Hedge Fund Definition
A hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund and invests in a variety of assets which generally is a pool of assets providing high returns in exchange of higher risk through various risk management techniques and hedging techniques
To invest in them you need Money like Bill Gates and to manage them you need Brains like Einstein. Hedge funds have been in the limelight due to various strategies used and some amazing returns generated. They have confronted the traditional fund sector with a strong challenge. They have attracted more attention and media interest than the traditional sector. You must have also heard a lot about Hedge funds.
They have been successful in getting the pool of talented fund managers due to their lucrative compensation packages. Over the years, they have attracted a very strong flow of capital.
You can say that the Hedge Fund is a type of pooled investment. But isn’t Mutual Fund the same? So what makes Hedge Fund different than the others?
The major difference is:
Investment in Hedge Funds is open only to a limited group of investors and its performance is measured in absolute return units.
If you go by the nomenclature of Hedge Funds, the term Hedge (Hedging) literally means lowering the overall risk. This is usually done by taking an asset position that helps in offsetting the existing risk.
How does Hedge Funds work?
- It takes both Long & Short Positions.
- It uses Arbitrage.
- It includes buying and selling of undervalued securities as well.
- It trades options or bonds.
- And basically invests in any opportunity that exists in the market.
- So you can say that its primary aim is to reduce volatility & risk and to preserve capital.
While we are talking about reducing risks, you may be amazed to know how the Hedge funds do it. For doing so, they use a variety of instruments and amazingly weird strategies too. They are also flexible in their investment options.
Well, that’s a lot of different things in one sentence. So let’s now move forward and take a look at its characteristics.
Hedge Funds Characteristics
One common and frequent thing that you will notice about Hedge funds is that they vary enormously in terms of investment returns, volatility, and risk.
- Some of them have the ability to deliver non-market correlated returns.
- Major investors in Hedge funds are Pension funds, endowments, insurance companies, private banks, and high Net Worth, individuals, and families.
- Hedge Funds are managed by experienced investment professionals.
- They are illiquid investments.
- They have little to no regulations.
- They are known to use Aggressive Investment Strategies.
Hedge Funds Organization Structure
- The major organizational structure that you will find for Hedge Funds is the one with a General/Limited Partnership Model.
- The General Partners here are involved in undertaking the responsibility of managing the fund whereas the Limited partners are involved in making investments to the partnership. The limited partners are however liable only to their paid-in capital amounts.
- Also, the Typical structure used for the General partners is the Limited Liability Company. A Limited Liability Company is a flow-through tax entity and investors are limited in liability to the amount of their investment.
You can check out the infographic for the diagrammatic representation of the What is Hedge Fund?
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Hedge Funds Fee Structures
Hedge Fund Managers are compensated with two types of Fees:
- Management Fee
- Performance-based Incentive Fee
A Management fee is measured by Asset under Management and is usually calculated as a percentage of the size of the fund. This fee can be anywhere from 1-4% of net assets under management, however, 1-2% is the most common range seen.
The Performance-based incentive fees can be 15%-20% of the Profit that the Hedge Fund makes.
Due to the High Incentive-based fees, the hedge Fund Managers are always seen to be aiming at the absolute returns rather than just beating the benchmark returns.
Investors in Hedge Funds
Following are the major investors in Hedge funds:
- Pension Funds
- Charitable Foundations
- University Endowments
- High Net Worth Individuals
Minimum Investing Requirements in Hedge Fund
Remember that Hedge funds aren’t for everyone. You have to meet the definition of an accredited Investor to invest in Hedge Funds. You will be considered as an accredited Investor if you meet the following requirements:
- The net worth of more than $1 million, owned alone or jointly with a spouse.
- Earned $200,000 in each of the past two years.
- Earned $300,000 in each of the past two years when combined with a spouse.
- Having a reasonable expectation of making the same amount in the future.
Hedge Funds Strategies
Varied range of hedging strategies is available to hedge funds. Some of them are listed below:
- Long/Short Equity
- Market Neutral
- Merger Arbitrage
- Convertible Arbitrage
- Capital Structure Arbitrage
- Fixed-Income Arbitrage
- Global Macro
- Short Only
To know more about the strategies in you can go through our detailed article on Hedge Fund Strategies.
Key Differences between Hedge Funds and Mutual Funds
The performance of Mutual Funds is measured relative to its relevant index. For example, the S&P 500 Index or other similar mutual funds in that sector. Whereas Hedge funds are expected to make a profit even though the relative indexes are down.
Mutual funds are highly regulated. Hedge funds, on the other hand, are not so regulated as compared to Mutual funds.
Fees paid in the case of Mutual Funds depend upon the percentage of Assets under Management. In the case of hedge funds, there are fixed fees as well as incentive fees that are paid to the fund managers.
Where Mutual funds are not able to save their portfolio’s against declining markets, Hedge Funds are able to do so due to the various strategies used.
You can say that the performance of the Mutual funds is largely dependent on the direction of the Equity Markets. In the case of Hedge funds, though, future performance is not drastically affected by the Equity market direction. Again the credit goes to the amazing strategies used here.
Benefits of Hedge Funds
- The majority of hedge funds have amazing strategies crafted by their brainy Fund Managers. Due to this, funds are able to generate positive returns in both rising and falling equity and bond markets.
- There is a wide range of Hedge Funds Strategies available which will help you to meet your investment objective.
- Be sure to reduce the overall portfolio risk if you include hedge funds in your balanced portfolio.
- Years of Statistics and Data have helped in proving that hedge funds have higher returns and lower overall risk than traditional investment funds.
- It is a long-term investment solution.
- It helps in Portfolio diversification.
Tips for Investing in Hedge Funds
- Be an Accredited Investor –You need to meet the minimum level of investment and income to be an accredited investor. Find out where you stand before investing.
- Know the Fees – The Management fee can be between 1%-2% and the Incentive fee can be up to 20%. Understand the fees properly as fees can highly impact your return on investment.
- Understand the Fund Prospectus – Go through the fund prospectus and other related material properly. Make sure you understand the terms and conditions, the Risk involved, Strategies, Time horizon, etc.
- Know Limitations if any – Understand the opportunities to redeem and the lock-up period properly.
So that’s about what is Hedge Fund that I had to contribute. From what we have heard about Hedge funds till now we can say that hedge funds have brought innovative investment strategies in this Investing world. It has given a new sense of excitement to the investment community.
So what do you say, sounds like a great Investing idea?
Other interesting articles related to Hedge Funds
- Hedge Ratio | Formula with Examples
- What is Merger Arbitrage?
- How to Calculate Net Assets for Individuals?
- Tangible Net Worth | Advantages & Disadvantages
- Example of Limited Liability Partnership
- Bill Gates Books Recommendation
- LLC vs Sole Proprietorship Differences
- Investment Banking vs Hedge Fund Manager
- Hedge Fund Jobs
- Hedge Fund Risks