Understanding & Making Money from Hedge Fund Investment ( Full Guide)
Understanding & Making Money from Hedge Fund Investment ( Full Guide): Understanding the Hedge Fund Process: What is a Hedge Fund? Types, Examples, and Strategies Employed By Hedge Funds.
For clarity, a hedge fund is a limited partnership of private investors whose money is managed by professional fund managers who use strategies like leveraging or trading of non-traditional assets to get profit above average investment returns.
Hedge fund investment is at most times considered a risky alternative investment option and usually requires a high minimum investment amount or net worth. It usually targets wealthy clients.
Key points about hedge funds
Hedge fund investment requires a high minimum investment or net worth from wealthy investors.
Hedge funds are actively managed alternative investment methods that use risky investment strategies.
Hedge funds attract higher fees than conventional investment funds.
Hedge fund strategies depend on the fund manager and include fixed-income, equity, and event-driven goals.
Understanding the Hedge Fund Process
The hedge fund is an investment system whereby the manager of the fund creates a hedged bet by investing a portion of assets in the opposite direction of the fund’s focus to offset any losses in its core holdings.
What this means is that a hedge fund that focuses on a sector such as energy, may invest a portion of its assets in another sector like automobiles, aiming to use the returns of the automobile stocks to offset any losses in energy stocks.
Hedge funds can use riskier strategies, leverage assets, and invest in derivatives such as options and predicted future success. The appeal of most hedge funds lies in the reputation of their managers and their previous successes in the closed world of hedge fund investing.
An investor in a hedge fund is regarded as an accredited investor, which requires a minimum level of assets or income. Typical investors in hedge funds include institutional investors such as insurance companies, wealthy individuals, and pension funds.
Investments in hedge funds are considered illiquid as they require investors to keep their money in the system for at least one year. This time is known as a lock-up period. They may be allowed to withdraw at certain intervals such as quarterly or biannually.
Types of Hedge Funds
Hedge funds target particular investments and pools of securities primed for gains. Four of the most common types of hedge funds include:
Relative value hedge fund: This seeks to exploit temporary differences in prices of related securities taking advantage of spread or price inefficiencies.
Global macro hedge funds: They have actively managed funds that attempt to make a profit from broad changes in the market caused by political and economic events.
Equity hedge fund: They may be global or particular to one country, investing in profitable stocks while hedging against downturns in equity markets by shorting stock indices or overvalued stocks.
Activist hedge fund: Aims to invest in businesses and take steps that boost the stock price which can include demands that companies cut costs on, change the board of directors or restructure assets.
How Do Hedge Funds Make Money?
Hedge funds use a standard “2 and 20” fee system, a 20% performance fee, and a 2% management fee.
The performance fee is 20% of the profit gotten. That means that if an investment of $1 million increases to $1.2 million, then $40,000 is collected by the fund.
The management fee is based on the total asset value of each investor’s share. This means that $1 million will attract a $20,000 management fee to cover the operations of the hedge and compensate the fund manager for that year.
Hedge Fund vs. Mutual Fund
Hedge funds are different from mutual funds in a couple of ways which are listed below.
Hedge funds are not as strictly regulated by the Securities and Exchange Commission but mutual funds are strictly regulated.
Mutual funds are a practical cost-effective method of building a diversified portfolio of bonds, stocks, or short-term investments and are available to the general public and average investor.
Hedge funds will only accept money from accredited investors which includes individuals with an annual income exceeding $200,000 or a net worth above $1 million excluding their primary residence. Such investors are considered to be suitable to handle the potential risks that hedge funds are permitted to take.
Mutual funds use stocks or bonds as their instruments for long-term investment strategies while a hedge fund can invest in land, stocks, real estate currencies, and derivatives.
Hedge funds use the 20% performance fee and 2% management fee structure. In 2021, the average expense ratio across all mutual funds and exchange-traded funds was 0.40% for an average investor
For mutual funds, an investor can decide to sell shares at any given time, but hedge fund limit opportunities to redeem shares and impose a locked period of one year before shares can be redeemed.
Understanding & Making Money from Hedge Fund Investment ( Full Guide)
What to Consider Before Investing in a Hedge Fund
Before investing in a hedge fund, you need to consider the firm or funds size, track record, and longevity of the fund, the redemption terms of the fund, and the minimum investment required to participate.
According to the SEC, potential investors in a hedge fund should also do the following when deciding to invest:
Carefully read the hedge funds documents and agreement which contains information about investing in the fund, the location of the fund, the strategies of the fund, and the risks anticipated by the investment.
Make sure to understand the level of risk involved in the fund’s investment methods and that they equate to personal investing goals, risk tolerance, and time horizons.
Determine if the fund is using speculative or leveraging techniques which will typically invest both the investor’s capital and borrowed money to make investments.
Evaluate potential conflicts of interest revealed by the fund managers and research the background and credibility of the fund managers.
Make sure to understand how a fund’s assets are valued as hedge funds can invest in highly illiquid securities and valuations of fund assets will affect the fees charged by the manager.
Understand how a fund’s performance is determined and whether it reflects assets or cash acquired by the fund as opposed to the manager’s estimate of the change in the value of a such asset.
Also, understand any limitations to time restrictions to redeem shares.
Examples of Hedge Funds
Here are examples of the most notable hedge fund around.
Bridgewater Associates is a global hedge fund leader with over $235 billion in assets AUM, and it has a rate return of 32% in the first half of 2022.
Elliot Management Corporation
Elliott Management Corporation has a 55-year-old history and over $50 billion in assets under its management. Its major holdings are in the energy sector.
Man Group offers a mix of short/long equity funds, real estate funds, private market funds, fixed funds, and multi-asset funds and its core value is responsible investing. It achieves this through its funds, and compliance with social, environmental, and governance ESG investing goals.
How can Investors Compare the Performance of Hedge Funds?
Investors are supposed to look at the annual rate of return in order to compare funds and reveal the funds with high expected returns. An investor can use an analytical software package like Morningstar to identify funds using similar strategies.
How Do Hedge Funds Compare to Other Investment methods?
Hedge funds, exchange-traded funds, and mutual funds are all pools of money contributed by many investors with the goal of earning a profit for themselves and their clients.
Hedge funds are actively managed by professional managers who buy a sell particular assets with the aim of exceeding the returns of the market, a sector, or an index of markets. They aim for the greatest possible returns and can take the greatest risk when trying to achieve them. They are also more loosely regulated than competing investment methods, with the flexibility to invest in options and derivatives and esoteric investments that mutual funds cannot invest in.
Why Do People Invest in Hedge Funds?
Wealthy individuals who can afford to diversify into a hedge fund might do so because they are attracted to the reputation of its manager, the unique strategy it uses, or the specific assets in which the fund is invested.
A hedge fund investment is considered a risky investment alternative and it requires a high minimum investment or net worth from accredited investors. Its strategies include investing in debt and equity securities, currencies, real estate, derivatives, and commodities.