What are Hedge Funds and How does it work?
What are hedge funds?
Hedge funds are financial partnerships that use pooled funds to make active returns using different strategies for their investors. Hedge funds are set up by a money manager or an investment advisor to make profit. HF managers short stocks if they anticipate a decline or hedge long if they predict markets are rising.
A hedge fund isn’t a particular kind of investment but rather an investment vehicle. In order to achieve higher returns, these funds can be managed actively or use derivatives and leverage. Hedge funds are known to diversify portfolios and they are absolutely focused on making a return.
Hedge funds charge an asset management fee of 1-2% of assets and a performance fee of 20% of the hedge funds profit. which is a way to encourage managers to make larger returns’ managers are often researched first to know their history within the asset management field.
How does a Hedge fund work?
A hedge fund manager normally raises capital from external investors and invests through a specified strategy. They usually use complex strategies and invest in complex products including listed and unlisted derivatives.
One of the popular strategies is called global macros, where the fund takes long and short positions in global financial markets based on perceptions influenced by economic trends. There are also “market neutral” strategies, where the manager aims to minimize market risks by investing in long/short equity funds, arbitrage funds, fixed income products or convertible bonds.
Another common strategy is “event driven” that typically takes advantage of price movements led by global key events. Merger arbitrage funds and distressed asset funds fall under this category.
Hedge Fund criteria
They also need to meet a certain criteria to be accredited or qualified investors, Hedge funds need to have a minimum level of income or assets to invest in hedge funds such a net worth exceeding $1 million or an annual income of $200,000. In other words, hedge funds are limited to wealthier investors who are able to afford higher fees and risks combined. And a qualified investor is someone with over $5 million who is able to invest in total assets or a number of entities.
A hedge fund manager is expected to place some of his own capital at risk while a mutual fund doesn’t face the same expectation.
To invest in hedge funds, you need to have a good understanding of the level of risk, the funds’ investments strategies and the risk tolerance and of course the higher the potential returns, the higher the risk.
There’s also a limitation on the ability to withdraw or cash out your shares to 4 times a year or less in addition to complying with a lock up period of the year that limits you to cash out your shares.
The difference between Hedge funds and mutual funds?
Hedge funds are not as tightly regulated as mutual funds, and typically have more leeway to pursue strategies and investments which may raise the risk of investment losses. They are also generally considered more aggressive and riskier than mutual funds.
Hedge funds can invest in anything, real estate, derivatives, currencies, junk bonds, businesses and other assets unlike mutual funds that stick to stocks or bonds. Hedge funds are designed to protect investment portfolios from marker uncertainty while aiming to achieve active returns.
Mutual funds on the other hand, is registered with the SEC and can be sold to an unlimited number of investors. whilst most Hedge funds are not registered and as previously mentioned can only be sold to a top tier of clients.
While hedge fund managers can be more flexible, use derivatives and make significant changes to the followed strategy, mutual fund managers cannot. However mutual funds can offer daily liquidity and withdrawals at any time, but in a hedge fund it is more constrained whether its cashing out periodically or at the lockup period.
Another notable difference is the difference in return, Mutual funds are managed relative to an index benchmark and are judged on its variance from that benchmark while returns for a hedge fund are absolute, positive returns are expected no matter what.