While nearly everyone has a good understanding of mutual funds, if you work outside the world of finance, hedge funds are likely a little more mysterious to you. You may have wondered what all the fuss is about and whether or not hedge funds might make sense for you.
They’re not for everyone; continue reading to find out more about this interesting investment vehicle.
‣ A BRIEF EXPLANATION OF HEDGE FUNDS
Hedge funds are privately managed investment funds that utilize sophisticated and frequently risky strategies to provide high returns to wealthy investors.
Estimates vary, but there are around 7,000 hedge funds at this time. These funds exhibit a tremendous amount of variety between funds, just as there is between different mutual funds.
Hedge funds are very loosely regulated and are only open to investors that meet stringent requirements. Hedge funds are quite popular and are estimated to have nearly two trillion dollars of capital invested.
At the most basic level, they’re quite similar to mutual funds, but the differences are very significant.
‣ REGULATION
While mutual funds must register with the Securities and Exchange Commission, hedge funds are exempt from this requirement due to a clause in the Securities Act of 1993. There is frequently talk of requiring hedge funds to register with the SEC, but it has not yet come to pass.
Even though they don’t register with the SEC, hedge funds are still subject to certain regulations. For example, they’re not permitted to advertise to the public or ask potential investors to join.
Instead, the manager of the hedge fund must already have a relationship with the potential investor or they must be introduced by a qualified party; this is usually a broker associated with the hedge fund.
Hedge funds will only accept “accredited investors”; these are private investors with net assets totaling over $1 million or $200,000 in annual income, with separate requirements for institutional investors, partnerships, and others.
‣ TYPES OF INVESTMENTS
Mutual funds are limited in the types of investments in which they can invest. Some of these requirements are somewhat self-imposed; they can only invest within the parameters laid out in the prospectus they provide.
Hedge funds, on the other hand, can invest in nearly anything they think might make a profit.
For example, if a hedge fund manager believed that silver was going to be a good investment, he could invest in silver coins, silver mines, silver bars, or nearly anything else a creative mind can think up.
Hedge funds can also utilize derivatives, which are discussed further below, while mutual funds are prohibited from investing in derivatives.
‣ DIVERSIFICATION
Mutual funds are required to maintain a minimal level of diversification, which provides protection against significant losses. It also limits significant gains.
Hedge funds aren’t required to spread out their investments. Technically, a hedge fund could invest all its money in a single investment if it so desires.
This lack of required diversification provides a hedge fund with a great deal of opportunity to do extremely well or to do very poorly.
‣ LEVERAGE
Hedge funds are permitted to employ a very high degree of leverage. Since they can invest in derivatives, many hedge funds take full advantage of that allowance and use it to drive higher profits.
This is how using leverage works with derivatives:
‣ Derivatives are essentially contracts between two parties that specify particular conditions that must be met by a certain date before the contract can be executed.
‣ Perhaps the easiest type of derivative to understand is the option to purchase stock, or a “call option.” This gives the holder of the call option the option (but not the obligation) to purchase a stock at a given price before some specific date in the future.
‣ If the stock rises above the agreed upon price (the strike price), the holder of the option can purchase the stock at that price. So they’re guaranteed to be able to buy the stock at a lower price than what the stock is selling for at that later time – which is a great deal as long as the price of the stock does go up.
‣ A single option gives the holder the right to purchase 100 shares of the stock. However, most options expire without the price of the stock rising high enough for the option to be exercised. The money paid for the option is then lost.
‣ However, the cost of the option itself is relatively low compared to the amount of stock that can be controlled. Options provide tremendous leverage and can provide spectacular returns, when they work out. Note that there are a very large number of different types of options.
‣ VALUATIONS
Mutual funds provide publicly, by law, their net asset value (NAV) on a daily basis. Hedge funds typically only provide valuations on a monthly or quarterly basis.
With a mutual fund, you always know where you stand as an investor, but an investor in a hedge fund can only find out how they’re doing on a monthly basis, at best.
‣ FEE STRUCTURE
Another difference is the fee structure. For most mutual funds, the only fee is a management fee, which is usually quite low (0.5 – 1%). This fee is paid regardless of the fund’s performance.
Hedge funds also charge a management fee (around 1-2%). In addition, they charge a performance fee as well, which is commonly 20% of the profits, but can be as high as 50%!
Many experts, including Warren Buffet, believe that performance fees are a bad thing. This is because the hedge fund manager gets such a significant portion of the profits, yet doesn’t share in the losses.
Considering the management fee is still a very significant amount of money, the hedge fund manager is potentially very well rewarded for taking huge risks, yet can still make over $1 million a year even if the fund loses money.
All in all, though, the manager has an incredibly high incentive to make the hedge fund hugely profitable because he gets a good share of those profits.
With such a large portion of the profits going to the manager, why would wealthy investors enjoy hedge funds? The answer is easy. They may share their profits with the manager, but they also stand to gain a huge profit themselves.
‣ SUMMARY
Hedge funds appeal to qualified investors due to the potential for much higher gains. These gains are achieved through a lack of constraints on the fund. These include the freedom to utilize
leverage, take advantage of nearly any investment, and not be constrained in any way by diversification rules.
The fees can be very steep for hedge funds, with the performance fee putting a lot of the profits in the pocket of the hedge fund manager.
These potentially high rates of returns do not come without disadvantages. Hedge funds can lose an astronomical amount of money quickly if the market moves in the wrong direction and the fund is heavily leveraged.
Are hedge funds for you?
If you don’t meet the requirements to be classified as an accredited investor, you still have some work to do before the question is an issue for you. For those with the necessary financial position, it really becomes an issue of risk and potential reward; both are very high.
There are thousands of hedge funds, and just like mutual funds, some are great and some are less than great. As always, perform diligent research before you invest your money in anything new.
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