What are hedge funds?

A hedge fund is a form of alternative investment that pools capital from individual or institutional investors to invest in varied assets, often relying on complex techniques to build its portfolio and manage risk. Hedge funds can invest in anything from real estate to currencies and other alternative assets; this is one of many ways in which hedge funds differ from mutual funds, which normally only invest in stocks or bonds.

The aim of all hedge funds is to maximise investor returns and eliminate risk, regardless of whether the market is going up or down.

Their popularity is often attributed to the US bull markets of the 1920s, prior to the great depression. Today, hedge funds have several trillion dollars are under management.

Investment strategy

Hedge funds are generally seen as aggressive and risky, particularly when compared to mutual funds. This is down to the way they invest.

While every hedge fund will have its own specified investment strategy, the idea of ‘hedge fund’ derives from the agency of the fund manager (or ‘general partner’) to implement certain trading tactics, such as shorting stocks (if they anticipate a drop in the market) or ‘hedging’ themselves by going long (if they foresee a market rise).

As you can see, much depends on the ability of the fund manager to anticipate shifts in the market and react accordingly.

What do hedge funds invest in?

Land, real estate, currencies, derivatives and other alternative assets – in short, anything. The only thing limiting the scope of any hedge fund is its mandate.

Hedge fund types

Since hedge funds are private investment vehicles, they can do more or less whatever they like so long as they are upfront about their strategy to investors. (The investment strategy is normally outlined in a prospectus for investors to read before they invest.) While this degree of latitude can prove highly risky, it also affords hedge funds a huge amount of flexibility.

Hedge fund strategies can focus on:

  • Macro – invests in stocks, bonds and currencies in the hope of profiting from changes in macroeconomic variables (e.g. global interest rates, economic policies etc)
  • Equity – invests in stocks globally or nationally while hedging against downturns in equity markets by shorting overvalued stocks or stock indices
  • Relative-value – takes advantage of price or spread inefficiencies
  • Activism - manager manipulates fund volatility by changing the board of directors, appointing new management or pushing for the sale of a company

In addition, it is possible for a hedge fund to take a ‘fund of funds’ strategic approach by combining other hedge funds or pooled investment vehicles. The aim here is to better control the volatility, risk and returns of the umbrella fund by strategically mixing the underlying strategies and funds.

What returns can I get?

It’s difficult to generalise on the potential returns of hedge funds, since whether or not they make money depends more heavily on the decisions of each fund manager rather than on current market conditions. In this way, hedge funds may be thought of as closer to trading than typical investing.

Can I invest in a hedge fund?

That depends on your net worth. Hedge funds are open only to accredited or qualified investors who have a net worth exceeding $1m (excluding their primary residence) or an annual income of over $200,000 maintained for the previous two years. This is part of the reason the hedge fund market is dominated by big companies why hedge funds face little official regulation, especially compared to mutual funds, pension funds and other investment vehicles.

Retail investors wanting to invest in a hedge fund may be able to take a less direct route by buying into a fund that then goes on to invest in hedge funds (sometimes known as a ‘fund of funds’). These tend to be big funds that invest into a spread of hedge funds with the aim of minimising the overall risk. As a result, such funds can prove highly expensive since you’re in effect paying more than one set of fees: the fees for the the original fund and the fees for every hedge fund it invests in.

What fees will I pay?

Due to the necessarily active management of hedge funds as well as their potential to provide high returns, the fees charged for participations are often very high. The basic fee normally falls at around 2% of assets under management, and is accompanied by a performance fee on any gains generated.

This structure is a bit of a hard sell for many investors since the fund manager gets the asset management fee – which can run into the millions – regardless of how well the fund performs. However, it is worth noting that part of the reasoning here is that hedge fund managers tend to have their own money in the game, which helps align their interests with those of the fund performing well.

The most common fee structure is known as ‘two and twenty’: a 2% asset management fee plus a 20% cut of any profits returned.

Benefits vs risks

Benefits:

  • A wide choice of investment strategies
  • The potential to generate positive returns in both rising and falling equity/bond markets
  • Can play a part in diversifying a balanced investment portfolio
  • Access to some of the world’s most talented investment managers

Risks:

  • Dependence on the investment decisions of the fund manager
  • Concentrated investment strategies can expose funds to potentially huge losses
  • Typically lower level of liquidity than mutual funds, meaning your money may be locked up for years

As with any investment, there are pros and cons to investing in hedge funds, and it’s ultimately up to you to determine whether or not your financial aims align. If in doubt, seek the guidance of a financial adviser.

Things to remember

  • Hedge funds vary massively in terms of investment strategy, risk, potential returns and volatility, so read through the fund prospectus carefully before you invest
  • Fee structures also differ from fund to fund, with managers often charging high fees unrelated to overall fund performance
  • There are many different types of hedge fund available; make sure whatever investments you pick align with your long-term investment objectives

As with any investment, if you are in any doubt you should seek independent financial advice.

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