A hedge fund is a pooled investment structure operated by a professional manager with specific goals in mind – to maximize returns and minimize risk. It got its name from hedging, a strategy wherein investors hold both long and short stocks to make sure they make money despite market fluctuations.
When hedge fund were first created, they were typically structured in two ways: a limited partnership (LP) or a limited liability company (LLC). A limited partnership is a structure wherein the partners are only liable for the money they personally invest, while an LLC is a corporate structure where investors cannot be held individually responsible for the company’s liabilities. Today hedge funds have many kinds of structures with different assets and securities.
Each hedge fund aims to take advantage of certain identifiable market opportunities. The most common hedge fund types are as follows:
Macro hedge funds invest in stocks, bonds, futures, options and sometimes currencies in hopes of maximizing changes in macroeconomic variables such as global trade, interest rates or policies. This kind of investment is usually highly leveraged and highly diversified.
Equity hedge funds attempt to hedge against declines in equity markets by investing long in stocks or stock indices and later shorting them (if they are overvalued).
This hedge fund typically buys securities that are expected to appreciate while simultaneously selling short a similar security – such as stock or bond from a different company in the same sector or the like – that is expected to depreciate in value.
Despite its name, this fund is not in trouble – it is simply frequently involved in loan payouts or restructurings. Sometimes these funds can help companies turn themselves around by buying some of the securities, such as bonds that have lost value due to financial instability within the company, in hopes they will appreciate. Still, this type fund can be risky, given that a company’s stock or bonds are not assured to appreciate.
While hedge funds and mutual funds share some similarities, including the same basic structure, there are some key differences between the two.
First of all, hedge funds have investment requirements, while mutual funds typically do not.
Another significant difference is that mutual funds have daily liquidity (or assets that can be quickly bought or sold without affecting the market value), whereas many hedge funds only have monthly, or even quarterly, subscriptions or redemptions.
That said, hedge funds can invest in nearly any asset classes than mutual funds can. These include traditional stocks, bonds and other commodities, as well as real estate, food, currencies, arts and whatever else these funds’ goals can encompass. Riskier and more aggressive than mutual funds, a hedge fund can short sell stocks and leverage more speculative positions that often ease making money even when the market is bad.
Another difference is that hedge fund managers can earn large profits from operating the funds, usually around 2% of the assets and 20% of the fund’s profits, while mutual fund managers usually only receive a percentage of the assets.
One main attraction of hedge fund is the potentially powerful diversification benefits and downside protection it can provide at the holistic portfolio level. The diversification of investment strategies reduces the fund’s exposure to one specific style, while this allocation of assets stabilizes and improves returns for the traditional investor. It can particularly play a valuable role during periods of equity or credit market volatility.
Due to being unshackled by restrictive investment guidelines or the heavier capital charges imposed on regulated entities like banks and insurance companies, hedge funds have few restraints on their potential returns.
One major disadvantage of a hedge fund are the fees, which can often be costly. The management fee is typically paid each month, while the performance fee relies on whatever the fund earns in any given year. Performance fees are mainly used to motivate fund managers to go after the largest possible profits.
Another concern is governance. Insufficient governance can result in disappointing returns from a hedge fund portfolio comprising average managers or, worse, create headlines and reputational issues from investment in managers who suffer a severe loss. Furthermore, stakeholders and beneficiaries may not have the investment expertise to properly judge whether managers are delivering returns that are diversifying and worth the high fees.
When you consider investing in a hedge fund, keep these pros and cons in mind, as they will affect your overall investment portfolio.
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