You’ve undoubtedly heard the term hedge fund before. Most people have, traders and non-traders alike.
However, relatively few actually know what a hedge fund is, and fewer still know how hedge funds work.
So … what is a hedge fund? This post takes some of the mystery out of hedge funds to give you a better understanding about what they are, how they work, and what makes them such an enticing investment opportunity for select investors.
Hedge Funds: The Basics
A hedge fund is a limited partnership. It’s a financial relationship that exists between a fund manager (also known as the general partner) and the investors (also known as the limited partners).
Let’s take a moment to look at how these two parties work together …
Fund Manager
The fund manager or general partner is the person steering the ship that is the hedge fund, creating a strategy and managing the funds.
Their goal is to maximize investor returns and eliminate risk, regardless of whether the market is moving up or down.
Investors
The investors, or limited partners, are the ones who contribute the money. However, not just anybody can be a hedge fund investor.
Who Can Invest in a Hedge Fund?
Nope: Hedge funds aren’t accessible to just anyone with a bank account.
To be eligible to invest, you either must have a net worth of over $1 million (excluding a primary residence), or you must have made over $200,000 for the past two consecutive years.
Hedge funds have a reputation for being very white collar, and now you can see why!
Benefits for Managers and Investors
Ideally, both parties benefit from the hedge fund relationship.
The investors benefit from having a fund manager who can take their investment and earn them returns, increasing their wealth.
The fund manager is typically paid by a fee schedule that is referred to as “two and twenty,” which means that they get a 2 percent asset management fee, and then 20 percent of any gains generated through their work.
When you consider that some hedge funds have earnings in the billions, it’s not a stretch to say that life can be sweet for hedge fund managers.
Hedge Funds By the Numbers
Hedge funds are growing. By the end of 2017, hedge fund assets weighed in at an incredible $3.2 trillion.
Just to give you an idea of the type of earnings an individual hedge fund manager might generate, here are the stats for the biggest earners in 2017:
- Michael Platt: $2 Billion
- James Simmons: $1.8 Billion
- David Tepper: $1.5 Billion
- Ken Griffin: $1.4 Billion
- Raymond Dalio: $900 Million
What Does a Hedge Fund Invest In?
A hedge fund can invest in just about anything. Some common investments might include land, real estate, currencies, derivatives, and stocks, though they’re not limited to these categories.
Hedge Fund Strategies
There are a number of different hedge fund strategies. Here are some common ones:
- Equity: With a focus on fundamental growth and value, these short-biased funds might focus on sectors like energy/raw materials, healthcare, and technology.
- Event Driven: This multi-strategy style of hedge fund might include credit arbitrage, merger arbitrage, and distressed or restructuring companies.
- Macro: Active trading is the name of the game here, with commodities and currencies playing into this systematically diversified strategy.
- Relative Value: This strategy focuses on fixed income (convertible arbitrage, sovereign, and corporate) and yield alternatives like real estate and energy infrastructure.
- Fund of Funds: This more conservative approach is diversified and market defensive.
How to Pick a Hedge Fund
Interested in hedge fund investing? Here are some things to be sure to research and inquire about with a potential fund manager:
- What are the five-year annualized returns?
- How big is the fund, and how big is the firm handling it?
- Does it feature standard, rolling standard, or downside deviation?
- What’s the minimum investment for this hedge fund?
- What are the redemption terms?
- How many months to recovery/maximum drawdown?
Pros and Cons of Hedge Funds
Like any type of investment, there are pros and cons to hedge funds. Here are some of the biggest benefits and potential pitfalls:
Pros:
- Ideally, a hedge fund is able to generate positive returns in both rising and falling markets.
- Hedge funds can reduce overall portfolio risk and volatility and increase returns.
- Investors can precisely customize an investment strategy.
- As an investor, you’ll have access to some of the world’s most talented investment managers.
Cons:
- You must have either a very big bank account or a large annual salary to be eligible to invest.
- A concentrated investment strategy exposes hedge funds to huge losses.
- Hedge funds use leverage. Use of leverage can turn what would have been a minor loss into a significant loss.
- A hedge fund requires investors to lock up money for a period of years. Withdrawals may only happen quarterly or biannually.
Conclusion
Hedge funds are a type of investing that employ sometimes high-risk methods in hopes of realizing high gains for investors.
Due to the relatively high level of risk and the stringent income standards for investing, these funds are only accessible to a fairly elite echelon of investors.
However, even if you’re not this level of investing (yet), traders even at a much more humble level can still learn from what hedge fund managers are doing, sectors they’re investing in, and what’s moving their money.
Moreover, by looking at what hedge funds are doing, you can gain direction for your stock research on StocksToTrade and gain insight about what’s moving the market.
