What is a hedge fund, is it an investment worth your time, and what should you know before investing? Hedge funds have been a hot topic for a while and today, we’re breaking it all down.
We’re going to answer What is a hedge fund and What do hedge fund managers do to ensure you understand these complex topics. Without further ado, let’s get into it.
What Is a Hedge Fund?
So, what is a hedge fund? Put simply, a hedge fund pools money from different investors and invests in securities or investments with the goal of getting positive returns. Put a bit more complicated, it is a limited partnership of private money, which professional fund managers manage. These managers use a wide variety of strategies to earn great investment returns.
Typically, hedge funds are considered more aggressive, risky, and exclusive than mutual funds. Also, they usually require a high minimum investment or net worth, so they’re targeted at wealthy clients.
Types of Hedge Funds
There are four common types of hedge funds to know, including:
- Global macro hedge fund
- Equity hedge fund
- Relative value hedge fund
- Activist hedge fund
Global macro hedge funds are funds that are actively managed and that attempt to profit from broad market swings. Either economic or political events typically cause those swings.
Equity hedge funds can either be specific to a country or global. They invest in lucrative stocks while hedging against downturns in equity markets by shorting stock indices or overvalued stocks.
Relative value hedge funds seek to exploit temporary differences in the prices of related securities. They take advantage of the spread or price inefficiencies.
Activist hedge funds aim to invest in the business and take action that boosts the stock price. That can include demanding the companies cut costs, change the board of directors, or restructure their assets.
A Quick Insight Into the Hedge Fund Industry
The first hedge fund was launched in 1949 by Alfred Winslow Jones’ company. Jones wanted to try out money management while writing about investment trends. In the process, he managed to raise $100,000. Since then, hedge funds have seen an incredible rise and there are over 27,000 funds in the world.
Out of those 27,000 funds, the United States holds the largest share with more than 65%. Following the United States, Europe hosts the next largest population, about 17% of all hedge funds.
How Do Hedge Funds Make Money?
As we mentioned earlier, a hedge fund is structured like a limited partnership. Investors who invest in a fund become limited partners, while the company is considered a general partner. The company will pool all of the money invested by the partners and invest it for them.
Hedge funds employ a standard 2 and 20 system. The 2 refers to a 2% management fee and a 20% performance fee.
The management fee is based on the net asset value of each investor’s shares. That means that an investment of $1 million garners a management fee of $20,000 that year. The fee will cover the operations of the hedge and compensate for the work of the hedge fund manager.
Hedge Funds vs. Mutual Funds
Both hedge funds and mutual funds are managed portfolios from funds pooled with the goal of achieving returns. That means that a manager (or a group of them) uses investment capital from multiple investors to invest in a security.
However, the biggest difference between the two is that hedge funds aren’t as strictly regulated by the Securities and Exchange Commission (SEC).
Mutual funds are considered to be a cost-efficient way to build a diversified portfolio of short-term investments, stocks, and bonds. They’re also available to the general public, which means any average investor can invest in one.
On the other hand, only accredited investors whose annual income exceeds $200,000 or have a net worth of 1 million can pool money for hedge funds. These investors are suitable to handle the potential risks associated with hedge funds.
What’s more, a hedge fund can invest in currencies, land, real estate, stocks, and derivatives. Mutual funds use either stocks or bonds as instruments for their long-term strategies.
Hedge funds can often limit opportunities to redeem shares, whereas mutual funds can elect to sell shares at any time. That is to say that hedge funds often impose a locked period before shares can be cashed and that period is typically one year.
What to Know Before Investing in a Hedge Fund
Even though we’ve answered what is a hedge, there are other things to consider before investing. For one, as we mentioned earlier, you would have to be an accredited investor and meet the minimum level of income or assets.
If you’re considering investing, you should read the prospectus and related materials of the funds. You have to make sure you understand the level of risk involved in the investment strategies of the funds. You should also ensure that the risks you are taking are in line with your risk tolerance and personal investing goals.
The next step is understanding how fund assets are valued and the valuation process. You should know the extent to which a fund’s holdings are valued by independent sources.
Another important step is understanding any limitations on your right to redeem shares. As we mentioned earlier, hedge funds typically limit an investor’s opportunities to redeem or cash in their shares.
The final, and perhaps most important step, is to research hedge fund managers, their credentials, and their history. The manager or managers you choose have to be qualified to manage your finances and you should know whether they have a disciplinary history within the securities industry.
Final Thoughts on What Is a Hedge Fund
We hope to have helped you learn the answer to the question of what is a hedge fund and how it works. If you’re interested in learning about a variety of other topics regarding all things finance – check out our blog.
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