An Overview of Hedge Funds
Hedge funds are private investment partnerships that employ a variety of unconventional strategies, many of which are considered too risky by traditional fund managers, with the goal of generating exceptional returns. The risks are reduced by employing a strategy known as hedging.
Hedge funds are similar to mutual funds and exchange-traded funds in that they invest in securities. All of these are funds entrusted to a financial advisor. However, one significant distinction is the hedge fund manager’s level of discretion. Their investment options are largely unrestricted, and the industry is unregulated.
They’re also more expensive in terms of the fees they charge, which typically include a management fee as well as a percentage of profits.
Important Points to Remember
- Hedge funds, unlike most mutual funds and exchange-traded funds, can invest in a wide range of assets and employ non-traditional investment strategies.
- These funds have high fees, which are usually made up of a management fee and a performance fee.
- Hedge funds seek outsized profits. They aren’t all delivered.
In-Depth Analysis of Hedge Funds
Hedge funds, once regarded as a shady and risky investment option for the wealthy, have evolved into a burgeoning industry. Even in a down market, they aim for higher-than-average returns. Individual investors, however, should think twice before investing in hedge funds, despite the allure of these alternative investment vehicles.
Hedge funds get their name from the fact that they use a variety of strategies to mitigate the risks of other investments in the fund.
Short selling is one of these strategies. That is, an investor finds a stock that appears to be on the verge of a price drop, borrows shares from another investor, and then sells the borrowed shares. The short seller anticipates making money later by purchasing the shares at a lower price to replace the ones that were borrowed. Only if the stock’s price falls does the short seller make a profit. If this is not the case, the short seller will lose money on the transaction.
Hedge fund managers may also invest in exotic securities such as derivatives, options, futures, and futures contracts.
Hedge funds, for the most part, are limited partnerships or limited liability companies with fewer than 500 investors. The minimum investment is high, with one million dollars being common. They appeal to both institutional and high-net-worth individuals.
The Rule of 2 and 20
Investors are typically charged according to the “2 and 20 rule” by hedge funds. This equates to a 2% fee on the amount invested annually plus 20% of the profits. 1
Hedge Funds: Pros and Cons
Traditional mutual fund managers typically invest in stocks and other assets that they believe will increase in value over time. It makes no difference to hedge funds whether the market rises or falls, at least in theory. There’s money to be made in both good and bad times.
Managers of mutual funds strive to outperform a specific benchmark, such as the S&P 500 Index. An investor in a mutual fund can see whether the fund beat the benchmark for the quarter or the year at a glance.
Hedge fund managers are unconcerned about benchmarks. Instead, they seek absolute returns, with the higher the better. In most cases, that means a consistent profit return year after year, regardless of how well the stock markets perform or whether the economy is strong or weak.
The argument goes something like this: Hedge funds protect their investors’ money by not following the stock market’s ups and downs. They are always on the lookout for money.
Hedge fund managers, on the other hand, don’t stand a chance if they fall short of the most widely followed indexes.
Several successful hedge funds have shown that they can generate extremely high returns while also experiencing extremely high losses. George Soros, the founder of Quantum Fund, famously “broke the Bank of England” in 1992 by shorting the British pound and profiting $1 billion when the currency was devalued. He then tried a similar gambit in 1994, shorting the Japanese yen, and lost hundreds of millions of dollars in a single day. To avoid regulatory scrutiny, Soros converted his hedge fund into a family investment vehicle in 2011. 2
According to a Reuters report, the average hedge fund will underperform the market indexes in 2020. The best returns came from stock-picking funds, which generated double-digit returns by investing in companies that focus on technology and stay-at-home products. 3
Why Investors Should Take a Second Look
To begin with, there is a snag: many hedge funds require a $1 million minimum investment. Granted, investors now have access to a growing number of hedge funds with lower minimum investment requirements. The cheapest ones, on the other hand, start at $100,000.
What about the dangers? Hedge funds are not immune to risk, as recent high-profile failures have shown. Long Term Capital Management imploded in the late 1990s, led by Wall Street trader John Meriwether and a team of finance wizards and PhDs. It nearly sank the global financial system, and Wall Street’s biggest banks had to bail it out. 4
Hedge funds are also more expensive than most professionally managed investments. The standard hedge fund fees are known as “2 and 20,” which means they charge 2% of assets under management plus 20% of profits above a certain benchmark. 1
Traditional financial advisors charge a one-time fee of about 1% of the assets they manage. The average mutual fund fee ranges from 0.5 percent to 1%.
Finally, hedge funds are not as tightly regulated as mutual funds. Many companies aren’t even required to register with the Securities and Exchange Commission or to submit public reports. 5
Taking a Closer Look at the Threats
It’s just as difficult to pick a long-term hedge fund as it is to pick stocks on your own. The rate of hedge fund closures (which has been on the rise during the 2020 crisis) is one of the most significant risks.
The high rate of attrition may be due to management inexperience. As of June 2020, there were over 3,600 hedge funds in the United States, up from 880 in 1992. 67 As a result, many of the managers are likely to have come from traditional mutual funds and have little experience with the esoteric options available to hedge funds. They will have to learn through trial and error.
It is also necessary to consider the high fees. To overcome a fee of 1% to 2% of assets plus 20% of profits, a fund must deliver exceptional results. Hedge funds frequently fail to deliver on their promise of market-beating performance due to the profits taken by managers.
A lack of transparency is another stumbling block. Hedge funds are not subject to the same stringent regulations as traditional mutual funds, according to the Securities and Exchange Commission. Managers are free to construct their portfolios as they see fit, and there are no requirements for disclosing information about their specific holdings and performance.
Despite the fact that hedge funds must adhere to anti-fraud regulations and undergo audits, you should not assume that managers are more forthcoming than they need to be. Because of this lack of transparency, it can be difficult for investors to tell the difference between risky and safe funds.
Finally, the profits of hedge funds can result in a significant tax bill for investors. Because managers buy and sell frequently, their investors experience significant capital gains, which are typically taxed at the ordinary income tax rate rather than the capital gains rate.
The logic behind hedge fund investing is compelling, but investors should take their time and do their homework on the fund and its managers before jumping in. Examine the fees in detail. Consider whether an index fund or an ETF would be a better option.