What is a hedge fund?

Despite the name, a hedge fund has nothing to do with the garden variety. In this article, we explain what a hedge fund is and how they work.

Hedge funds are an alternative investment choice for more experienced investors, often of high net worth. They employ a wide range of different strategies to provide active and high returns for investors. To achieve this, they are often aggressively managed using derivatives and leverage domestically and internationally to achieve a rate of return that is generally high or over a certain benchmark. These funds are usually not accessible to everyone as they face less regulation than other investment options and are much higher risk. They are expensive to enter and maintain and are therefore limited to sophisticated investors.

What is a hedge fund?

Hedge funds offer an investment alternative for the more sophisticated investor. They aim to create value through their manager’s skills and do not rely solely on market growth to make profits. They have the flexibility to use derivatives and arbitrage strategies and may offer performance potential and diversification benefits.

Hedge funds are similar to managed funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. The general objective of a hedge fund is to provide investors with positive returns in most market conditions. Most hedge funds use non-traditional investment strategies and asset classes to achieve a higher return.

Each hedge fund is built to make the most of a certain identifiable market opportunity, and as they use different strategies, they are often classified by their investment style. For legal purposes, hedge funds are set up as private limited partnerships which means they are only open to a number of accredited investors and require a large upfront minimum investment. Most funds aren’t liquid which means it takes longer to move investors money around and they can’t easily sell to withdraw money. Many have lock-up periods where no money can be withdrawn, so investors are required not o sell for a least a year, and can only withdraw at certain time periods like bi-annually or quarterly.

Related reading: How to buy US Stocks in Australia

Is a hedge fund the right investment option for me?

Generally speaking, hedge funds are not for beginner investors or low-net-worth individuals. These specialized portfolios often attract top fund managers, institutions, pensions and wealthy individuals due to their high entry-level price and restrictions. But as an alternative investment vehicle, they are not without risk. Hedge funds are constantly balancing opportunity with risk and this is where the skill of the manager is paramount.

Portfolio managers typically take short positions in securities — bets on falling prices — as well as long positions that benefit from rising valuations. They also use borrowed cash — leverage — to magnify returns. Hedge funds aim to hedge against market declines to produce consistently positive returns irrespective of the overall market conditions.

To do this, hedge fund managers use a wide range of strategies and tactics such as investing in (and with) debt, derivatives, bonds, stocks, options, commodities, taking stakes in companies directly and other alternative investments. As they are not limited to traditional investment options, when there is an opportunity to make money, they often invest. There are many different types of hedge funds and the features and risks of each will depend on the fund’s strategy, the types of assets it invests in, where the assets are located, the investment tools used and the managers’ skill and knowledge.

The main allure of hedge funds is that, when done well, they contribute a return that isn’t closely tied to global stock and bond markets, providing diversity to an investor’s portfolio. However, if not done well though, it could magnify your losses.

Related reading: Shorting stocks: How does short selling a stock work?

How did hedge funds start?

Melbourne man Alfred Jones is credited as the ‘inventor’ of the hedge fund, starting the first in the United States in 1949. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage in an effort to enhance returns.

Since those days, hedge funds have diversified and there are now thousands of funds around the world offering an ever-increasing array of exotic strategies, including currency trading, high-frequency trading and derivatives such as futures and options.

How do you invest in a hedge fund?

This area of investing was always reserved for the rich, and in some cases in Australia, the minimum you’ll need is $50,000. However, today’s hedge funds have also expanded to encompass those with thousands of dollars, rather than millions, to spend.

If you’re considering investing in a hedge fund, it’s a wise move to do your research and seek professional advice first. Choosing the investments that are right for you doesn’t just involve focusing on returns. There are other factors to consider, like the frequency of income, how that income is impacted by tax and the level of underlying risk in relation to your life stage and personal goals.

It’s important to understand the underlying assets involved in the fund and what they are investing in. For beginners, a great place to start is understanding how investing in online share trading accounts work.

What are the risks with hedge funds?

Hedge funds can pose much more complex risks for investors compared to traditional funds. This is because of their diverse investment strategies, complex structures and use of leverage, short selling and derivatives. Investors need to have strong investment knowledge to assess factors such as how their money is to be invested, who makes key decisions for the fund, how the assets will be valued, and how investors can withdraw their money, as well as details relating to leveraging, derivatives and short selling.

As with any investment, you should understand exactly what you are investing in. You need to know the strategy of the fund and ensure it makes sense to you. Most hedge funds are created by fund managers who decide to start their own business and, because the skill of the managers is a key performance driver, you should understand the people involved.

The liquidity offered to you by the fund and the liquidity of the underlying investment should be consistent. There have been many problems caused by funds holding illiquid investments when large numbers of investors want to redeem units. You may have to accept that investments can only be redeemed with considerable notice or at particular intervals.

Joining a hedge fund could mean:

• Membership has its price: Hedge fund investors must usually be wealthy already. There are hedge-like managed funds that give ordinary investors an opportunity to invest in a similar way. But the more accessible funds may offer more limited opportunity by having less flexible tools and strategies at their disposal.
• Fees and taxes: Fees can be hefty, typically 2% of assets plus 20% of profits. The trading patterns of hedge funds also expose you to larger tax bills. You need to understand how much of the performance is being eaten away in fees and whether you believe that the performance of your investment return is commensurate with the risks involved.
• Leverage and short selling: These are great tools for funds but they also present greater potential risk. Leverage and short selling are crucial tools that can help hedge funds generate steady gains even if markets are falling. However, they also present potential risks that traditional managed funds don’t face. A short position can lose an unlimited amount of money as the security in question keeps rising. In contrast, a long position can fall no further than zero. Leverage, or borrowed money, can magnify gains, but can also exacerbate losses and force some managers to sell positions into weak markets. The ability to use leverage is important, but you also have to understand that it adds dramatically to the amount of risk you’re taking.
• Lockups and lack of liquidity: Hedge fund investors often must commit their money for three months or more and managers have the right to limit withdrawals. Hedge funds don’t let investors withdraw their money daily like managed funds. In fact, most hedge funds have so-called lockups of at least three months. Some tie up clients’ money for as much as three years. “Gates” are also common. A gate limits the proportion of a fund’s capital that can be withdrawn by investors. If investors representing a big enough portion of a hedge fund’s assets clamour for their money, the gate comes down and all redemptions are frozen. Lockups and gates help hedge fund managers invest in less liquid assets and securities. But investors need to know that their money could be inaccessible for long periods. If you think you’re going to need the money for something within a short time, you probably shouldn’t be investing in hedge funds.

It is important to educate yourself as much as you can before adding a complex product such as a hedge fund to your investment portfolio.

Cover image source: Greg.Kay/Shutterstock.com

Original Author: Christine Thelander