What is Hedge Fund Investing and How Does It Work?

| Updated
by Osaemezu Ogwu · 13 min read
share this:
Photo: QuoteInspector
Photo: QuoteInspector

Hedge funds provide institutional investors with an opportunity to receive returns that are not closely tied to the performance of the stock or bond market. In this guide, you may find everything you need to know about this investment opportunity.

Hedge funds are one of the most popular types of investment due to their potential to yield massive profit. These funds are quite similar and at the same time dissimilar to private equity funds and mutual funds. As such, potential investors have to make an informed decision before venturing into any. Here’s all you need to know about hedge fund investments.

What is a Hedge Fund

A hedge fund is a pooled investment since money is sourced from several accredited, institutional investors. The money can then be used to invest in various assets that could potentially yield immense profit for investors. However, risk management is often implemented to curb the losses that may be inevitable in these investments, and complicated portfolios may have to be set up.

What’s more, hedge funds are one of the top alternative investments. As such, their characteristics differ from traditional asset classes such as stocks, bonds, and cash. Also, the strategy employed in managing these funds as well as the regulations that guide their operation differs from other alternative investments.

On the other hand, hedge funds may rely on borrowed money or leveraging in order to increase their profit. Nonetheless, borrowing is quite risky and a real-life scenario of its negative impact was witnessed in the 2008 financial crisis.

Characteristics of Hedge Funds

Some characteristics of hedge funds are:

Non-Mandatory Registration

Hedge funds are not required to register since the Securities and Exchange Commission (SEC) already knows its participants. Even though registration is not mandatory, there are cases where funds managers may still register in a bid to give their investors more confidence. The regulations that protect investors in other assets are not applicable here. Nonetheless, these funds are mandated to adhere to laws pertaining to insider trading, fraud, amongst others.

Participants and their selection

Accredited wealthy individuals or companies are the main investors in hedge funds. And before a person qualifies to be a hedge fund investor, they must have earned over $200,000 annually, for the last two years or have a net worth of not less than $1 million. A person who meets either of these criteria is believed to have met the SEC’s requirement. And qualified individuals can handle the risks that may occur through this investment.

There may be discrimination in this investment since hedge fund managers have the freewill to approve or disapprove participants. They could do so without providing any suitable reason. In comparison to stock investments or mutual funds, this differs since the latter allows just about anyone to be an investor. There’s, however, a benefit to selecting members who can join. Here, members that have the same capital allocation policy can be allowed to join and this can help to reduce potential conflicts in the near future.

Structure

The hedge fund structure is made up of investors, investment managers, prime brokers, and executing brokers. The investment manager takes decisions pertaining to where the pooled money should be invested or how risks should be mitigated. Also, the prime broker enables the fund to complete huge investment transactions while the executing broker helps in the processing and completion of hedge fund investments.

Fee Structure

Hedge funds have a fee structure known as Two and Twenty These funds charge two major fees and these are the expense ratio and a performance fee. The expense ratio is used to cover management, administrative and advertising expenses. In contrast, the performance fee is paid to the fund’s manager to ensure a positive outcome of investments.

Liquidity

Unlike other investments where users withdraw their funds more often, the same cannot be said about hedge funds. They may be short or medium-term investments, but managers still restrict how often investors can make withdrawals. Accordingly, investors may have to leave their capital for months before taking profits.’

Range of Options

Investors have the freedom to invest in stocks, bonds, commodity futures, arbitrage, derivatives, and other financial instruments. This varies from other investments, that source for capital from large investors, where the only options to invest in, are stock and bonds.

Hedge Fund vs. Private Equity Fund

A comparison of hedge funds with private equity funds shows there are similarities and differences between both. Let’s take a look at each.

Similarities Between Hedge Funds and Private Equity Funds

Some similarities between these funds are:

Type of Investors

When it comes to their similarities, the type of investors in either of these is the same. Accordingly, the main participants of these funds are institutional investors.

Participation Fees

Investors of these funds are required to pay management fees and a part of their profit to the managing partners.

Differences Between Hedge Funds and Private Equity Fund

When it comes to their differences, their objectives and the type of investment sought after by both differ. Here’s what it looks like:

Investment Type

Hedge funds and private equity funds attract wealthy individuals, however, the type of investment made differs. For instance, hedge funds invest in a variety of options such as stocks, currencies, commodity futures, etc. to yield profit for investors. On the contrary, the latter invests in companies. In this case, private firms can be purchased.

Liquidity

Investors in hedge funds can make withdrawals sooner unlike participants in private equity funds who may have to wait for years. The reason is, hedge funds majorly target liquid assets, which enables investors to make withdrawals within some months or after a year. Contrastingly, private equity funds may require investors to wait for three to ten years before they make withdrawals. The latter is a result of the length of time it could take for investments to yield significant returns.

Level of Risk

Hedge fund investments are risky and the same can be said about private equity funds. Nonetheless, their level of risk differ and in this case, hedge funds may pose a higher risk. This is because it centres on achieving massive profits within a short period. Despite this, both funds implement risk management. Risks are curbed by merging investments that are of high risks with safer investments

Structure

A good number of hedge funds can be said to be open-ended, thereby offering investors an opportunity to increase their investment. They can also redeem their shares in a shorter time frame on a yearly basis. In contrast, closed-ended investments can be used to describe private equity funds since investors cannot put in more capital after the investment period has passed.

Hedge Fund vs. Mutual Funds

Modern-day mutual funds were first created in March 1924. The first hedge fund was the Massachusetts Investors Trust and it was offered at the time by American-based global investment manager, MFS Investment Management. Of late, these funds have gained popularity, and they offer their participants a wide range of investment options that are passively and actively managed.

Similarities Between Hedge Fund and Mutual Funds

Some similarities exist between hedge funds and mutual funds and some of these are:

Investors

Hedge funds and mutual funds both receive money from a pool of institutional investors. However, it is worth noting that mutual funds may also receive funds from retail investors, hence, its participants are not only high-net-worth individuals.

Accreditation

Investors of either a hedge or mutual fund have to be accredited before they are allowed to invest their money. However, it may not always be the case with mutual funds.

Diversification

The money raised from investors of hedge funds and mutual funds is invested in securities. As such, these two investments bring about diversification of the individual’s portfolio.

Differences Between Hedge Fund and Mutual Funds

The differences between these funds include:

Investors

Hedge funds are primarily targeted at accredited institutional investors while mutual funds’ products are available to the public. As such, its investors can also include retail investors. Hedge funds can, therefore, be viewed as private investments while mutual funds are public investments.

Level of Risk

Hedge funds pose a higher level of risk compared to mutual funds. This is because the funds adopt high-risk strategies when investing with the aim of generating huge profits for investors. On the other hand, mutual funds reduce its use of high-risk investments and it does not have a heavy reliance on derivatives or alternative investing. This makes it a suitable investment vehicle for the public.

Management

Hedge funds pose more risk due to their adoption of strategies like options, leverage, short-selling, etc. all in a bid to make higher returns. Nevertheless, hedge funds are better managed than mutual funds. The aim is to mitigate the risks that may occur especially when consideration is given to the millions invested.

Flexibility

As a private investment, hedge funds offer higher flexibility when it comes to investment provisions and terms of investment. For this reason, these funds require higher fees compared to mutual funds.

Liquidity

Hedge funds have low liquidity since funds can be locked up for months or years before investors finally cash out on returns. The same is not the case with mutual funds since investors can withdraw their money within a shorter period. What’s more, investors in a mutual fund are able to redeem their shares irrespective of the business day.

Fees

Hedge funds require a 2% and 20% management and performance fee respectively. However, the operational fees for mutual funds range between 0.05% and 5%. These fees are considerably cheaper than what hedge fund managers charge.

Regulation of Hedge Funds

The regulation of hedge funds is not as strict as other alternative investments such as mutual funds. For starters, hedge funds may not comply with the requirements outlined in the Securities Act of 1933. Even though these regulations are overlooked, the Securities and Exchange Commission (SEC) still mandates that accredited individuals participate in hedge funds.

Accordingly, accredited, institutional investors with millions to their name are allowed to participate. Also, individuals who have made a minimum income of $200,000 within the past 2 years while expecting that they’ll make something similar in the current year are allowed. These individuals must also have good knowledge about investing, trading, and personal finance, to minimize the risks.

On the other hand, there’s also the Investment Company Act of 1940 that demands investors of large hedge funds to have around $5 million in investments. Companies are required to have $25 million in investments. In line with that, the Investment Company Act of 1940 also restricts funds from running a public offering.

Consequently, these requirements automatically mean that hedge funds are not open to the public and an individual may find it challenging to invest in a good hedge fund. Individuals may have to invest in a company’s stock, that is, if the company invests in hedge funds. The latter is an indirect way of investing in these funds.

Regulation D

The SEC’s Regulation D restricts the number of people that can be investors in a particular hedge fund. Also, hedge fund managers have a minimum investment amount an investor can make. Accordingly, each investor may be required to bring $500,000 to $1 million.

Regulation D Ban on Advertisement

In the past, Regulation D banned the advertisement of hedge funds. As such, it made it difficult for individuals to learn about new investment opportunities except they had ties with an affiliated broker-dealer. It was believed that keeping these funds out of the public’s notice would protect investors.

Nonetheless, applications were made to the SEC to lift this restriction. Although the ban has been lifted, some hedge funds do not still advertise themselves. As such, it still makes it hard for potential investors to recognize when there is a new opportunity to invest.

CFTC’s Regulation of Hedge Funds

The Commodity Futures Trading Commission (CFTC) also regulates hedge funds in the U.S. Accordingly, hedge funds the CFTC regulates are subject to its requirements outlined in the Commodity Exchange Act.

What’s more, there have been changes in the regulatory requirements for hedge funds in the U.S. after the passage of the Dodd-Frank Act. The Act brings about new registration as well as other requirements for the fund’s managers.

Lawmakers in Europe have also made changes to regulations pertaining to hedge funds. The EU approved the first EU directive in 2010, and it is specially tailored to alternative investments. The directive is known as Alternative Investment Fund Managers (AIFMD). One of the AIFMD’s requirements is for managers of these funds to register with the country’s regulators.

How to Buy Hedge Funds

Here’s how to buy hedge funds:

Before you can qualify to invest in a hedge fund, you must meet the fund’s minimum investment requirement. Depending on the hedge fund you settle on, a minimum capital of $500,000, $1 million or more may be required. Nonetheless, there are still hedge funds that are like mutual funds, giving the average investor an opportunity to be a part.

Review the Fund

Once, you’ve met the qualification to be a hedge fund investor, it is important to review the fund you’ll invest in. Here, you can review the fund’s prospectus and performance-related collateral. But if you have little or no knowledge about either of these, you can employ the services of a financial adviser. It’ll help you to evaluate potential risks and how these risks align with your goals and investment needs.

Evaluate the Value of the Fund’s Holdings

A good understanding of the value of the fund’s holdings will help you to ascertain if it is worth investing in. And there are cases where hedge funds may hold investments that are difficult to sell or price.

Understand the Fee Structure

Hefty fees and taxes are often levied on hedge fund investors. While these fees may vary, 2% in management fee and 20% of profits made are often required even by the best hedge fund managers. Some hedge funds have lessened their fees to 1.5% and 17.5% for the annual management fee and performance fee, respectively.

Understand the Strategy

Leverage and short selling are tools that can be used in an investment of this nature to yield profit. However, it is worth noting that they still pose potential risks. The Derivative is another complex strategy that is used by hedge funds to generate returns.

Know Your Redeemable Times

Before investing in hedge funds, you need to know that investors have limited access to their money due to the lock-up period. As such, you’ll be required to wait for three months or even up to a year before making withdrawals. It is, therefore, important to know when you can withdraw your money to ascertain if it aligns with your financial needs. You can find this information in the hedge fund’s legal documents.

Know if You Can Afford to Lose

Finally, it is needful to ascertain if you can bear the losses that may occur. This is because hedge funds come with the promise of higher returns but then, their level of risk is just as high. As such, an investor could lose every penny they have invested in the fund if its investments perform poorly. Consequently, meeting the requirement to be a hedge fund investor should not be the only yardstick in deciding if you become a participant or not.

Conclusion

Hedge funds provide institutional investors with an opportunity to receive returns that are not closely tied to the performance of the stock or bond market. Much more, investors can diversify their portfolio thereby spreading the risk. In the end, investors would’ve hedged against declines in the market to yield positive returns consistently.

share this:
guides