What Are The Advantages And Disadvantages Of Hedge Funds Investment

Last Updated: December 10, 2019
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The advocates of hedge funds paint a colorful picture about this type of investment. Is it true? Here's all the advantages and disadvantages of hedge funds

Have you wondered why people invest in hedge funds?

The advocates of hedge funds paint a colorful picture of this type of investment. What you will hear less about the funds are its negative aspects.

Looking at the hedge funds, investors have to be concerned with some key aspects. These include:

  • Alignment of interest
  • Higher fees
  • Less liquidity
  • Less transparency
  • Effective implementation

All these are issues that investors have to address before stepping into hedge fund investments. If one is able to manage these issues effectively, then we are able to take advantage of the benefits hedge funds bring along.

Unfortunately, investors find their way into poor hedge funds. In most cases 2 out of 5.

Why?

This comes from a poor judgment which majorly results from a lack of understanding beyond what seems a sound risk investment.

So what are the advantages and disadvantages of hedge funds?

Advantages Of Hedge Funds

Flexibility

Unlike mutual funds, the hedge funds are much more flexible.

Why?

SEC [Securities and Exchange Commissions] do not put much focus on hedge funds. Basically, people do not trade hedge funds publicly. Therefore, for this reason, they are more flexible as there is no particular body regulating their performance.

A hedge fund could use strategies such as short selling, derivatives, and leverage to invest across an array of investments.

Short selling is a key element you need to look at. Short selling (shorting) in finance is a way to profit from declining price of the security, bond or stock. This is an aspect contract to what most investors would want. Benefiting from the rising price of their investment option.

This makes hedge funds more secure and interesting to trade-in.

For example:

To better understand, look at what happened in 2007. In about 7 months, investors had made $1 billion. Now, what normally happened is that shares in a bank, Northern Rock were about $12. this was in February. In September the same year, the shares had dropped to $2.

Therefore, when comparing this to all other investment options, hedge funds are much better. What makes the hedge funds even better is the fact that, their managers do not have to be fully invested. Thus, there is no need to evaluate the performance against a particular benchmark.

Aggressive Investment Strategy

When hedge funds are in question, one thing is particularly clear: aggressiveness in investment.

This is important in order to realize the higher return. These investment strategies include short selling as well, using borrowed money to buy more assets [ Leverage buying] and finally derivatives.

Long Or Short Selling Of Hedge Funds

This is one of the effective strategies hedge fund managers utilize. They can either purchase the stocks they feel are undervalued or in the same case, sell the stocks they deem undervalue. However, it is better to note that funds will have positive exposure to the equity market.

Let’s do some basic calculations to understand the concept of positive market exposure:

  • Stocks long position, say you have invested 60% of the funds
  • Short-sell stocks in 40% of the funds.
  • Now, the net exposure to the equity market would be 20% (60%-40%).

The result?

In this case, the fund would not be using any leverage. Since their gross exposure is 100%. In case the manager increases the long investment position, by 10%, this would amount to 70% while still holding the short run constant at 40%, the fund would now have a gross exposure of 110% which would indicate growth in leverage to 10%

(70%+40%)=110%

(110%-100%)= 10%.

Leverage Strategy

In a leverage strategy, the investors will borrow and trade money on top of the capital that they will gain. The benefit of the strategy is that it can enhance returns.

However, anticipation for a huge gain is a measure against the chances of huge loss. Thus, if the hedge fund managers are to use this strategy, then complex tools to manage the risk should be in place.

Increases The Chance Of Diversification

There are a variety of reasons to include hedge funds in a portfolio of investments. One of the most important and basic reason is the fund’s ability to add diversification and also reduce risk.

What does it mean?

Hedge funds have the ability to diversify the investment in that it offers an array of investments. These include, the long/short, tactical trading, event-driven and also the emerging markets are some of the opportunities managers take.

By taking advantage of this diversification opportunity, the managers are able to reduce the risks. However, in a certain specific style. Hedge funds enable investors to obtain instant diversification in a portfolio of investment. This is particularly beneficial for the investors with a larger basket of hedge fund portfolios but too small to achieve proper diversification.

Here’s the secret:

The allocation of a class of assets to a hedge fund from a traditional investment portfolio diversifies the risks that may be associated with the conventional equity and bonds market.

By focusing on certain specific risks, the funds reduce the risk exposure by 50% to the general market movements. This is made possible by specific risk targeting. The fund could produce a stream with a lower correlation level and lower downside volatility than general risk assets like the equities.

From 0% to 10% and so on, the portfolio creation would continue to grow in magnitude leading to a more diversified portfolio. Also, funds of funds (alternatives to investing directly into individual funds) are a good case to mention.

They are well-diversified investment vehicles that are made up of a variety of other funds.

For example, with the hedge funds minimums often starting at $1 million, it would be difficult for an investor with $2 million accounts to diversify their portfolio hedge funds.

Lose Reduction

In many cases, a hedge fund that provides consistent results in returns increases portfolio stability. This is in case all the traditional investments are falling or underperforming. There are some hedge funds strategies nice returns with the fixed-income-volatility.

During the sharemarket sell-offs, the hedge funds are able to reduce the losses.
How?

For example, if there is a sell-off in the market, somewhat an unpredictable trend, the chance of loss may be reduced by quite significantly and even by close to 80%. Unlike in traditional investments, where chances of loss are 100%.

With the loss reduction strategy by the hedge funds, the investor would be able to improve their portfolio by over 50%. This is rare compared to other investment platforms.

Expert Advice And Transparency

Hedge funds are one of the funds that offer handsome payments to their workers. The hedge funds managers, aside from being advanced in matters to do with investment, they are also well versed in financial management matters.

Therefore, when you go to the market, as an investor, you are sure to get the best information. Advice on which hedge funds to use. Also future predictions in the performance of the individual funds.

One thing that attracts investors to hedge funds is their disclosure. They do not require any public trading. Basically, the investors and the regulators are unable to regulate the activities of the fund’s managers

Hedge Funds Investment  – Disadvantages

Hedge Fund Fees

Most of the operating hedge funds have a fee structure known widely as “2 and 20”.

In the structure, what normally happens is that investors pay a 2% in management fee. This fee is usually for the operations of the fund. Additionally, they have to also pay 20% to the fund manager. This is usually a performance fee to fund the manager for any profits made through the year.

Sounds familiar?

Consider an investment vehicle such as mutual funds. In mutual funds, they often have their management fees below 2%. In addition to that, there is no performance fee. The high fees mean that the growth of an investment of a hedge fund needs to be big enough. This is to outweigh the performance status quo.

Let’s not forget:

In hedge fund investment, it means more risk for better performance.

The management and the performance fee are based on this. This results in the manager taking up more risks in order to increase the performance and thus a nicer return. This could amount to huge loses making the investors pull away from the fund. For more info, see fees and other expenses associated with mutual funds.

To Sum up:

In 2016, 1057 funds were closed as investors pulled $70.1 billion. The shutdown in comparison to 2015 was worse. It had totaled to 10.4% which brought down the number of the remaining hedge funds to 9,893.

The Downside Capture

This is a risk management measure used to assess what level of correlation a hedge has to a specific market. This happens to the hedge funds that demand/claim the absolute returns objectives.

Now:

The lower the downside capture, the better the fund preserves wealth during any market downturn.

The perfect correlation with the market comes about when there is an equation of 100%. the disadvantage of this is that all the funds there is being compared to a unified benchmark for the market.

The Risks And Returns

Hedge funds are regarded as an investment vehicle taking up so many risks.

Why is that?

In their investment strategies, they usually drag so many risks with them in pursuit of a larger return (report from SEC). The higher risk could lead to a fallout in the returns. However, in this case, this issue is double-edged. It may be a boom and it may also be a bust.

In 2011, the hedge funds were falling below the market with a 4.8% fallout. This was quite disappointing as the other counterpart (mutual funds) were performing relatively well.

Standard Deviation

Hedge funds use this statistical tool to anticipate the risk of investing in a particular fund.

Let’s look at it in detail:

If a certain fund has an average annual return of say 8% and the standard deviation is about 3%. Then an investor would expect a return that is between 5% and 11%. 68% of the time (one standard deviation from the mean 8% -3% and also 8% + 3%).

In the same case, the investor would be expected between 2% and 14%. 95% of the time  (two standard deviations from the mean 8%-6% and also 8%+6%).

Bottom line:

The disadvantage of this statistical tool is that it measures the volatility of possible gains. This is normally expressed as a certain percentage per year. Thus, it doesn’t indicate the overall picture of the risk of return.