Hedge Fund Risks

Hedge Fund Risks and Issues for Investors

The main reasons of investing in hedge funds is to diversify the funds and maximize the returns of the investors, but high returns comes with a cost of higher risk since hedge funds are invested in risky portfolios as well as derivatives which has inherent risk and market risk in it, which may either give huge returns to the investors or turn them into losses and investor may incur negative returns.

• The primary goals of investing in hedge funds are to diversify the investor's portfolio and increase returns. Still, these goals come at the expense of higher risk because hedge funds invest in risky portfolios and derivatives. 
• They carry both inherent and market risk and can either result in enormous gains for investors or losses and negative returns.
• To prevent "Double Taxation" and the passing of profits and losses to investors, hedge funds are typically taxed as partnerships. The General Partner allocates these profits, losses, and deductions to the investors for the relevant fiscal year.

Explanation

Hedge funds appear to be a very lucrative proposition for investors with High Risk and High Return appetite. However, it does pose some challenges, especially for the investors investing Millions and Billions of Dollars. There are some inherent issues of hedge funds that have also increased significantly post the 2008 Financial crisis.

Hedge Fund Investors from most countries are required to be qualified investors who are assumed to be aware of the investment risks and accept these risks due to the potentially large returns available. Hedge Fund managers also employ comprehensive strategies of risk management for protecting the hedge fund investors, which is expected to be diligent since the hedge fund manager is also a significant stakeholder in the particular hedge fund. Funds may also appoint a “risk officer” who will assess and manage the risks but will not be involved in the Trading activities of the Fund or employing strategies such as formal portfolio risk models.

Video Explanation of Hedge Funds

#1 - Regulatory and Transparency

Hedge funds are private entities with relatively less public disclosure requirements. This, in turn, is perceived as a ‘lack of transparency’ in the immense interest of the community.

• Another common perception is that in comparison to various other financial investment managersrisk appetite it needs to spur for earning large returns.
• A fund in such instances will need around three years to break even after it can earn profits and breach its high-water mark limit for charging Performance Fees.

Below is a sample table explaining the same for ABC Fund Ltd:

Year	Assets Under Mgmt ($MM)	Performance	Gross Income – Mgmt Fees($MM)(Assumed @ 1.75%)	Gross Income – Performance ($MM)(Assumed)	Expense ($MM)(Assumed)	Profitability ($MM)(Performance Income minus Expense)
1	50	12%	0.875	1.05	2.625	-1.575
2	100	12%	1.750	2.10	2.625	-0.525
3	200	12%	3.50	4.20	3.50	0.70
4	500	12%	8.75	10.50	5.0	5.50

From the above example, we can ascertain that as the Assets for the fund increases, so do the expenses. In this case, we are assuming the income to double every year, and only then can it break-even once it enters the third year with assets of $200MM. It is from here that the skills of the fund manager come into play and need to ensure that the returns are regularly increasing to attract the cream of the investors in an ever-increasing and competitive hedge fund industry.

Frequently Asked Questions (FAQs)

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