Hedge funds are among the most popular investment vehicles for wealthy individuals and institutional investors. And it’s no wonder why. Hedge funds offer a unique combination of potential return, downside protection, and diversification that are not found in any other asset class.
But what exactly is a hedge fund? This blog post will give you a crash course, sort of a hedge funds 101. We’ll cover everything from how hedge fund managers structure hedge funds to what kinds of strategies they employ. By the end, you should understand what hedge funds are and how they work.
What are hedge funds?
Hedge funds pool money from high net asset investors and invest in various assets, including stocks, bonds, short positions, futures contracts, and commodities. Hedge fund investors invest intending to get positive returns on the capital. However, they are not regulated as much as mutual funds and have more leeway than mutual funds. Therefore, investments in hedge funds and hedge fund strategies may increase the risk involved in investment losses. In addition, although hedge funds invest in various assets, their management fee is higher. So hedge funds are limited to wealthier investors who can afford the higher costs and risks of hedge fund investing and institutional investors, including such funds like pension funds.
What is the difference between a hedge fund and a mutual fund?
The Securities and Exchange Commission (SEC) regulates mutual fund investments while banks and investment firms offer them to the public for daily trading. They are less risky and yield less than hedge funds. Mutual funds also have a lock up period of a minimum of 3 years. During the lock up period, the investor is prohibited from redeeming the units of the fund, either partially or wholly.
In contrast, hedge funds are private investments that use higher-risk investing strategies and are only available to qualified investors. Hedge funds typically have a lock up period which can range from 30-90 days. Thus, giving the hedge fund manager time to exit investments without driving prices against their overall assets under management portfolio.
Hedge funds employ a hedge fund manager to manage the fund’s investment strategies, ergo the reason for exorbitant management fees and the performance fee. Hedge funds typically charge a 2% management fee. The management fee is based on the net asset value of each investor’s share. Aside from the management fee, a performance fee is 20% of the hedge fund’s profit which is given to a hedge fund manager as an incentive. It is used to motivate a hedge fund manager to take more significant risks to generate a higher return.
Mutual fund managers passively manage mutual funds. This means that the fund manager does not actively seek new investment opportunities. Instead, the fund manager maintains the portfolio as specified by the fund’s investment objectives. As a result, the expense ratio for mutual funds is much lower than hedge funds because there is no performance fee.
What are the benefits of investing in a hedge fund?
Diversification
One of the benefits of investing in a hedge fund is that it allows you to diversify your investment portfolio. Investing in several different assets under management can spread out your risk and potentially avoid losses in any particular investment.
Potential for high returns
Another benefit of investing in a hedge fund is that many hedge funds offer the potential for high returns. Experienced hedge fund managers often manage hedge funds that use various hedge fund strategies to generate above-average returns.
Access to new and alternative investments
Investing in a hedge fund can also give you access to new and alternative investments you may not have otherwise had the opportunity to invest. Hedge funds often invest in select investments not typically available to retail investors, such as private equity and real estate.
What are the risks of investing in a hedge fund?
Loss of capital
One of the risks of investing in a hedge fund is that you could lose all or part of your investment. As a result, hedge funds are generally considered to be riskier than traditional asset classes, such as stocks and bonds.
Lack of liquidity
Another risk of investing in a hedge fund is that it can be challenging to sell your investment. Hedge funds are often not traded on an exchange, making it difficult to find a buyer for your investment. And they have a lock up period which prevents you to sell your hedge fund assets whenever you want to.
High fees
Investing in a hedge fund can also be expensive. Hedge funds typically charge high maintenance fees and an additional performance fee, which can affect your investment returns.
What are the types of hedge funds?
There are many different types of hedge funds, but some of the most common include the following:
Equity hedge funds
An equity hedge fund may be global or country-specific, investing in attractive global assets while hedging against downturns in equity markets by shorting overvalued stocks or stock indices. A relative-value hedge fund takes advantage of price or spreads’ inefficiencies.
Fixed-income hedge funds
A fixed-income hedge fund strategy gives investors guaranteed returns with minimal monthly volatility. It aims for capital preservation, taking both long and short positions in fixed-income securities.
Macro hedge funds
Hedge fund managers actively manage global macro hedge funds that attempt to profit from broad market swings caused by political or economic events. Global macro hedge funds are market bets around economic events.
Managed futures funds
Managed futures refers to an investment where professionals actively manage a portfolio of futures contracts. Managed futures are considered an alternative investment that institutional investors use to provide portfolio and market diversification.
Multi-strategy hedge funds
Multi-strategy hedge funds are the most diverse portfolios in the hedge fund universe. Multi-strategies combine different single investment strategies in one portfolio and differentiate considerably from each other. Such portfolios often include a variety of long-short, relative value and event-driven investment strategies.
How do I choose a hedge fund?
The best way to choose a hedge fund is to consult a financial advisor. However, there are some things you should keep in mind when choosing a hedge fund, such as the management fees involved and the fund’s investment objectives. You should also consider the hedge fund’s performance over time and the fund manager’s track record. Knowing these things will help you make the best decision for your investment needs.
How do hedge funds work?
Fund managers here do their best to reduce or remove market exposure and generate good returns despite the market movement. They function in small market sectors to reduce risks by more diversification. Some of the strategies that hedge fund managers use are:
Short-selling
This strategy involves selling fund assets you do not own and hoping to repurchase them at a lower price so you can profit. Here, the investment manager, hoping to drop prices, can sell shares to buy back in the future at a lesser price.
Going long on the market
This investment strategy is the complete opposite of short-selling. You buy fund assets when the prices are low and wait for the prices to go up so you can sell them at a higher price and make a profit.
Derivatives trading
This strategy involves trading in contracts that derive value from an underlying asset. For instance, major market events like acquisitions, mergers, and spin-offs can influence a fund manager’s investment decisions.
Arbitration
This strategy is when you take advantage of the differences in prices of the same fund asset in different markets. Sometimes related securities may have contradictory or inefficient pricing. Managers use this to their advantage.
Invest in securities with high discounts
Some companies facing financial stress or even insolvency will sell their securities at an unbelievably low price. The manager may decide to buy after weighing the possibilities.
How do I invest in hedge funds?
It’s important to note that hedge funds are geared toward a high-net-worth individuals who are accredited investors. This requirement reassures fund managers that they are financially capable of investing. According to the Securities and Exchange Commission (SEC), an accredited investor is someone who can tick off at least one of the following boxes:
An accredited investor must have an income that consistently surpasses $200,000 ($300,000 for married couples)
A wealthy individual with a net worth exceeding $1 million (excluding the value of their primary residence), regardless of their marital status.
An accredited investor is a qualified and licensed financial professional, such as a registered broker, investment adviser, or investment manager.
What is the best way to learn about hedge funds?
If you’re interested in investing in hedge funds, the best way to learn about them is to speak with a financial professional. They can provide information about how hedge fund investments work and their risks. Additionally, they can help you determine if investing in hedge funds is right for you based on your financial goals and risk management and tolerance.
The Wealth Map can help guide you to some of the best resources for learning about hedge funds and other investment strategies. In addition, our financial experts can provide you with personalized advice and help you develop a plan tailored to your unique needs.
What are some other things I should know about hedge funds?
Hedge funds are complex investment vehicles, so it’s important to understand how they work before you invest. Here are a few things to keep in mind:
Hedge funds are private investments, so they’re not subject to the same regulations as public investments.
Hedge funds are often highly leveraged, which means they carry a higher risk of loss.
Hedge funds typically have high fees, so they’re only suitable for people who can afford them.
Hedge funds are often illiquid, which means you may be unable to access your money for some time.
If you’re considering investing in hedge funds, speak with a financial professional to get started.
What should you consider before investing?
When investors research to find the appropriate hedge funds, they generally look at the size of the fund’s assets, track record and longevity of a fund, minimum investment required, and redemption terms. However, according to the SEC, investors should also make the following investment decisions:
1. Determine your investment objectives.
2. Consider your risk tolerance.
3. Review the fund’s offering documents.
4. Ask questions and get answers in writing.
5. Make sure you understand the management fee involved, including the performance fee.
What tools can investors use to compare the performance of hedge funds?
Investors look at annualized returns to compare hedge funds to identify investments with high expectations. An investor may use an analysis tool such as Morningstar to establish guidelines in a particular investment strategy to locate an array of similar funds. This tool will give the investor an idea of what returns are associated with a certain level of risk. Additionally, some investors compare individual hedge funds to relevant investment benchmarks, such as the S&P 500 Index for large-cap equity funds or Barclay’s Aggregate Bond Index for bond funds. By understanding how a fund has performed compared to its peers and a market index, investors can better understand the fund’s relative risk and return. Finally, some investors consider qualitative factors, such as the experience and tenure of a fund’s management team, when making investment decisions.
Conclusion
Hedge funds can be complex investment vehicles, so it’s essential to understand how they work before you invest. Speak with a financial professional to get started. Additionally, ensure you understand the management fees involved and consider your risk tolerance to the risk involved before making any decisions. Use tools like Morningstar to compare the performance of different hedge funds to make the best decision for you.
The Wealth Map is an investment company with the best resource for learning about hedge funds and other investments. In addition, our financial experts can provide you with personalized advice and help you develop a plan tailored to your unique needs.
Get started on your hedge fund investing journey today by scheduling a consultation with The Wealth Map.
