The 101 on Hedge Funds – What is a hedge fund, how they work, and what can we expect from them this year?

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With over $3.3  trillion invested in the hedge fund industry, hedge funds are notoriously big business. Synonymous with the extravagance of Wall Street, hedge funds have proved to be one of the most attractive investment vehicles of modern times.  

But what is a hedge fund?

If you’re a beginner investor or you’re looking to diversify your portfolio, we take a look at the basics of hedge funds – how they work, their strengths, their weaknesses and the future trends we expect to see, to help you decide if hedge funds are right for you.

What is a hedge fund, and how do they work?

Hedge funds are often-complex investment pools that allow access to only a select number of investors, generally those who are relatively well off and have access to the kinds of funds that are necessary to engage in these high-level investments. The goal of many hedge funds is to provide a “hedge” against potential economic uncertainty, providing each investor with a potentially high return on their investments. 

Most hedge funds are set up as either limited partnerships or limited liability companies. Limited partnerships ensure that each partner is only held liable for the funds that they actually invest–that is, that they won’t have to worry about losing more money than they’ve invested if those investments should fail. Limited liability corporations provide the same degree of security through a company structure that sets the hedge fund up as a separate legal entity. Its financial successes, therefore, result in payouts to the investors, but financial failures will not cause further losses on the part of those investors. 

How Hedge Funds Work

When you invest in a hedge fund, you will commit a set amount of money–usually a large sum–into the investment pool. Other investors will also contribute their funds. These investors will:

Set financial goals. These goals may relate to the types of investments that the members of that hedge fund wish to make, or they may be based on the specific financial goals those investors want to achieve. 

Choose a strategy. Usually, hedge fund managers will choose a specific strategy that they will use to reach the members’ specific financial goals. Those managers are expected to stick to that strategy. 

Hedge funds require little day-to-day input from their investors since the manager handles most of the financial decisions related to the fund. Those investors may, however, need to provide input into investment decisions or continue to invest in the hedge fund over time. 

Key Characteristics of Hedge Funds

Now that we’ve gone through ‘what is a hedge fund?’, let’s take a closer look at their characteristics. 

Hedge funds are a nontraditional type of investment. To the accredited investors that choose to invest in them–usually, those who have a net worth of at least $1 million or those who make $200,000 or more each year, they offer the potential for enormous return. They have several key characteristics to keep in mind when determining if they are the right investment strategy for you. 

1. Hedge funds do not have required legal oversight. While many hedge fund managers choose to register their funds with the SEC or Financial Industry Regulatory Authority, they need not do so in order to meet legal requirements. 

2. Hedge funds typically use aggressive investment strategies. The goal of hedge funds is to produce large returns on those investments for the investors who choose them. In order to achieve that, hedge fund managers may choose very aggressive investment strategies, including short selling and leveraging. The lack of regulatory oversight makes it easier for many hedge fund managers to use these strategies. 

3. Hedge funds are illiquid. Hedge funds are designed to make as much money for their investors as possible, but they usually don’t make it easy for investors to pull their money out. Many hedge funds will lock up funds taken from investors for at least two years following the initial investment. Investors may also have limits concerning how often they can make withdrawals and how much they can withdraw at any given time. 

4. Hedge fund managers are usually paid differently than mutual fund managers. Mutual fund managers usually receive a set fee for their services, regardless of how their investments perform. Hedge fund managers, on the other hand, may contribute nothing to the investment pool themselves, but still receive a percentage of the return on that investment in addition to the management fees they receive for overseeing the fund. 

5. Most hedge funds and their managers are highly secretive about their exact strategies. They want to maintain their corner of the market and use their own unique strategies to help improve their results. Many hedge fund investors and managers do not want to share those strategies, since they could decrease their personal successes and allow others to replicate their results. 

Types of Hedge Funds

Now you understand ‘what is a hedge fund’, it’s important to note that not all hedge funds are created equal. Understanding the different types can help you choose the one that’s right for you.

Macro Hedge Funds

Macro hedge funds require their managers to pay close attention to economic and political events. Global and political change has the potential to create immense impact in a variety of industries, from currency to commodities. An effective macro hedge fund manager understands what potential these political events can have on those industries and may seek to make fast sales to help the fund grow rapidly during those periods. 

Equity Hedge Funds

In an equity hedge fund, the fund holds a core investment of long stocks that are designed to provide a “hedge,” or protection, against short stocks. The fund will typically hold those long stocks and allow them to gain steadily over the life of the fund while also investing in short stocks with a set percentage of the fund. These short stocks may have a much higher risk associated with them, but that also means that they have the potential for immense gain for their investors. 

Relative Value Arbitrage Hedge Funds

Relative value arbitrage hedge funds will often buy securities in a specific industry that are expected to appreciate while selling those, sometimes in the same industry, that are expected to depreciate in the near future. These funds may make short sales of securities that are expected to depreciate rapidly in the immediate future while buying up securities that are expected to see rapid appreciation. 

Distressed Hedge Funds

Investing through distressed hedge funds can prove risky, but it often attains the higher reward associated with those risky investments, as well. Distressed hedge funds buy up securities that are currently low in value in the hopes that they will appreciate in the near future. Distressed hedge funds may also aid businesses and corporations that are currently struggling financially, but that the manager believes shows promise for future performance. The distressed hedge fund may buy up stocks and bonds belonging to the company or offer funds to help the company achieve its current financial goals or meet its needs in the hopes of a better return on that investment in the future. 

The Advantages and Disadvantages of Hedge Funds

Thinking about investing in a hedge fund? Before you dive in, consider the advantages and disadvantages of that type of investment and how it has the potential to impact your finances in the future. 

The Advantages of Hedge Fund Investing

Hedging is, by its nature, a risk management strategy. As such, it offers a number of advantages to investors. 

1. Investing through a hedge fund limits the losses you may experience. A hedge fund, by its nature, is designed to “hedge” against loss. Most managers select a specific investment strategy that is likely to help protect against some of the losses the fund can experience while still producing the potential for gain, 

2. Investing in a hedge fund offers immense opportunity for financial gain. Hedge funds often offer the potential for much higher gains than many other forms of investing. 

3. Investing in a hedge fund can help the investor save time and effort. Since the manager of the hedge fund bears most of the responsibility for handling the fund, individual investors don’t have as much to do with the day-to-day management tasks. 

4. Hedge funds take the weight of the investment out of the stock market. Many types of hedge funds do not rely on stocks to be successful, which can help protect investors against the volatility of the stock market. 

The Disadvantages of Hedge Fund Investing

While investing in hedge funds offers a number of clear advantages, this strategy is not without its disadvantages. You should carefully explore them before deciding if hedging is the right investment strategy for you. 

1. Investing in a hedge fund may require a considerable up-front investment. You must be a qualified investor in order to invest in most hedge funds. Since the income requirements are high, this is not an investment strategy that is right for everyone. 

2. Hedge funds carry risk. While investing in a hedge fund may sound like a great idea, it does bring a substantial amount of risk along with it. Some hedge funds have caused significant financial failures for their investors. 

3. Hedge funds can tie up your funds. When you invest in a hedge fund, you cannot sell your shares immediately. Even when you’re ready to sell your shares, the terms of the fund may limit how quickly you can act. 

4. Hedge funds may require a fee. You will need to pay your manager their fee regardless of how your investments perform. If your market takes a hit, this could mean significant financial losses. Other investors find that the management fees, brokerage fees, and other fees associated with hedge fund investing eat into their profits significantly. 

Hedge Fund Trends 

We’ve given you an overview of ‘what is a hedge fund’, let’s take a look at what you can expect from hedge fund investing this year. Consider some of these important highlights. 

1. Technology is becoming increasingly necessary for hedge fund managers to consider. Not only does investing in technology offer immense potential for hedge fund investors and managers, but many managers are also discovering just how important it is to take advantage of the latest technological advances when it comes to their management strategies. With more data to analyze than ever, it’s important for hedge fund managers to consider how that technology can help them make wise investment choices, pay attention to the latest trends and changes in their chosen markets, and improve the ultimate success of their funds. 

2. Diversified hedge fund portfolios may have lower returns than in previous years. Low-interest rates are having a significant impact on many hedge funds, which means that those investors may see a lower return on their investment. With these rates so low, many hedge fund managers are turning to other investment strategies–and the demand for funds that focus on strategies that rely on interest rates has shifted. 

3. Hedge funds are rotating assets more often. Hedge funds rely on the regular rotation of assets. By shifting assets regularly, these funds are able to make a significant amount of money for their investors. In a volatile market, it’s necessary to shift those assets even more frequently. While this can add to the fees associated with managing the fund, it can also provide increased reward potential for investors. 

4. Many hedge funds are moving toward investor-led solutions. Instead of using traditional manager-led investment strategies, many hedge funds are choosing instead to allow their investors to choose their investment strategies and plans, reducing the fees associated with those investments. 

How we can help.

If you’re thinking about hedge fund investing, it is important that you understand exactly ‘what is a hedge fund’ and you stay informed to ensure that you choose the fund that is right for you. 

Our global investment funds team provides pragmatic and trusted advice on all funds and across all assets. From formation to structuring, both domestic and offshore, we assist sponsors and investors in all stages of a fund and provide on-going counseling regarding fund operations and relationships with investors. Contact us on [email protected] Let us navigate the regulations, so you can disrupt the future without reservation.