Hedge funds have been for decades one of the favorite picks for wealthy investors in search of high returns. Hedge fund strategies are often risky, but are very diverse and can offer a suitable investment approach for almost everything. Why some people invest in hedge funds is an all-time favorite, and that is why we will try to dive deeper into the reasoning behind it.
Among a series of investment vehicles like mutual funds and index funds, hedge funds always stood out from the crowd. While other funds offer modest to low returns, hedge fund investment has a solid chance to generate substantial returns. They also offer a unique level of asset diversification, accompanied by complex risk management strategies.
With potentially high returns, come greater risks. Leveraging capital for amplifying investments can lead to massive losses. Also, it is not unknown for short-term bets to go astray. That is why not everyone can invest with hedge funds. Stay with us while we dissect this topic, after which you will know why hedge funds are attractive, and if that is the way for you to go.
Key Takeaways
- Hedge funds offer potentially high returns, drawing wealthy investors.
- Due to the diverse array of strategies hedge funds can offer an investment plan to almost every investor.
- Besides potential upturns, hedge funds also have several off-putting characteristics. Long lockdown periods, high risks, above-average fees, and low transparency plague hedge fund operations.
Hedge Funds As An Attractive Way To Invest
While the majority of individual investors choose passively managed funds, a specific type of risk takers refuse to accept returns that are in the margin with the index that the fund is tracking. They are looking for investment techniques that include significant risk that can generate high and consistent returns in all market conditions.
Although this looks like an impossible task to accomplish, there are hedge funds that managed to do just that. Of course, bad periods can come from time to time, but these funds, with their investment strategies, are beating the indexes most of the time.
The hedge fund industry is changing, and hedge fund managers must adapt. Those who manage to do it, will not have problems drawing new accredited investors and continuously generate high returns.
These high-performing hedge funds often offer a wide array of asset diversification, ranging from public and private equity, real estate, commodities, and currencies, to gold.
Due to their often high-risk bets, hedge funds employ several risk-mitigating strategies to lower potential losses. Stop/loss orders, position sizing, and asset diversification are just a few.
Benefits Of Investing In Hedge Funds
Active Management And Abundance Of Strategies
The excitement of investing with hedge funds lies in making bets that the investments are going to beat the index. While the majority of investment vehicles are trying to replicate the index performances and choose the same assets, hedge funds offer something different.
Managers are actively investing, meaning they make their own picks from the stock market. This way they make a unique blend of investments with a potential for beyond average returns.
Besides their active investing approach, hedge funds can employ several strategies to make this come true. Some of the most popular strategies are:
- Global macro
Focus on finding chances in the volatile periods in the market due to major global shifts.
- Long/short equity
Investing in both short and long positions aims to generate gains from both market directions. While long positions create gains in the long run, short positions do that in the short term.
- Trend following
From time to time, a specific trend emerges that is capable of delivering extravagant returns. Sometimes that is an asset class, while in other cases a trend is in a specific industry, or in a handful of companies.
- Event-driven
Unlike global macro which is looking for shifts on a global scale, event-driven strategy is focused on companies that could go through events that can majorly impact their stock price. Those can be acquisitions, mergers, bankruptcies, or similar breakthrough scenarios.
- Market neutral
With this strategy fund managers are focusing on minimal market exposure to offset market risk. Maybe the most commonly used technique for this strategy is using derivatives to hedge exposure. Another approach includes buying stocks in pairs. One includes buying undervalued stock for the long-term benefit, while the other is short positioning in overvalued stocks.
- Activist investing
Activist hedge funds are oriented to making changes from inside the company. They acquire a solid stake which can grant them board member spots. From there they can make operational changes that will result in better performance of the company.
Diversification Of The Portfolio
In contrast to index funds, hedge funds offer a chance for an investor to invest in a highly diverse portfolio. Some of the top picks for hedge funds among alternative investment options are:
- Private Equity
- Real Estate
- Currencies
- Venture capital
- Distressed debt
- Activist investing.
These alternative assets frequently have a low correlation to traditional markets. This results in low market volatility in comparison to stock and bond markets. Hedge fund managers use this tactic not only to diversify the portfolio but also to lower the risk of a downturn in a market.
Risk Management
Besides the already mentioned diversification, hedge funds use other risk-mitigating strategies. Often before investing, managers conduct stress-testing to simulate different market scenarios. They put an asset through an extreme downturn scenario while measuring its resilience to it. Stress testing is also done on already acquired holdings, to predict its future condition.
Another favorite approach is making stop/loss orders. With these orders, managers are setting a low or high price limit before selling a security. By doing so, funds protect their portfolio from a sudden downturn in the market.
Worth noting are strategies when constructing a portfolio. It is important not only to properly diversify a portfolio but to carefully calculate each portfolio position. This is called position sizing, and its goal is to limit exposure to volatile assets that can end up with significant losses.
To accomplish this, hedge funds usually have teams dedicated to risk management. Their job is to plan, implement, and supervise risk management strategies.
Considerations Before Choosing Hedge Funds
From the points above, hedge funds seem like an almost perfect way to invest. But, that is just it. Hedge funds do have many tempting features, however, they come with a handful of downsides. Also, these downsides can result in solid losses, while you end up waiting for returns for several years.
High Fees
The typical hedge fund fee structure is called “2 and 20”. Managers annually earn 2% of all assets under management. On top of that, they get a 20% performance fee for all investments that outperform an earlier set benchmark.
When we compare hedge fund fees to the usual rates that mutual funds and especially ETFs charge, we can conclude that hedge funds have the highest costs.
High Risk And Potential For Losses
Due to the frequent use of leverage and high-risk strategies, hedge funds are regarded as high-risk investment vehicles. Depending on the market sentiment, and the expertise of fund managers, you can expect high returns. But, in case of a sudden downturn, or a bad managerial decision, you can end up in losses.
Liquidity Issues
Other types of investment funds in most cases have options for relatively fast redemption. This means if you want to pull out your investment, you do not need to wait long for it.
In the case of a hedge fund, usually after an initial investment, investors cannot redeem their investments for at least a couple of years. Even after that period passes, investors have to announce that they want to pull out a part or the entirety of their investment. Depending on the specific fund the redemption period can be once in a quarter, annually, or biannually.
The reason behind this practice is that hedge funds want to protect their investments and remain liquid. In a case of market volatility investors often tend to pull their investments, and in the case of a hedge fund, it could lead to a lack of capital.
Low Transparency
Even in movies and books, we saw situations in which hedge funds were acting out and going against all rules and regulations. After several implications, the latest one being in the economic crisis of 2008, hedge funds are under increased scrutiny from the regulators.
However, they are still less regulated than mutual funds and ETFs. This is reflected in the lack of transparency both to the public and to investors. Investors often do not know the bigger picture that the fund has in store. Regarding reports to the SEC, hedge funds provide only the most basic information.
Exclusivity
Not all individual or institutional investors can invest with hedge funds. To invest in a hedge fund an investor has to be accredited. In reality, this means that an investor must have an annual income of at least $200 thousand or a net worth of $1 million.
Even in that case, not all hedge funds will accept the investors' capital. Some funds are closed off or only accept recommended investors. Others have a cap on investments, meaning that investors must place a substantial predetermined initial investment.
Choosing The Hedge Fund To Invest
Finding the right hedge fund to invest in is crucial for every investor, no matter his experience or knowledge. When choosing the investor should not be primarily focused on the past performance of the fund. Exquisite performance in the past period does not guarantee future results.
The first thing that every investor should do is to define his goals. Does he aim to generate high earnings in the short term with a chance of high risk? Or is he looking for steady income over a long term combined with lower risk?
Does the investor have a preferred strategy? If not, it is crucial to analyze all the popular strategies and find something soothing. Remember, you are placing your capital, and you should know how the fund is going to use it. Some investors have issues with strategies like shorting or distressed debt because funds are often betting that the company will go under.
Here comes the next question. Does the investor have ethical boundaries? Hedge funds often operate on a thin line and some decisions may seem unethical or even against the law. To better understand this, potential investors should check the track record of the company. Red flags include accusations of insider trading, market manipulation, and use of excessive leverage.
So, an investor and a hedge fund should have aligned strategies, risk tolerance, and ethical norms. An investor should also investigate the hedge fund manager's track record, and how the fund approaches transparency. And, as a final piece of the puzzle, fees that hedge funds charge should be acceptable to the investor.
Final Thoughts
If you are looking for an investment vehicle to suit your needs, you have a wide array of financial structures on the market. Some deliver modest or even low returns but with almost non-existent risks. Others, like hedge funds, can deliver exceptionally high returns with a higher risk norm.
Before you decide to invest, be sure of your goals, and do your research thoroughly. When it comes to investing, you are planning ahead, and only a good plan can satisfy all your needs.
