For the past few years hedge funds have been the stuff that headlines and stories of great success and profit have been made of. But what exactly are these mythical investment instruments? And is it worth the risk trusting your money to them?
What is a hedge fund?
Hedge funds are a form of alternative investment that use pooled funds to earn returns for their investor. Hedge funds invest in domestic and international market and are set up with the goal of making high returns. Hedge funds are less regulated than mutual funds or other more conservative investment vehicles. By their nature, Hedge Funds are normally very secretive. Their trading and other information is normally kept in-house, and these secrets are closely guarded.
Some commentators however warn that Hedge Funds are not as straightforward as they seem. Research shows that properly investing in a hedge fund needs an elaborate approach to decision-making that exceeds that currently employed by most investors and would require a trade-off between profit and loss potential.
In essence, Hedge Funds are a type of investment which is geared towards a certain type of investors. This investor is generally a wealthy individual or investment institution who is prepared to trade higher risk for the potential for higher than normal returns on investment.
Who can invest in a hedge fund?
Hedge funds are only open to qualified investors. Accredited investors typically need to have an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. This requirement has been set by the Securities and Exchange Commission as investors must be able to handle the potential risks. This means that Hedge Funds are not an appropriate option for every investor.
How do hedge funds work?
Hedge funds are set up to take full advantage of certain opportunities in the market by implementing a specific strategy. Hedge Funds are classified according to this strategy called “investment style”. Unlike mutual funds that have to stick to stocks and bonds, hedge funds can invest in anything, including land, real estate, stocks, derivatives and currencies.
As a rule, Hedge Funds have a general partner in charge of the fund. The general partner invests capital according to the funds’ objectives and strategy. Investors are known as “limited partners” and provide the capital for investment.
The fund executes on its investing strategy with the money from general and limited partners. Hedge Fund strategies can range from trading currencies with extreme leverage to using event-driven tactics such as taking activist positions in companies.
What are the risks of investing in a hedge fund?
Although investing in Hedge Funds can bring great rewards, as is often the case for these kinds of situations, they also involve significant risks. These could include potentially huge losses, as well as having your money locked into your investment for some years, meaning you are unable to access it if your needs change.
The Securities and Exchange Commission advises that there are several steps investors can take to protect themselves while investing in a hedge fund. These include being an accredited investor who has the required minimum level of income or assets, reading the fund’s prospectus and all related materials and understanding the level of risk involved. They add that investors should understand how the fund’s assets are valued, what the fee structure is and also research their hedge fund manager.
What is leverage?
Hedge funds will often use borrowed money to amplify their returns – this is known as leverage. He explains that this adds to the risk profile of hedge funds and in 2008 during the financial crisis this is what caused many hedge funds to be wiped out. Hedge fund profits are subject to capital gains tax in the United States.
How to Pick a Hedge Fund
When picking a hedge funto identify important investment goals and what results would be required to satisfy these. These can then be used to find the right hedge fund.
One of the most famous hedge funds in history was started by George Soros. Forbes describes him as a “legendary hedge fund tycoon who managed client money in New York from 1969 to 2011.” The article goes on to describe how in 1992, Soros shorted the British pound and reportedly made a profit of $1 billion. “He became known as the man who broke the Bank of England” according to Forbes.
Soros’ success after setting up his Quantum Fund was phenomenal. His fund reached $381 million by 1981 and by 1993 it was producing an average annual return of 40%. As the fund’s manager Soros earned more than $1 billion that year. By 1997 he owned 6 funds and by 2018 these were managing funds totalling $28 billion.