In this article, we break down what hedge funds are, how they work, and who they're best suited for.
So, what is a Hedge Fund?
A hedge fund is an investment vehicle that relies on aggressive but risky strategies to achieve above-average returns. They often use a variety of different trading tactics as well as non-traditional portfolio structures throughout their operations. Risk management techniques and analysis are also constantly used by hedge funds, as accurate predictions are often critical to their success.
Generally, hedge funds are considered a risky choice for investment because of the techniques used. In order to invest in one, investors are usually required to have a fairly high minimum net worth and are usually accredited, investors. Although different hedge funds will use different strategies, there are a few common techniques that they will use on a daily basis to generate returns for their investors.
Hedge Fund Techniques
One of the hallmark characteristics of a hedge fund is its use of non-traditional techniques and alternative investments. Three of the most common hedge fund techniques are:
- Short Selling
Leverage is an umbrella term referring to any investment strategy that relies on using borrowed funds in order to generate greater returns and profit. The idea is that these funds can increase your investment power, thus increasing your investment return, allowing you to pay back the loan and make a profit.
Another popular hedge fund technique is short selling. Short selling is also a leveraged investment strategy because it relies on borrowing. Instead of investing in stocks for the long term and betting on increased returns as the company or fund grows, short selling is a bet against a certain stock or security. In a short sale, the investor borrows securities and then sells them. The hope is that the value of those securities will go down. If that occurs, the investor then purchases those securities back and returns them to the borrower, earning a profit that is the difference between today’s price and the original price.
Finally, there are derivatives. Derivatives are an investment strategy that involves investors speculating on the future price change of a particular asset by purchasing or selling off derivative contracts. Some common derivative contracts you may have heard of include “futures” and “stock options.”
Hedge Fund vs Mutual Fund
Both Hedge Funds and Mutual Funds are considered institutional investors. The biggest difference between hedge funds and mutual funds is that hedge fund managers have much more flexibility when it comes to investing. Hedge fund managers can use any combination of the investment strategies and techniques we’ve discussed. They are also not held to the same regulations as mutual funds. For example, hedge fund managers are not required to disclose their holdings to the public like mutual fund managers are. This lack of transparency can be seen as a downside by some investors, but others view it as an advantage because it allows hedge fund managers to take more risks without the worry of public opinion.
Another key difference is that hedge funds are not available to every investor. In order to invest in a hedge fund, an investor must usually be an “accredited investor.” This means that the investor must meet certain criteria, such as having a net worth of over a million dollars or an annual income of over $200,000.
Hedge Fund vs Pension Fund
Pension funds are another type of investment fund that you may be familiar with. Like hedge funds, pension funds are not available to every investor. In order to invest in a pension fund, you must usually be a current or retired employee of the company that sponsors the fund.
Pension funds and hedge funds share some similarities, but there are also some key differences. The biggest difference between hedge funds and pension funds is that hedge funds are not regulated in the same way that pension funds are. Pension funds are subject to strict government regulations, while hedge funds are not. This lack of regulation gives hedge fund managers more flexibility when it comes to investing, but it also means that hedge funds are riskier than pension funds.
Hedge Fund Examples
A famous hedge fund, ARK Invest, run by Cathie Wood, is known for its disruptive innovation investing strategy. ARK has a $14 billion AUM. The fund invests in companies that are developing and commercializing new technologies that have the potential to “disrupt” traditional industries and business models. Some of the companies in ARK’s portfolio include Tesla, Square, and Roku.
Another popular hedge fund is Bridgewater Associates, run by hedge fund manager Ray Dalio. Bridgewater is a “macro” hedge fund, meaning that it takes large bets on the direction of the economy and global financial markets. Bridgewater is one of the largest hedge funds in the world, with over $160 billion in assets under management.
Hedge Fund Structure and Operation
A hedge fund earned its name from the fact that they often rely on a two-pronged approach to investing. Usually, a hedge fund will focus on a specific area and simultaneously invest in a separate or even opposite space to “hedge” its investments as a risk management strategy. The idea is that if one side goes down, the other side will go up, and the fund will maintain its financial position.
The first hedge fund in history was founded in 1959 and relied on a combination of short-selling as a way to hedge against the risks of several long-term stock investments. Since then, a variety of structures and strategies have been developed for successful hedge funds.
Most hedge funds require investors to be accredited. There is no formal process for a person to become an accredited investor. Rather, they must simply meet the criteria as stated by Rule 501 of Regulation D of the Securities Act of 1933. These requirements state that an investor must make an income exceeding $200,000 in the last two most recent years or have a net worth that exceeds $1 million, excluding the value of the primary residence of the investor.
Most hedge funds are structured as a limited partnership, a limited liability company, or an offshore corporation. In general, they will charge higher fees than conventional investment funds. The typical fee structure is 2% & 20%. They charge 2% as a management fee and keep 20% of the profits that the fund generates as a performance fee.
The 4 Kinds of Hedge Funds
Hedge funds typically fall into 4 main categories:
- Global Macro
- Relative Value (Arbitrage)
These categories are based on the overall strategies and goals that form the guiding principle of the hedge fund.
A global macro hedge fund focuses on currency markets and tries to anticipate global macroeconomic events.
A directional hedge fund tends to try to identify current market movements or trends and invests in stocks across a variety of markets.
Event-driven hedge funds focus on investment strategies related to specific, corporate events such as consolidations, acquisitions, and bankruptcies.
Relative value arbitrage hedge funds build investment strategies around the relative discrepancies in price between securities.
Hedge Fund Fees
There are many ways to structure fees for a hedge fund. One of the most popular fee structures is 2/20. This means that they typically charge 2% of your invested capital upfront (management fee), and then keep 20% of the returns they generate. The percentage of profits is motivation to perform well.
It is not uncommon for a hedge fund manager to charge more than 20% of the profits generated. If the fund manager has a good track record, they will charge up to 40% of profits generated by their performance.
Hedge funds are a high-risk, high-reward investment vehicle that is often only invested in by wealthy individuals. According to Forbes, the top 50 hedge funds generated returns of 15.5% over the last 5 years. The basic difference between a hedge fund and other investment funds is that they are free to use more aggressive, riskier financial products and techniques. Many of these strategies are speculative and require large amounts of technical analysis in order to predict market trends.
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