Hedge funds are pooled investments, whereby a number of investors entrust their money to a fund manager, who invests in various traded securities.
Hedge fund managers will use active fund management strategies as they seek to provide positive absolute returns, regardless of overall market movements.
Typical hedge fund trading strategies could include:
- Using debt to leverage (gear up) investments made
- Taking ‘short’ positions in assets, which will provide a positive return if the price falls
- Buying undervalued assets and using arbitrage to ‘lock-in’ profits from a price discrepancy.
- Using high-frequency trading algorithms to execute trades on an automated basis
- Using a combination of derivatives and investments to take complex positions.
What makes a hedge fund different from a mutual fund?
These regulations place necessary constraints on the type of investments they can make, whether the fund can borrow, and how much risk it can take on. This serves to reduce the risk of funds and ensure that their activities can be understood by ordinary investors.
Free from constraints, hedge funds have a much wider array of investment strategies available to them.
This allows them to pursue investment strategies that have the potential to deliver returns that are not correlated to a straightforward investment in the stock market.
This has led many to argue that hedge funds are in fact an asset class in their own right, which produce a different pattern of returns and could help investors diversify their portfolio.
Pension funds and large institutions appear to agree, with such investors accounting for over 25% of the money in hedge funds back in 2016.
Hedge fund risks
With great freedom, comes the potential for higher risk.
Hedge funds tend to borrow money to allow them to take larger positions. Like all forms of financial leverage, this can lead to higher volatility of returns.
When a hedge fund uses complex derivatives to construct its portfolio, it exposes itself to counterparty risk or the risk that the derivatives don’t behave in the manner that was expected.
These two possibilities can be summarised as follows: hedge funds have the potential to surprise investors.
That could be a pleasant surprise or a not-so-pleasant one. In 2012, a study showed that only 1/10 hedge funds managed to beat the S&P US stock market index. Underperformance and disappointment is a commonly raised complaint, and partially this is due to the high fees that hedge fund managers pay themselves.
The costs of investing in a hedge fund
This brings us to the topic of high investing costs. Hedge funds have attained mythical status. Their exclusivity and good PR has allowed them to charge much higher fees than actively managed mutual funds.
But when hedge fund managers can earn in excess of $1 billion in fees per year, you have to wonder if this is at the expense of investor returns.
The traditional hedge fund fee is 2% of assets plus 20% of any out-performance of the benchmark. This performance-based fee is quite unique to hedge funds and can act as a major drag on performance, particularly in choppy markets.
If a fund doubles in value in year 1, then halves in value in year 2, you’d expect to be back where you started. Only with a 2%/20% model, you will have handed over a sizeable fee in year 1, which wouldn’t have been returned in year 2!
If the hedge fund manager only earns his performance fee if their fund is in the top half of funds, this could encourage them to take more risk when the fund is underperforming.
Can I invest in a hedge fund?
Hedge funds tend to have high minimum investments (for example, £100,000 – £1m) which takes them out of the reach of most investor wallets or purses.
They’re also restricted to sophisticated investors, and therefore you may not be permitted to invest if you were new or inexperienced to investing.
That being said, it’s possible to invest in a unit trust or mutual fund which in turn, invests in hedge funds. This can provide broad access to this asset class, whilst side-stepping the hurdles for direct investment.