 What is a Hedge Fund?
Hedge funds are private investment funds that are usually limited to smaller number of wealth investors. A hedge fund is run by professional money managers who often have their own money in the fund as well. Hedge funds were once used by either institutional or wealthy investors but with the dot com days and all the transformations in last decade, hedge funds have gained a substantial size and popularity. Also, when stock market does not perform well, talk of hedge funds gets intense. One important thing to remember is that hedge funds are not mutual funds but often investors mistake them as such.
What Does Hedge Mean?
Technically the word ‘Hedge’ implies defensive management or insurance against bad market conditions. This often requires producers and processors of buying or selling futures contracts to limit or ''hedge'' exposure to price movements. Most hedge funds don't hedge in the strict sense. Rather, they use a variety of trading strategies to limit exposure to the overall market. Hedge funds are loosely-defined and encompass a variety of complex investment strategies. Many hedge funds generate profit by either "going long", i.e., the investor makes money if the price of the security goes up, or "going short", i.e. identifying overvalued shares that are likely to go down, and buying them when the price drops. One of the concepts that most hedge funds deploy on a regular basis is shorting stocks. Also, hedging can work in commodity and currency markets as well. One of the good examples of hedging is what German sports car maker Porsche did couple of years ago. Porsche decided to “hedge” its base currency euro against dollar because euro was becoming more and more expensive against dollar. United States is Porsche one of the largest market and this hedge was meant to eliminate any exchange rate fluctuation in coming years. This strategy worked out so well that Porsche made more money by hedging currency as compared to selling cars!.
What About Government Regulations?
Hedge funds are private partnerships and are not required to register with the SEC or disclose their activities to third parties. Hedge funds are only slightly regulated compared to other investment funds, like mutual funds, partially because many hedge funds are based off-shore, where they are not subject to much regulation. Hedge funds are largely unregulated, on the assumption that wealthy investors are also sophisticated and can do their own due diligence. In fact, hedge-fund investors are limited partners in the fund. Since government involvement is limited, Hedge funds often deploy risky and sometimes illegal trading activities that can make or break a fund. Even though hedge funds operate without much government regulations, SEC can become involved in the event of a fraud.
How to Invest in Hedge Funds?
Hedge funds are not usually available to ordinary investors like mutual funds. Hedge funds have to reasonably believe that you meet investing requirements, and funds are legally required to ask you if you have the money. Generally, hedge fund managers meet this obligation by making prospective clients fill out a lengthy questionnaire. Even with the qualified investors, there are separate categories – : accredited investors, who need a net worth of more than $1 million; and qualified purchasers, who need to have $5 million in investments not including a primary residence or any property used for a business. re that you have US$ 1 million or more in investable assets and/ or an annual income of $250,000 for the past two years. These limits have been lowered by some of the newer hedge funds to attract more investors. Even with all these guidelines, hedge fund managers aren't required to ask you for much documentation backing up your questionnaire. You may need to provide a financial reference, such as your broker, but it's unlikely that someone is going to comb through your tax returns. Hedge funds can make many types of potentially risky investments, such as investing in derivatives or betting on currency moves. Leverage is a mainstay of these funds, often in much greater degrees than most individual investors are used to.
Hedge funds are characterized by high performance fees, which give a share of positive returns to the manager. Performance fees exist because investors are usually willing to pay managers more generously when the investors have made money themselves. Hedge funds usually change 1% to 3% management fees and 10% to 20% of the annual profit. Unlike mutual funds, which can be bought and sold every day, hedge funds do not tend to have daily liquidity. Most hedge funds are only open to new investments at the beginning of each month and permit money to be redeemed at the end of the month. Investors may have to commit to being in a hedge fund for at least 12 months from the date of their initial investment. After a year, there can be monthly, quarterly or semi-annual withdrawals. Bottom line, you can’t just get in and out in a hedge funds like mutual fund. Most of the times your money is tied up for at least one year and up to 5 years in some instances.
Also, hedge funds are not allowed to advertise. They attract investors through consultants or word of mouth. Offshore funds, a type of hedge fund domiciled in foreign countries, are usually for foreign investors who want to avoid U.S. taxation, but some can accept domestic investors.
Conclusion
Hedge funds are attractive investment vehicles but you have to have a higher risk tolerance to be able to benefit from them. First of all, any investors interested in hedge funds must have substantial assets to invest. On top of that they should be willing to take big losses if things don’t work out. Remember, financial markets work on collective wisdom and sometimes even smart fund managers get in trouble. One of the recent examples is Harvard University endowment fund. Harvard University has a 29 billion endowment fund managed by some of the best hedge fund managers. However, poor hedges and failed bond market bets caused a staggering loss of $250 million and sudden collapse of Sowood Capital Management fund run by managers of Harvard University endowment. Sowood's losses appear to be the result of a combination of excessive leverage in its portfolio of corporate bonds, credit default swaps and loans - sectors where prices have come under severe pressure in recent times. |
