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 The stock market is simply an amazing organization when it comes to creativity. Take hedge funds for example, they're not exactly mutual funds and they're not exchange traded funds either - so what exactly is a hedge fund?
Hedge Fund Definition
Technically, a hedge fund is defined as a private investment fund. They are usually organized as limited partnerships and often employ non-traditional investment strategies. Meaning they often shy away from investment strategies that involve long-term buying and holding of securities in the portfolio.
Hedge funds have been around since the late 1940s. In their early days a hedge fund was used to reduce market risk by selling short some stocks and buying others at that same time. Today, some hedge funds don't even include stocks in their portfolio, so the investment instrument has certainly evolved over time.
Hedge Funds and Mutual Funds
Whenever the stock market is under performing, whispers of hedge funds start to be heard. The word "hedging" itself implies taking a defensive position or placing an insurance "bet" to balance against down markets. The past 4 or 5 years has seen a pretty flat market and therefore a dramatic rise in the interest in such funds. Right now, it is estimated that there are approximately 9,000 hedge funds managing roughly $1.3 trillion in assets for their clients.
Hedge Fund Performance
Interestingly, there are several studies that indicate that hedge funds out perform their mutual fund counterparts in bear markets. But as is the case with any investment vehicle, you should understand the risks and rewards. So let's examine the differences between hedge fund and mutual funds. Later on well also examine a fund with a funny name - a fund of hedge funds.
Hedge Funds versus Mutual Funds
Just like mutual funds, a hedge fund pools money from various investors in an effort to provide acceptable returns. However, unlike mutual funds, most hedge funds are not registered with the Security and Exchange Commission. This means that hedge funds do not have to abide by the reporting requirements of the SEC and that agency does not provide the investor with any degree of regulatory oversight.
As mentioned earlier, hedge funds are considered private investment vehicles and are restricted to accredited investors with net worth in excess of $1 million or an income in excess of $200,000 per year. Qualified purchasers can also join hedge funds if they own at least $5,000,000 in qualified investments.
Often hedge funds have a limited number of investors - less than 500 - that's why they are organized into a limited partnership. There is no limit on the fees these funds can charge and many have generous performance incentives for the fund managers in addition to normal fund management fees.
Hedge Fund Management Fees
If successful, starting a hedge fund can be very rewarding for the fund's management team. The hedge fund manager is sometimes referred to as a "general partner" and this position is responsible for making investment decisions that are aligned with the fund's investment strategy.
The normal payment arrangement for fund a manager is that they receive one or both of the following:
- Management Fees - usually based on a percentage of the fund's assets. Management fees are often in the range of 2% of assets.
- Performance Incentives - the payment of incentives is usually tied to a performance threshold and based on a measure of the fund's profitability. Incentives can be quite high for a profitable fund and fees in excess of 20% are possible.
Investing in Hedge Funds
Hedge funds offer the investor less liquidity when compare to mutual funds. Often there is a short window of opportunity to invest or close out a position - quarterly or sometimes only annually. Hedge funds are also not limited to a single class of investment such as stocks. They can utilize investment instruments such as financial leverage, derivatives, short selling, commodities, and they can even take a large stock position in just a single company.
Fund of Hedge Fund
A fund of hedge funds closes some of the gaps between hedge funds and mutual funds. Most of these funds have a lower minimum investment requirement; typically in the range of $25,000. The idea behind a fund of hedge funds is to lower the risk of a single hedge fund by creating a portfolio, or fund, of hedge funds.
Some funds of hedge funds are registered with the SEC. If the fund is registered, they are required to provide investors with a prospectus and file semi-annual reports - just like a mutual fund. Unfortunately, a fund of funds can also carry with it an additional layer of management fees. In addition to paying the embedded management fees mentioned above, an additional 1 - 2% of assets might be paid to the fund managers as well as added performance incentives.
Basics of Hedge Funds
So what are some things you should understand before deciding to invest in a hedge fund or a fund of hedge funds?
- Risk and Reward - In a perfect market there is a balance. If the rewards are high, you can be sure that significant risk exists.
- Asset Valuation - Since hedge funds can place money into investment vehicles such as derivatives, these assets are often hard to value accurately. It's important for you to understand how these valuations are calculated by the fund.
- Fees - We mentioned this in our article on no load mutual funds, and the same applies here. Management fees can have a significant impact your total return on investment. Hedge funds include both management fees and generous performance-based incentives.
- Redemption Policy - Liquidity can also be a problem with hedge funds. You might get locked into a one-year term or have limited opportunity to enter and exit the fund. Make sure you understand the fund's policy on exiting the investment.
Because of the way hedge funds, and a fund of hedge funds, can be structured you should not expect to automatically get the same protections you would with mainstream investment offerings. The SEC and other securities agencies may only have a limited ability to monitor the activities of the fund. Do your homework and don't be afraid to ask questions. Check out the track record of the fund manager, and be skeptical of inconsistent patterns.
We're going to continue to research this particular topic and in the near future will also be including a list of some of the best hedge funds on the market.
About the Author - Fund of Hedge Funds and Hedge Funds
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