If you are confused by the question “what is a hedge fund?” you are not alone. Part of their appeal is their exclusivity and secrecy.
Hollywood only adds to this mystery by portraying hedge fund managers like the charming but ruthless Bobby “Ax” Axelrod on the hit TV show. Billions…
While hedge funds are considered unique investments in the world of personal finance, in simple terms, they are nothing more than a mutual fund-like investment vehicle. The difference is that the fund manager has broader authority to invest in a wider range of financial products beyond stocks and bonds.
The popularity of hedge funds has skyrocketed over the past few decades, with nearly $ 4 trillion invested in hedge funds around the world.
What is a hedge fund?
Basically, a hedge fund is a partnership between a professional fund manager and investors (often referred to as limited partners). The manager and investors pool money into a fund using different strategies to grow the fund.
If this sounds a lot like an actively managed mutual fund, you’re not wrong. The main difference between a mutual fund and a hedge fund is the degree of risk and the variety of products that a hedge fund can invest in versus a mutual fund.
Typically, a mutual fund is limited to investing in stocks and / or bonds. A hedge fund can invest in many other, often exotic, financial products. This can include real estate, derivatives, commodities, currencies, and more.
Hedge fund strategies
While hedge funds use hundreds of strategies to generate returns for their investors, most can be divided into four main categories:
- Global Macro
- Directed
- Eventful
- Relative value
Global macro strategy
Global macro strategy hedge funds study the big picture of economic and political trends around the world and try to capitalize on these big ideas. Examples of this strategy include global trade imbalances, the growth of emerging economies, business cycles, and supply and demand.
Directional strategy
A directional hedge fund uses market trends and directional market movements to identify stocks or other securities. Computer simulations are often used to analyze technical trends. One example of a directed strategy is a long / short stock hedge fund that identifies the opportunities for potentially undervalued stocks (long positions) and overvalued stocks (short positions). If the stock is trending, the fund will make money.
Event strategy
An event-driven hedge fund strategy aims to identify risks and opportunities in specific events and conclude deals that pay off if those risks or opportunities are realized. For example, trading opportunities may exist in connection with major corporate events such as mergers, consolidations, liquidations, or bankruptcies.
Relative value strategy (arbitrage)
The relative value strategy will try to exploit the price difference between securities, otherwise known as arbitrage. Investopedia defines arbitrage as “the simultaneous buying and selling of the same asset in different markets in order to profit from a small difference in the quoted price of the asset. It uses short-term price fluctuations for similar financial instruments in different markets or in different forms. “
A simple example of arbitrage is buying collectibles at a garage sale for a few dollars and then selling them on eBay for $ 50, $ 100 or more. In this case, you are taking advantage of the mismatch in the price of what you could pay for something, compared to its value in the broader market. Some people do it as a part-time job (or even full-time), earning $ 1,000 a month or more. Likewise, hedge funds use price mismatches in the market to generate profits.
How can you invest in hedge funds?
Investing in a hedge fund is not as easy as buying stocks. Due to government restrictions and minimum investment thresholds, the average person cannot directly invest in a hedge fund.
So who can invest in a hedge fund?
Because of their high risk, the SEC (Securities and Exchange Commission) requires you to be an accredited investor (or, in some cases, a qualified buyer) in order to invest in a hedge fund.
An accredited investor must have a net worth of $ 1 million not including the value of their main home, or an annual income of $ 200,000 if single and $ 300,000 if married. A qualified buyer the notation is even more rigid. You must have at least $ 5 million in investment assets.
If you meet these requirements, you can research funds online or get a recommendation from a financial advisor who may have more access to affordable hedge fund investments. Another thing to be aware of is that most hedge funds require a sizable minimum investment, typically between $ 100,000 and $ 1,000,000.
All of these obstacles and limitations make most hedge funds inaccessible to the average investor. If you are just starting out and want to learn how to invest $ 1000, hedge funds are not the right fit for you.
In many cases, highly liquid individuals invest in hedge funds in order to diversify their portfolios or reduce some of the risk of their investments. For the average person, investing in broad base index funds may be the best choice since investing in hedge funds carries a lot of risks.
How do hedge funds make money?
Hedge funds make money from their fee structure as well as their core business.
The typical hedge fund fee structure is “2 and 20”, which means that they charge 2% per annum on all assets under management, as well as a performance fee of 20% of the total return.
This fee structure is subject to much criticism as it does not fully meet the interests of investors. The fund will receive its 2% stake even in a bad year when the fund breaks even or loses money.
Compared to the index fund’s ultra-low fees (0.1% or less in many cases), the hedge fund manager has to perform significantly better than the market as a whole, just to offset his fees.
Benefits and risks of hedge funds
Compared to investing in index or mutual funds, hedge funds have some unique advantages and risks.
Benefits of hedge funds
- Flexible investment strategies – Unlike mutual funds, hedge funds have more freedom to use strategies such as leverage, short selling, and derivatives to maximize profits.
- Reducing losses during market downturns – Many hedge fund strategies tend to be “market neutral” and provide reasonably consistent returns regardless of whether the market as a whole is going up or down.
- Diversification – With the ability to implement many different strategies, outsourcing a portion of your portfolio to hedge funds effectively hedges your exposure to market exposure as a whole.
Hedge fund risks
- Fees – Compared to mutual funds and index funds, hedge funds have much higher fees, so their returns must be even higher just to break even.
- Lack of transparency – Hedge funds are not regulated with the same rigor as public funds, so it is difficult to assess whether a manager is making the right decisions or not.
- Liquidity – Most hedge funds have lockout periods of one to five years or more when you cannot withdraw your money or a significant financial penalty is imposed if you can.
Notable examples of hedge funds
Many well-known hedge fund managers have achieved celebrity status, at least in financial circles, and some have become famous, especially after the 2008 financial crisis. Here are some of the major hedge fund players today.
1. Blackrock Counselors
Blackrock was founded in 1984 and now manages trillions of assets in various hedge funds and even passively managed index funds. Blackrock rose to prominence in the aftermath of the 2008 financial crisis, becoming one of the largest single-family home funds and significant returns on real estate capital.
2. AQR Capital Management
AQR Capital Management started its activity in 1998 and pays great attention to quantitative (computational) investing. The company, founded by Cliff Asness, David Kabiller, John Lew and Robert Crail, manages over $ 140 billion in assets.
3. Bridgewater Associates
Ray Dalio founded Bridgewater Associates in 1975 and has grown to roughly $ 140 billion in assets. Dalio is especially a public figure and has written numerous articles and books on macroeconomic trends and investment.
4. Pershing Square Capital Management
Led by billionaire Bill Ackman, Pershing Square was founded in 2003. Akman is best known as an active investor, investing in troubled companies and helping them move in more profitable directions.
The last word
While hedge funds can be a powerful investment tool, they also come with unique risks. For the average person who doesn’t have millions to invest, high commissions and minimums can turn off. But hedge funds can be a great way for high net worth individuals to diversify their portfolio and do what their name says – hedge against market downturns or other portfolio risks.
This post originally appeared on Savoteur.
