What Is Hedge Fund And How Do They Work?


 

Have you ever wondered what is hedge fund?

Well, you’re not alone.

Hedge funds are yet another investment opportunity in the whole wide world.

Most analysts and experts like them for mutual funds. Indeed they share many common features. Nevertheless,  they also demonstrate several differences.

In this article, we will be dealing with hedge funds and how they function.

So What is hedge funds and how do they work?

“Hedge funds engage in a variety of investment activities. They cater to sophisticated investors and are not subject to the regulations that apply to mutual funds geared toward the general public. Fund managers are compensated on the basis of performance rather than as a fixed percentage of assets. ‘Performance funds’ would be a more accurate description.”

George Soros

What Is Hedge Funds And How Do They Work?

Major Characteristics Of Hedge Funds

Even though it’s hard to strictly define the term, here are some of the major characteristics of hedge funds. Below we will be discussing them in detail.

  • This is a pool of investors’ money managed by a professional manager.
  • This investment vehicle is not accessible to anyone, only to high-profile investors
  • Hedge funds are not regulated by the U.S. Securities and Exchange Commission (SEC). In comparison, mutual funds are.
  • However, keep in mind that most hedge fund managers have to register as such following an amendment to the Investment Advisers Act in February 2006.

Hedge vs Mutual Funds

As we already mentioned, hedge funds are often compared to mutual funds.

Both opportunities represent a pool of investors’ money, which the manager of a fund invests in various types of securities and assets. However, the SEC is currently not regulating the activity of hedge funds.

Regulation

Hedge funds don’t have to comply with the Securities Act of 1933 nor to fill in reports under the Securities Exchange Act of 1934. On the other hand, mutual funds are strictly scrutinized. Here is a report on hedge funds you might find interesting and informative.

Even though the Sec does not require hedge funds to fill reports and register with the authority, any fraudulent actions are prohibited according to federal law.

Liquidity

As a rule, mutual funds are much more liquid than hedge funds. Investors can sell their shares anytime. Hedge funds, on the contrary, adopt a different strategy – “lockup period.” This is a period in which investors cannot sell their shares because the fund seeks a predetermined return over a specified period.

Pros and Cons

In addition to our broad article about the Advantages And Disadvantages Of Hedge Funds – We’ve added the most important of them here:

Pros

On account of the lax regulation, these types of funds offer a wider range of securities to purchase. Most of them can also invest in stocks and bonds.

However, they tend to use other, riskier, investment techniques and strategies (you can learn and try it yourself by online games which help to implement and practice all of these strategies )

Cons

Something we might consider a drawback is the fact that only accredited investors may participate.  These are wealthy institutions or individuals, also called sophisticated investors.

The reason for this is that these funds are riskier investments. The risks associated with this venture are primarily due to their lax regulation.

Limitations

In the US, an accredited investor is an individual who has a net worth of minimum $1,000,000 or in the previous two years had an income greater than $200,000.

For example:  the requirement for banks and corporate entities is to have assets totaling at least $5,000,000. Another thing on the downside: under the Investment Company Act of 1940, hedge funds cannot make public offerings. Most of the risks are similar to the mutual funds risks.

Leverage

One of the investment strategies hedge funds use is the so-called leverage. This is a type of technique which involves investing with borrowed money in order to increase the potential return. Of course, this poses a higher risk of losses. This is what a “hedge fund” literally means – hedging investments to increase returns and mitigate losses.

Example

Both George and William have $200,000 in cash.

George decides to invest the money and purchases 10 acres of land for personal use. William, on the other hand, invests his $200,000 and borrows $400,000 and with $600,000, he purchases 30 acres of land.

Who is using leverage (also known as financial leverage)

William is.

Let’s imagine, the price of the land increases by 10%.

George’s investment will give him $20,000 return. William’s, however, due to the leverage he used, will bring to the table some $60,000, which is three times more. Another option for William is to keep 10 acres for himself and rent the rest to someone else.

Managing Hedge Funds

On top of both sits an expert who manages the investments.

Mutual funds offer their managers a flat pay regardless of the fund’s performance. Hedge funds, on the contrary, stimulate their managers. Their payment depends on the moves they have made and their performance.

Let’s look at it in detail:

Usually, managers receive a percentage of the returns of each investment they’ve made. Of course, there is a fixed management fee between 1% and  4% of the net asset value. On one hand, it’s great to invest in a fund where managers try to perform exquisitely. On the other hand, it increases the risk of future losses because of constant attempts for higher returns.

Hedge Funds Popular Strategies

In spite it’s far from intraday Trading strategies – some of the most common strategies used by hedge funds are also used in Intraday trading (not all of them) – Emerging markets, Fixed income,  Candlestick patternsConvertible arbitrage, Options strategy, Macro, Activist, Support and Resistance Levels, Fund of funds, and others (If you want to know more, see our technical analysis section).

Bottom Line

Overall, hedge funds are quite similar to mutual funds and managers take care of investors’ money.

Even though it’s always safer to trust your money in a professional, one never knows what they might be hiding from them. Especially, given the fact that the SEC does not strictly regulate hedge funds. In addition, though technically almost everyone can become a part of such funds, practically only accredited investors can.

Now you know the basics, but be ready to do extensive research before placing your money and trust in a hedge fund.

Good luck!

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