Alternative Investor
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Hedge Funds

What is a Hedge Fund?

A hedge fund is a form of alternative investment where a specified number of individuals pool funds together to buy fluid or illiquid assets. The investment is usually made with a specific objective in mind and is managed by professional fund managers. The managers’ main role will be to reduce the risks with the investment funds and maximize the benefits.

Not everyone can invest in this type of investment fund due to its expensive nature. In most cases, only investors with high net worth, institutional investors, and fund managers qualify for such opportunities.

Despite the minimized eligibility, hedge funds don’t have strict regulations that other investments like mutual funds have. The fewer regulations by the securities and exchange commission guarantee that only accredited investors gain access to alternative investment opportunities.

Although most of the securities that these funds invest in are not mandated to register with the U.S securities and exchange commission. The structure of most hedge funds structures requires managers handling large funds to register. Also, the structure of the fund has two options: limited partnerships, where partners will be responsible for the money they invest, and limited liability company, which is an institutional structure, where the company is liable instead of the individual investor.

How it works with an example

The process starts with a manager of the fund identifying an opportunity and coming up with the correct investment portfolio and strategies. They then collect the money they need from eligible accredited investors and invest it in suitable equities and securities. The managers must explain to the equity investors the investment strategies they intend to use to reduce the risks. The investor will expect the money manager to stick to the strategy.

Some hedge investments may be long-only equities that never sell short or are only in the common stock. Others will involve private equity or real estate investment, which means the funds can hedge other assets. You get to choose one of the funds you’re most comfortable with, depending on the risks it has and its ability to withstand market fluctuations.

Example 

If a hedge fund is set up as an LLC where investors remain anonymous and the starting costs are low, you sign an operating agreement that stipulates the investment manager can get 25% of returns over 3% annually if they invest anywhere across the globe. They can also invest in any opportunity, whether stocks, mutual funds, real estate, private equity, or any other suitable type.

Hedge fund investing can involve 10 investors who put in $10 million each, totaling $100 million, or an individual or institutional investor that can put in the entire $100 million if it’s an LP. The equity investors must sign the operating agreement before handing over the checks to the investment manager, who records the investment amount, then sends the funds over to the fund broker. The manager will be looking for the right hedge funds and working with a broker to invest the money in them. Investors must comply with the guidelines on the agreement and any other government regulations available.

The manager must first reach a hurdle rate of 3%, which is the profit that investors make first. If the fund makes a 50% profit in the first year, 3% will first be deducted and shared among accredited investors. Out of the remaining 47% returns, the manager will get 25%, leaving the remaining 32% to be shared equally among the investors again.

The bigger the fund, the higher the manager’s earnings will be. For instance, from the example above, the first returns from the hurdle rate to the investors will be $4.5 million. From the $45.5 million remaining, hedge fund managers will get $11.375 million while the investors share $32.125 million. If the hedge funds double, the amount that investment managers get increases, which in some cases is more than what each investor gets.

Hedge funds investment criteria for United States residents and investors

Hedge Fund folder on top of some performance graphs

Government regulations surrounding hedge funds are few, but they still determine the right investor and investment criteria for the funds. For instance, individuals must be accredited investors or high-net-worth institutions. It’s also important to note that these equity investors are not protected by federal rules like traditional investors. This is why they are also classified as alternative investments funds because of the risky investment strategies used.

For individuals:

You must have a net worth of at least $1 million or be earning an income of at least $200,000 every year. If you have a spouse, the money you make every year must be more than $300,000 for at least two consecutive years. You must also show that your income will be at this level in the future. The $1,000,000 net worth must not include the value of your house or primary residence.

For corporate investors or an entity:

A trust with at least $5 million is mandatory, but it should not be formed for the sole purpose of the investment. It’s acceptable for the trust to be under a group of unaccredited investors as partners, so long as a qualified investor manages it. According to the securities laws, the qualified investor should have relevant knowledge and experience with not just alternative investments but also within the hedge fund industry today to be able to accurately analyze the risks and make the right decisions about an opportunity.

Features of hedge funds

Apart from only allowing qualified investors, hedge funds also have other characteristics that differentiate them from other investments like mutual funds. The net worth requirement is usually because of the high-risk level of these funds. The security and exchange commission perceives the availability of more money as a way to help investors withstand the possible losses they could incur.

Many hedge funds are available

Fund managers can invest in whatever they prefer ranging from real estate, stocks, private equity, mutual funds, collectibles, and currencies. This is one of the reasons why hedge funds are preferable to mutual funds, especially to those who can afford them.

Hedge funds usually have leverage

If you don’t have enough funds to invest, you can borrow money to increase the returns, especially if you want to take advantage of short investments. However, this option increases the risks of losing the returns, especially if the economy goes down.

Hedge fund’s fee structure

The common fee structure for hedge funds is known as 2 and 20, which refers to a 2 percent assets management fee and 20 percent off gained returns. These percentages are the performance fee and expense ratio that the managers get. This fee structure is the reason why managers are usually frowned upon. It allows them to profit even if they fail to make good returns with the investment. For instance, if an investor puts in $1 billion and fails to make any profits that year, the manager can still get away with 2% of the assets.

Hedge funds charge a performance fee without the asset management cut. This arrangement usually increases the chances of the investor making money because the manager will only get paid if there are notable returns. Very few managers accept this deal.

Investors also get protection from the manager’s compensation scheme in two ways. The first is through fee limitations, which ensure managers don’t use a compensation structure that allows them to get returns from the same strategy twice. The other is securities fees that prevent the manager from taking a risk that is too high. Consider the level of protection the fund is giving you before putting in your money.

Picking hedge funds

The industry has a lot of options that accredited investors can put their money in. You need the right information and a clear goal to help you define what you’re looking for in a fund strategy. That is the only way to make appropriate decisions that will help you reduce the risks associated with your funds.

As an investor, you should consider a high-quality fund only. You can identify them by focusing on the most important features and the possible ways they can help you achieve your investment goal. One of the factors you can focus on is consistency. A fund that has brought in 20% or more returns in five consecutive years will be better than one that hasn’t. Considering the strategy that a hedge fund manager has also helped. Another option is to invest your money in the highest-performing hedge funds available in the category you’re most interested in.

In some cases, high returns aren’t always enough to determine if the hedge fund is attractive or not. Some funds implement a strategy that works well in specific categories, which drives their performance very high. Your best option is to compare the strategy with the returns and the hedge fund strategies used by other funds in that category.

Other factors that can reduce the number of funds and leave the ones most relevant to your goals are:

Size of fund

Most funds usually have a minimum amount for institutional investors because they tend to invest large amounts of money. For an individual investor, too-high investments come with an increased risk, but you can still use potential challenges and risks to gauge previous successes. You must always

consider that huge hedge funds can still fail even if they use the same strategy they used successfully in the past, especially those in the small-cap equity.

Proven record 

If you’re looking for a type of hedge fund with a record dating back to 24 to 36 months, your options won’t include new funds, even if they are good. To capitalize on this, you can search for new funds with managers that have a proven track record. Sometimes a fund manager will start their equity hedge fund, but they will have longer performance experience that can reduce the hedge funds risk.

Minimum investment

Most funds usually have minimums that may make it harder for individuals to diversify their assets because of the net worth requirements. On the other hand, the minimum in a fund can show the type of accredited investors it has and the manager you’re likely to work with. In most cases, larger minimums have more institutional investors, while lower minimums have more individuals.

Redemption terms

You should focus more on the redemption term if your investment is illiquid. A term that exceeds a month also has more challenges. That makes it difficult to be incorporated into a portfolio. You could use the redemption term to eliminate funds with illiquid portfolios.

Available hedge fund types

A wide range of hedge fund strategies, such as distressed securities, equity, relative value, activist hedge fund, and macro investment that involves currencies, stocks, and bonds, are available for all types of investors. These hedge investment funds can be international or in a specific country. Many other hedge fund strategies, including emerging markets, short selling, and aggressive growth, also exist.

Distressed hedge funds 

These are hedge funds that mostly operate in loan restructuring or payouts. The fund manager buys some securities in the form of invaluable bonds from companies that are financially unstable, hoping that their value will increase. This is usually a high-risk venture because there isn’t a guarantee that the cheap or low-valued assets will appreciate and bring in the desired returns.

Macro hedge funds

These hedge funds usually invest in bonds, stocks, and currencies that are likely to profit from economic policies in a country or the changing interest rates internationally. The diversification and high leverage of these hedge funds are what make them appealing. However, this investment has an unimpressive track record and has been known to have the biggest failure.

Long-short hedge fund

Also known as equity funds, this option aims to provide a hedge against fluctuations in equity markets. The manager will compare the possible demerits with the potential profits. In most cases, the fund will retain underpriced stocks and sell the high-valued ones.

Another option is the equity market neutral, which involves the exploitation of different stock prices in stock categories with similar characteristics. With the market direction neutrality, the fund manager will take a chance in long and short stocks in the same country or hedge fund industry.

Arbitrage hedge funds

Relative value arbitrage: It involves the purchase of securities that show the potential of appreciating and selling short stocks that show signs of reducing their value at the same time.

Merger arbitrage: Also known as risk arbitrage, the fund involves the sale of stocks of two companies during their merger. It is known as a riskless hedge funds venture, but the arbitrageur must still determine the chances of the merger not going through successfully.

Convertible bond arbitrage: This option deals with convertible bonds and related stocks. The arbitrageur will take a chance with the long and short positions at the same time by setting up the right hedge between them.

Volatility arbitrage: This hedge fund relies on the difference between the predictable price changes assets are likely to go through in the future and the implied volatility options of that same asset.

Hedge fund regulations

Although hedge funds still have very few government regulations compared to other investments, the securities and exchange commission is beginning to pay more attention to them. The main reason for this is the increasing rate of insider trading even though the hedge funds still have accredited investors only.

A major regulatory change was witnessed in 2012 through the Jumpstart Our Business Startups Act, whose main goal was to help small businesses access funds. This led to the lifting of the advertising ban that was imposed on hedge funds. The funds can now place ads to attract the investors they want to help upcoming businesses. Hedge funds still have to accept accredited investors only and ensure that majority of those involved are qualified, especially if the fund has exceptions of a few unqualified ones. Since a hedge fund has a high number of investors putting money in small businesses and startups, placing ads that allow them to get more money can help the businesses grow.

The ads offer products available in that fund to accredited investors through online platforms and traditional advertising methods like TV. According to the regulation, the fund manager must file a Form D at least 15 days before placing the ad. The form allows SEC to keep tabs on how funds are using advertisement opportunities and their performance. Failure to comply by filing the right form at the right time could result in penalization that may include prohibition from creating securities for a year.

Pros and cons of hedge fund investment

Vector pros and cons compare model - advantages and disadvantages

Despite all the changes and challenges, hedge funds still have many advantages over other types of investments. The following are some of the reasons that make hedge funds worth investing in.

Pros

  • The possibility of positive return generation regardless of whether the equity rises or falls, can make the funds hedge other investments.
  • Portfolio managers usually try to protect all the investment partners from high-risk and volatile assets, which increases the chances of not losing your money.
  • Multiple hedge funds are available, which allows you to gather all the information you need and strategize properly before choosing what makes you most comfortable.
  • You get to work with the most reputable investment managers across the world.

Cons

Like every other investment, hedge funds also have their disadvantages.

  • In case of a loss, you lose a lot of money. The way the strategies are always focused on one sector increases the chances of that happening.
  • Some funds are very illiquid, which means you may not access your funds when you need them.
  • You may have to lock the money for a longer duration.
  • In cases where leveraged funds are used, the slightest loss can become a bigger debt.

Hedge Funds V Mutual Funds

Differences between hedge funds and mutual funds

Mutual funds and hedge funds have similarities in structure, but they also have some differences, such as the qualifications of investors. Unlike hedge funds, mutual funds don’t have net worth requirements for investors.

It’s also easy for a hedge fund investor to access funds from their mutual counterpart than from a hedge fund. The former has more liquidity than the latter.

Hedge funds also have a wider range of options, such as currencies, traditional stocks, real estate, commodities, and other industries. This makes hedge funds better and riskier than mutual funds, which are limited to one sector of investment.

With a hedge fund, it’s possible to sell short stocks or leverage more positions, which helps the investor gain returns even with a low market. A mutual fund is safer but is susceptible to losses if there’s a drop in the market.

A hedge fund manager is likely to make a lot of money because of the fee structure, but a mutual fund manager only profits from the assets they handle. (You can check out our full article on the differences between Hedge funds vs. Mutual funds)

Hedge fund tips

The first step to investing in a hedge fund successfully is becoming accredited. Make sure your income potential or net worth is high enough. You must also determine the investment risks you’re willing to take as you identify your investment goals. Do your due diligence on the hedge fund options available, and choose the one with the most potential or the most befitting one for your capital. Other tips to consider are:

Always read the prospectus given for the hedge fund. It will show you the strategy and the hedged risk, which will help you determine whether the hedge fund works for your financial objectives and risk tolerance.

Search for content about the assets valuation process and the fee charged on the investment, especially the performance fee, incentive fee, and the fund profit. The basic rule is that the higher the potential returns, the higher risks. Make sure you can withstand the loss that a hedge fund can bring.

Look for the right money manager and understand any limitations that may be imposed when you want to redeem your shares. This is usually related to the lockup duration.

A hedge fund is a good option whether you’re a managing director or looking for a good retirement employee benefit plan. There is a lot of content and information that can help you get started. Make sure you do your due diligence and choose the right investments.

Conclusion

Some of the popular hedge funds an investor may want to pay attention to are Elliott Management Corporation, Two Sigma Investments, JPMorgan Asset Management, and Bridgewater Associates LP