Deconstructing the intricacies of Hedge Funds

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The world of finance & investments is like a giant iceberg. Investment vehicles like stocks, bonds, and mutual funds form its upper portion – for all types of investors to see and visit. In the depths, far from the reaches of the retail investor, lies the relatively obscure investment vehicle known as Hedge Fund. To explore it, you must be an experienced investor, and more importantly, a rich one.

Hedge Funds 101: What is a hedge fund?

A hedge fund is a type of alternative investment that pools funds from multiple investors and is set up as a limited partnership. Since it is a partnership, a typical hedge fund is not open to any and every investor. Hedge fund investors must be creditworthy and possess a sufficient amount of wealth. However, smaller investors can also indirectly invest in hedge funds by investing in a company known as a ‘Fund of funds’, whose investment strategy is to invest in multiple hedge funds.

How are hedge funds operated?

The investors in a hedge fund are the limited partners and the firm that manages the fund is the general partner. For managing the fund and generating returns to the investors, the general partner demands a management fee from the investors. While there are varying fee structures, the most common is the ‘2 and 20’ fee structure. The general partner receives a fee from the limited partners that is 2 percent of the assets under management, and 20 percent of any surplus gains generated over the course of the investment period.

Essential Hedge Fund terms; source: visualcapitalist.com

What makes them different from traditional investments?

Investments in hedge funds are substantially large. As a result, they are less liquid than other investment types, with definite lockup periods that prevent early withdrawal. Another distinctive feature of hedge funds is that they are not as transparent as other investment vehicles. They are not obligated to disclose their numbers and investment strategies to the public or regulatory bodies. Since hedge funds are not subjected to much regulation, it is imperative for investors to perform their due diligence with utmost scrutiny before investing in one.

Investing Strategies

In essence, the profitability of a hedge fund depends on its fund manager. Hedge fund managers are known to follow aggressive investment strategies of varying types, with the common objective of generating the highest alpha, which is the excess return against the benchmark. They often employ significant amounts of leverage or debt, taking long and/or short positions in not only stocks, but also other asset classes like commodities, currencies, and real estate. Hedge fund managers are expected to be at the top of the league, with an in-depth understanding of the financial market and world economy. Strong foresight, risk-taking ability, and analytical proficiency are quintessential to be able to provide investors a return on their investment.

Hedge Fund Legends

In 2008, when the financial crisis had just hit the global economy, most hedge funds made significant losses because the U.S. subprime mortgage market collapsed. Michael Burry was one of the very few hedge fund managers who anticipated the crash, and made an investment decision that was ridiculed by all those around him – his analysis and insight led him to bet against the housing market by buying large amounts of credit default swaps (read: insurance) on subprime mortgages. He liquidated his swaps at the peak of the crisis and generated returns of over 400% for his hedge fund, besides gains in millions of dollars for himself. The moral of the story is that hedge fund managers are constantly on the lookout for market opportunities that are relatively unexplored in order to profit as much as possible.

Why Hedge Funds? 

Hedge funds are fundamentally high risk, high return investment vehicles. Their complicated nature and intricate strategies require investors to be wary and well-researched before investing. Nevertheless, hedge funds are a good alternative for diversifying a portfolio in order to achieve extra returns. Before making an investment, an investor should evaluate a hedge fund in the context of his/her entire portfolio and risk/return objectives. Despite how intimidating they seem to be, hedge funds can prove to be lucrative investments.

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