Hedge funds are a type of alternative investment that pools capital from institutional or individual investors to invest in diverse assets. They often rely on complex strategies to manage risk and build their portfolio. Hedge funds are able to invest in real estate, currencies, and other alternative assets. This is one of the many ways hedge funds differ from mutual funds which typically only invest in stocks and bonds.
They were designed to generate returns regardless of market conditions. They have been branded as immune to market forces. However, performance analysis shows this may not be true.
It is important to understand what hedging means in order to fully comprehend what a hedge fund does. Many hedge funds were created to reduce risk. Risk is a function of the return, meaning that the greater the risk, the greater the return.
However, a hedge fund manager can reduce risk while still maximizing investment income. She may be able to find ways to eliminate some risks and take on others that offer a good return.
Risk is the key to return, so no matter what hedge fund strategy, risk will always be there. Hedge fund managers face the challenge of balancing risk and maximizing return. This is why they are paid well if they succeed.
Characteristics for Hedge Funds
These unique strategies can sometimes lead to enormous gains, while traditional market measures may languish. Hedge funds are more attractive than many qualified and accredited investors because of the potential return. Hedge funds are basically
Hedge funds can be volatile. Hedge fund managers restrict how often investors can withdraw their money. A fund might lock in investors for up to two years. Because the money you invest in a hedge fund may be held for many years, it is a long-term investment.
Exempted from most regulatory oversight
Hedge funds do not need to register with U.S. Securities and Exchange Commission. Neither are their managers required by the Financial Industry Regulatory Authority or Commodity Futures Trading Commission.
These are the two major self-regulatory bodies for the investment industry. Many funds do register with these organizations to provide investors with peace of mind and protections not offered to others (not to mention protection from losing their money). Hedge funds, regardless of whether they are registered, can’t commit fraud or engage in insider trading or violate any other laws.
Only qualified investors
Hedge funds must only accept money from qualified or accredited investors, which are people and institutions with high networks. This is to ensure that they don’t fall under strict regulations. Each of these requirements makes sure a Hedge Fund is right for you.
Aggressive investing strategies
A hedge fund manager can use a wide range of investment strategies, including short selling and leverage, to achieve a higher level of return while taking on more risk than expected. This is possible because he has access to many investment options that aren’t available to a strictly regulated investor. This is why a hedge fund’s relative lack of regulatory oversight is so important.
Types Hedge Fund
Absolute return funds
An absolute-return fund, also known as a non-directional fund or a fund that generates a steady return regardless of market movements, is sometimes called a fund with no direction. A pure-alpha fund is another name for an absolute return fund.
The fund manager attempts to eliminate all market risk, also known as beta risk, in order to create an investment that is consistent with the market. The manager must remove all market risk so that the fund’s performance is entirely dependent on his skill. This is alpha, in academic terms.
A strategy that is absolute-return is best suited for conservative investors who are willing to take some risk in return. Absolute return fund managers can generate a bond-like yield. This is because they have similar returns to bonds but with relatively stable returns.
An absolute-return fund’s return target is typically higher than that of bonds. The typical target for an absolute return fund is 6-8 percent. This is higher than the long-term return on bonds but lower than the long-term return on stocks.
Hedge funds that don’t hedge, or at least not completely, are called directional funds. Although they have some exposure to the stock market, managers of directional funds try to achieve higher-than-expected returns given the risk they take.
Beta funds are directional funds that have some exposure to the stock market. They can be described as having a stock-like return. Although the fund’s returns might not be consistent from year to year they are more likely to remain steady over the long term than absolute-return funds.
Although the return on directional funds may be greater than the risk, it is still a risk. These funds can swing wildly, with large returns in some years and big drops in others. As long as there is an upward trend, investors who are longer-term may not mind.
How Hedge Funds Work
Hedge funds are able to invest capital in any market, through almost any strategy. It is difficult to define what a “typical” hedge fund does. There are some common characteristics, however: A preference for public markets investments and a tendency not to use traditional trading techniques like derivatives or short-selling.
Hedge funds can be structured as limited partnerships. The hedge fund pooled money from its limited partners to invest it for them. Hedge funds can be more aggressive in investing by limiting themselves to accredited investors, as they are not subject to the same strict regulation as mutual funds.
Managers use sophisticated strategies such as leverage, short positions, and derivatives-like options. They can also invest in a variety of markets including stocks, bonds, and commodities. There are many opportunities to make money.
Hedge funds can be very volatile investments. There are restrictions on when you can buy in and withdraw, as well as a lock-up period that can last several months to many years. This allows fund managers to be more aggressive without having to provide liquidity at all.
Hedge Fund Fees
Hedge funds can be expensive for many reasons. Fund managers who find a way to achieve a higher return while taking on a greater risk should be compensated for their efforts. There are many other fees that fund managers receive, in addition to the performance and management fees they receive.
Hedge funds can be expensive to manage. General partners of a fund must pay for many aspects of the business including rent and utilities, research fees, specialized software and brokerage commissions, salaries for fund managers and staff, as well as fees for accountants and lawyers who provide professional services to the fund.
Management fees are usually 1% to 2% of fund assets. These fees are typically due at the end of each fiscal year. There are some funds that charge higher fees, especially for strategies that require extensive research and associated expenses such as shareholder activism. Some funds charge a fee but only pay a portion of it. Other funds pay other bills directly from their assets, including legal and accounting costs.
No matter how well the fund performs, a hedge fund manager gets a management fee. The fee increases if the fund’s assets rise. A 20% investment return equals a 20% increase in management fees. Two percent of $60,000,000 is greater than two percent of $50,000,000.
Hedge funds have expenses throughout the year. Hedge funds can require money upfront to be able to operate. In these cases, they may charge upfront sales fees, often at the same rate as management fees (1 to 2%) which is deducted from the investment amount. Funds can charge a sales fee to cover their expenses and pay staff until they receive management fees or performance fees.
As a reward for achieving high returns for investors, hedge fund managers may charge performance fees. Hedge funds have many appealing features. Their incentives align with the goals of their investors. The fund manager is not paid if the fund does not make money.
Many hedge funds are set up under the 2 and 20 arrangement. This means that the fund manager gets a 2 percent annual fee and a bonus equal to 20% of the year’s profit.
Fund managers have to be aware that performance fees can come with a drawback. The fund is only paid if it makes a profit. Most funds set a high watermark. A performance fee can only be charged if the fund’s assets are back to their pre-loss. The manager cannot charge a performance fee if the fund has $10 million in assets and loses 10 percent. This would make the asset worth $9 million.
Redeeming fees are often charged by hedge funds when investors withdraw their money. These fees can be anywhere from 1 to 2 percent of assets. Hedge funds want their limited partners to understand that investing is a long-term venture and they cannot get out quickly.
The general partners must also deal with the administrative and sales costs associated with raising the funds to redeem the shares. Funds charge redemption fees because they can. This also helps the fund manager make more money.
If the hedge fund charges a redemption fee, it may waive it if the investment has been held for a specified amount of time or you give a specific amount of notice when you intend to withdraw the funds.
A broker or consultant who helps you find the right hedge fund will be compensated. You may be charged a flat fee or a percentage of assets invested by the consultant.