Discussing investment options is often a complex topic that can demand significant knowledge and understanding of economic principles. Since investors often come from unrelated fields, bringing these topics closer is essential. So, the topic of what a hedge fund does is a way to remove fog from this somewhat ominous topic.
Hedge fund is a pooled investment vehicle, that utilizes a wide array of strategies to generate higher returns. These come with the risk involved, but a special breed of investors is ready to take it on. Hedge fund managers with their expertise are finding securities appropriate for their investment approach and risk levels and placing their bets.
One important aspect to consider when evaluating hedge funds is their assets under management (AUM). AUM is significant as it can indicate the size and reputation of a hedge fund, although it does not guarantee better performance. Careful consideration is needed when selecting a hedge fund manager based on AUM.
Due to the complexity of the topic, we will leave no stone unturned. We will define hedge funds in depth, explain their strategies and risks, and go through the positive and negative sides of hedge fund investing. This article should give you headway in making a decision about investing in hedge funds.
Key Takeaways
- A hedge fund is a pooled investment vehicle, meaning it gathers capital from investors and invests it into various asset classes and securities.
- While it can deliver above-average returns, it also comes with numerous risks. The success of a hedge fund is driven by its team, strategy, and the market landscape. Hedge fund strategies, such as equity long/short, global macro, distressed securities buying, merger arbitrage, and fixed-income arbitrage, play a crucial role in determining the fund's performance.
- Investing in hedge funds demands in-depth due diligence, and aligning investor’s goals with the goals of the fund.
Hedge Fund Structures
Hedge funds are usually structured as limited liability companies (LLCs) or limited partnerships (LPs).
LLC can be viewed as a hybrid business that combines characteristics of corporations and partnerships. They are formed by members or owners who have flexibility in management and structure. Members share a limited liability meaning that they are not personally responsible for hedge fund debts.
A limited partnership consists of a general partner (GP) and one or more limited partners (LPs). The GP is responsible for the debts and operations of the fund, while LPs are in most cases passive investors with limited liability. The level of liability depends on the amount they brought in the fund.
Defining Hedge Funds
A hedge fund is an alternative investment vehicle that offers a diverse approach to investing that can bring solid gains. Unlike mutual funds or similar investment organizations, hedge funds can combine sometimes risky techniques, like leverage, and have access to uncommon asset classes like derivatives, or distressed securities. Mutual funds, on the other hand, are available to the general public, are more regulated, and primarily focus on stocks and bonds. Investors can easily cash out of mutual funds, unlike in hedge funds, which often have lock-up periods.
What hedge funds set apart from other investment forms is the constant chase for generating alpha, meaning its focus on beating benchmark indexes. ETFs, mutual funds, and similar forms of investments often do not compete with indexes, and only try to replicate their results.
Hedge funds never settle for gains that are measured by indexes. Hedge fund managers would either bet everything and hit big, or sustain a hit. Fund’s investment strategies sometimes employ approaches that profit from falling markets which is rarely seen from other investment vehicles.
A regulatory environment that is rather loose in the case of hedge funds, allows them to use high leverage, and some controversial strategies, like shorting. These can be the key factor in overachieving, but can also bring major downturns to investors’ capital.
Who Can Invest In Hedge Funds
Similar to venture capital firms, hedge funds only deal with accredited investors. These high-net-worth investors must get accredited status from the Securities and Exchange Commission (SEC). These regulations demand that an individual has a $200 thousand annual income or $1 million net worth.
A significant portion of hedge fund capital comes from institutional investors, such as pension funds and insurance companies. These institutional investors are typically the primary investors due to their ability to meet the higher risks and fees associated with hedge fund investments.
And this is not the end of it. Even if the investor becomes accredited, he must find a fund that will accept his capital. There are closed-off hedge funds that accept capital only from employees, or by a recommendation. So, becoming an accredited investor is not the end of it. The next step is to find a suitable fund.
Hedge funds depending on the size and exclusivity can have a large minimum investment threshold that can be even several million dollars. Depending on the size of the fund, the figure varies. Smaller funds accept initial investments in the range of $100 to $500 thousand. Mid-tier funds deal with investors with $500 thousand to a million. Top-tier funds will rarely accept less than a million, while the figure can go astronomically high.
Upsides Of Investing In Hedge Funds
Professional Management
While many think that the first and crucial upside of investing in a hedge fund is potential high returns, we think that professional management is the key. While all investment vehicles employ professionals, to work at a hedge fund managers must be at the top of their class. They usually start their careers in ETFs, mutual or pension funds, and from there move to the hedge fund big leagues.
Not only do they employ top professionals, but they are actively developing new strategies and finding ways to generate higher gains. They do not ponder about Russell or S&P's performance, they are there to beat it.
Innovative And Diverse Hedge Fund Strategies
Most hedge funds combine different strategies, and the most frequently used are short/long equity, event-driven, global macro, distressed securities, and arbitrage strategies. Hedge fund strategies encompass diverse investment approaches, covering a range of risk tolerances and philosophies.
For instance, equity long/short involves buying undervalued stocks and shorting overvalued ones. Global macro strategies focus on large-scale economic and political changes. Distressed securities buying targets undervalued companies in financial trouble.
Merger arbitrage involves exploiting price differences during mergers, while fixed-income arbitrage capitalizes on pricing inefficiencies in bond markets. Besides strategies, funds can be invested all over the world. Utilizing so many different approaches on different parts of the globe is an upside because it offers the investors potential for diversification and lower risk.
What is another benefit of this investing approach is often low correlation to traditional asset classes. What does this mean in reality? It can provide a significantly lower risk level in case of a market downturn.
What is important to note is that these strategies are not set in stone. If something is clearly not working, managers will often rethink their approach and change the strategy. This can take them to often uncharted territories that can generate even higher returns than those before.
Investors who are looking for a potential big upturn find hedge funds the only way to invest. Since hedge funds employ risky strategies, combined with using borrowed money returns in a case of success can be substantial. Depending on their personal investing goals, investors can find a short or long-term strategy that can suit them, and combine it with a preferred risk level.
Potentially High Returns
Due to the use of multi-layered strategies that often hit both ends of the market, and the extensive use of leverage, hedge funds if successful can deliver returns that mutual funds and ETFs cannot dream of. Hedge funds in the top tier usually go around 30% annual gains, however, there are numerous funds that underperform the S&P 500 index.
Several factors impact the success of the fund, while fund managers, strategies used, and market landscape are at the top of the list. Before placing investments accredited investors should check the track record of the fund. While it cannot predict future returns, it can show crucial information about the fund.
Risk Management
To counter those high risks, hedge fund managers over the years developed several ways to mitigate risk. The first way is to diversify the portfolio. If the investments are divided amongst sectors and geographies, there is less of a chance of being hit by one issue on the market.
There is a different school of thought that says that funds should specialize in markets and sectors. Yes, there are upsides to that, and these funds employ different strategies to lower the risk. They have a deep understanding and expertise in the field, and they can manipulate with different levels of leverage to adjust their risks.
Also, what most hedge funds use are tactics like stop/loss orders when a security is automatically sold when it reaches a certain price. This way the fund protects its investment and minimizes the loss. Taking long and short positions is another way to win the market. The fund can win in any direction the market is taking, either by betting long on good stocks, or short selling underperformers.
Downsides Of Investing In Hedge Funds
When going through these upsides one must be thinking, is this too good to be true? Well, it can be, but there are certainly downsides and risks that hedge fund investors must think about.
High Risk
The most obvious problem is high risk. Yes, it is nice to be able to beat the market and earn a massive gain at the end of the year. But, it is not nearly as interesting when a sudden market downturn in a specific sector can turn a hedge fund strategy upside down. No matter the level of diversification, there are always risks of underperformance that can come from numerous reasons.
Sometimes the management is hardly to blame, like a macro risk that came up out of nowhere. In other situations, bad operational positioning can leave major parts of the portfolio exposed to multi-level risks. A hedge fund manager is not a magician, and no matter the experience or knowledge can make a mistake that can be costly.
Investing in non-traditional assets hedge funds may aim to diversify or maximize their returns, but potential can harm the investor. This factor also comes as a part of the risk, but accredited investors must be aware of the approach their fund is taking.
The high risk involved is one of the reasons why the accessibility to hedge funds is so low for regular investors. Unavailability could be seen as a downside, but in some way, it is protecting an average Joe from losing all his money on one investment.
Low Liquidity
Lower liquidity is one of the factors closely tied to high risk. Many hedge funds opt for investing in liquid assets, but most of them in some part rely on less liquid investments. Those include investments in debt, special situations like mergers, and acquisitions, or when funds invest in private equity.
Investment Redemption
No matter of liquidity, investors should accept that redeeming an investment with hedge funds is not that easy. After making an initial investment, most hedge funds have a lock-up period. Depending on the strategy it can be one or even several years. When it passes, the investor must demand a redemption, and then wait for the approval from the fund.
Transparency And Reporting Practices
One of the most discussed downsides of hedge funds is the lack of transparency and reporting practices. However, this varies between funds and their policies, and finding a transparently operating hedge fund is possible for sure.
Hedge funds during major crises got a bad rep due to often unethical approaches, including insider trading, conflict of interest, and market manipulation. Several hedge fund managers got convicted on these charges and gave the industry a bad name.
High Fees
Hedge funds charge a unique fee, that is composed of a performance fee and a management fee. Before it was usually a 2/20 fee structure with 2% being the management fee which managers earn from total assets under the management of the fund. 20% represents the bonus the manager gets if the investment outperforms the threshold that was set earlier.
Due to lower hedge fund returns in the last decade, and the emergence of passive investing, some hedge funds decided to lower their fees. This was seen as a great way to attract new investors and bring new capital to the market.
So, this is where comes due diligence in. When you decide to invest in hedge funds, you need not only to check their approach, risk management strategy, and track record, but their culture and ethical views. It doesn't matter much if the fund delivers above-average returns if the investor is not fine with the way they are conducting investments.
How To Invest In Hedge Funds
Before an investor decides to invest with hedge funds he should first check other ways to boost personal finance. Besides hedge funds, there are pension funds, ETFs, and mutual funds, that are a bit conservative in comparison but can provide a stable income.
If the hedge fund is the chosen way to invest, investors should conduct due diligence regarding preferred investment strategies, risk management, and track records. Consulting a financial advisor is also recommended because professionals can shed more light on this complex topic.
An investment strategy should be complemented with an exit strategy. An investor should define goals regarding returns, losses, and other crucial factors that can impact the future of investment.