so that your fund is not dictated by the market performance. Once all the market risk is removed, the performance of a non-directional fund is solely based on the manager’s skill. This is one of the best forms of investment for a conservative investor because it offers a much lower risk than directional funds and can give some returns. Absolute return funds have been likened to investing in bonds because of their relatively steady nature and also low returns.

Equity long-short

A fund manager may choose to purchase long positions in stocks that are expected to appreciate in value and at the same time short-sell equities which are expected to decline. This means that the fund can sell equities that it actually never owned or intended to own. In a scenario where the long positions balance the short then the fund can take a neutral strategy. This fund typically takes both long and short positions in the hopes that they will outperform the general market.

There are other types of hedge funds such as the market-neutral funds and event-driven funds. Event-driven funds as the name suggests, attempt to take advantage of market events such as mergers and natural disasters or political turmoil to obtain higher returns. Macro funds are also another type of mutual funds that take directional bets on the market based on factors such as the fund’s philosophy.