In the world of finance, investors always look to double or triple their return on investment given that the fund manager deploys the money in the right assets. In such scenario, hedge funds which raise capital from institutional and accredited investors ensure that the outcome of the investment is positive.
The global hedge fund market was valued at $4.8 trillion in 2022 and is projected to reach $13 trillion by 2032. This indicates growth at a CAGR of 10.7 percent from 2023 to 2032, according to a report by Allied Market Research.
Understanding hedge funds
Hedge funds pool investors’ capital and use it to purchase securities or make other kinds of investments with the objective of generating profits. In general, they have more flexibility than mutual funds to make investments and techniques that raise the risk of investment losses since they are not subject to similar regulations. Wealthier investors who can afford the higher expenses and risks associated with hedge fund investment, as well as institutional investors like pension funds, are the only groups that can invest in hedge funds.
Types of hedge funds
Here are four common types:
Global macro hedge funds: These are actively managed investment vehicles that aim to capitalize on significant fluctuations in the market, which may arise from political or economic events.
Equity hedge funds: These may be global or specific to one country, investing in lucrative stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices.
Relative value hedge funds: These aim to take advantage of gap or price inefficiencies by short-term variations in the prices of linked assets.
Activist hedge funds: These aim to invest in businesses and take actions that boost the stock price such as demanding that companies cut costs, restructure assets, or change the board of directors.
Features of hedge funds
Below are some features:
Smart management: They are taken care of by experienced experts who use special plans based on what’s happening in the market.
Alternative strategies: They invest in a variety of assets, including stocks, real estate, and other items.
Intelligent techniques: These funds employ unique approaches to investing in an effort to increase returns. In an attempt to improve their profits, they may take measures like borrowing money or placing bets against certain investments.
Flexible: They are able to respond quickly to shifting market conditions by promptly reallocating their capital.
Risk management: To mitigate risk, hedge funds diversify their holdings and use instruments such as hedging, diversification, and risk assessment models to safeguard against losses.
Expensive: The professionals who manage these funds can make them more costly. Depending on how well they function, they could also charge fees.
Accredited investors: A lot of hedge funds only accept accredited investors that meet specific net worth or income thresholds. This is so because hedge funds are seen as having a greater level of risk and are intended for affluent, more seasoned investors.
Read more: What is swing trading? A beginner’s guide to profiting from market fluctuations
Things to consider before investing in hedge funds
Here are some points that you must take into consideration before deciding to invest:
Become a qualified investor: Before investing, you often need to meet certain income or asset requirements and be an authorized investor.
Study the prospectus and supporting documents for a fund: Verify that the fund’s investment methods and the degree of risk they entail are appropriate for your individual investing objectives, time horizons, and risk tolerance. Like any investment, you have to incur more risks in order to realize bigger potential profits.
Understand how fund assets are valued: They may hold investments that are difficult to sell and may be difficult to value. You should understand the valuation process and know the extent to which a fund’s holdings are valued by independent sources.
Understand the costs: Fees affect your return on investment. They generally charge an asset management fee of 1-2 percent of assets, as well as a 20 percent ‘performance fee’ on the hedge fund’s profits. A performance fee may encourage a hedge fund management to take bigger risks in hope of earning a higher return.
Understand any restrictions on your ability to redeem your shares: They often limit the total number of times you can redeem, or cash in, your shares to four or fewer per year. And, they frequently impose a ‘lock-up’ period of one year or more during which you cannot cash out.
Check hedge fund managers: Make sure hedge fund managers are qualified to manage your money, and enquire about their disciplinary past in the securities business.
Ask questions: You are entrusting your money to someone else. You should understand where your money is going, who manages it, how it is invested, and how to get it back.
Benefits of hedge funds
There are several benefits of hedge funds, below are some:
Potential for higher returns: Unlike standard investments, hedge funds aim to boost profits by employing unique approaches. Hedge funds might be riskier, but they can also provide higher gains, particularly when the market is moving.
Adaptability: Hedge funds can consider ways to mitigate losses. This helps them manage risks and could reduce the impact of market downturns.
Expert management: Hedge funds are managed by highly experienced experts who utilize their knowledge to make prudent choices regarding investments.
Bottom line
Empirical data suggests that hedge fund investing, when done correctly, can deliver greater portfolio returns, reduced portfolio investment correlations, and some protection against losses in weak markets. However, hedge fund investing presents unique hurdles that the average long-only investor may not have encountered before. Determining how much of a typical portfolio to allocate to hedge funds requires a thorough evaluation of the investor’s risk tolerance and target return expectations, as specified in the investment mandate. The lack of open data and hedge funds’ non-normal return distributions make it difficult to create an allocation that fits these standards. Investors must equip themselves with more advanced analytical approaches such as factor analysis and risk adjusted performance statistics that are suited for non-normal return distributions, as well as in-depth understanding of hedge fund methods to provide value-added examination.
Frequently Asked Questions (FAQs)
Who typically invests in hedge funds?
Usually defined as ‘Accredited Investors’, various institutions, corporate treasuries, endowments, fund of funds, family offices, private banks and pensions invest in hedge funds.
Do investors still pay fees even if the fund loses money?
The investor always pays the management fee on assets held within the fund, but performance fees are applicable only after positive performance has been achieved (even then a hurdle rate or high water mark may grant the investor exemption of performance fee payment).
What are the risk and return profiles of hedge funds?
Hedge funds use a different risk-return goal than conventional investments like equities, bonds, and mutual funds. Most hedge fund investors anticipate significant returns to make up for the associated risks they are exposed to.
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