The use of hedge funds in personal financial portfolios has grown dramatically in the last 5 years. A hedge fund is basically a fancy name for an investment partnership between a fund manager (partners designated to make investments and manage the partnership) and the investors, sometimes known as the limited partners, who pool their money together for investment.
Potential hedge fund investors need to understand how these funds make money and how much risk they take on when they buy into this financial product. This post is a highlight of everything you need to know about hedge funds – what it means, investment strategies and risks.
What is a Hedge Fund?
Hedge funds are privately-owned companies that pool investors’ dollars and reinvest them into complicated financial instruments. Their goal is to outperform the market, by a lot. They are expected to be smart enough to create high returns regardless of how the market does.
Hedge Fund is an investment partnership restricted to “sophisticated investors” – people who have enough experience to protect themselves. Hedge Funds are not allowed to accept capital from the general public; in exchange, they don’t have restrictions on what they can invest into.
How Hedge Fund Works
You’ll need an entity that can combine your capitals if you want to co-invest with others. Various sorts of investment partnerships are possible depending on what this company invests in and who is authorized to join it. Hedge funds cater to a select group of extremely wealthy individuals. These investors are typically highly rich and have a great appetite to accept a loss on their entire investment.
The fund is overseen by a Hedge Fund Manager, who is in charge of the fund’s investment decisions and operations. In most situations, this fund manager must be one of the fund’s major investors, which will cause them to be cautious while making investment decisions.
Hedge Fund vs. Mutual Fund
The premise is similar to that of a mutual fund, except hedge funds are less regulated, allow for more diverse and aggressive tactics, and seek for high capital returns. Unlike mutual funds, which are open to the general public, hedge fund investments are always limited to “accredited investors” – or those who have a particular amount of money to invest.
Hedge funds are more risky or aggressive than mutual funds since they can short sell equities and take more speculative positions, making it easier to profit even when the market is down. Mutual funds, on the other hand, are unable to operate in the same manner in favor of a more secure mode of operation.
Hedge funds, like mutual funds, can invest in traditional stocks, bonds, and other commodities, as well as real estate, the food sector, currencies, and other areas.
C’mon Hedge Fund Strategies
While no two hedge funds are alike, the majority of them make money by employing one or more of several distinct techniques.
1. Long/Short Equity Investments
A long/short strategy involves buying stocks of firms that are projected to outperform and selling short stocks that are expected to underperform. Long/short fund success hinges on fundamental company research and stock selection.
2. Global Macroeconomics
Global macro funds are a subset of hedge funds that are significantly more diverse. Stocks, bonds, currencies, and commodities are all options. Making macroeconomic bets and looking for global possibilities are at the center of the approach, regardless of the investment vehicles used.
3. Arbitrage of Fixed-Income
Fixed-income arbitrage funds, like long/short equity funds, profit from price disparities between two fixed-income instruments. Corporate bonds, municipal bonds, treasuries, and credit default swaps are some of the securities used in fixed-income arbitrage.
Hedge funds buy the debt of corporations that are in financial difficulties or have already filed for bankruptcy in an event-driven strategy.
5. The market is neutral.
Market neutral funds are similar to long-short equity funds in that they target returns that are unaffected by market performance. The goal of these funds is to reduce or eliminate market volatility.
Hedge Fund Investment Risks
Hedge funds are extremely dangerous. Many investors are attracted to this risk because they assume that increased risk equals higher reward. Because of the leverage, most hedge funds invest in derivatives, which are extremely dangerous. This is why investors must be competent investors who are aware of the investing dangers and are willing to take them because of the potentially enormous profits offered.
Unlike mutual funds, which are heavily regulated, hedge funds are typically unregulated. Although hedge funds are still forbidden from engaging in fraudulent activity, the lack of regulation introduces new hazards. Hedge fund investors have always been exposed to a wide range of risks. You can control your hedge-fund risk as an investor by being aware of the various dangers and taking efforts to lessen each one.
Before investing in a hedge fund, investors should do significant due research. The first stage is to figure out which tactics the fund employs, as well as the level of risk involved.