Hedge funds are a limited partnership comprising private investors whose funds are pooled together to then be managed by expert fund managers. Such managers are known to use a broad range of strategies, like leverage, aka borrowed money, and trading in nontraditional assets, all so that above-average investment returns may be achieved.
Hedge funds are often regarded as risky investment choices since they typically require higher minimum investments or net worth. It is for this reason that a hedge is usually geared towards the elite or wealthy investor class.
The hedge fund sector has grown substantially in recent years. By mid-2023, over $4.3 trillion were being managed by almost 9,400 hedge fund managers. Over 29,000 funds were provided to investors globally.
What the “Hedge” in Fund Means
“Hedge fund” as a term simply refers to investment instruments consisting of pooled funds that are managed to beat average market returns. Fund managers usually hedge the positions of the fund to safeguard them from any market risks.
They do that by investing a part of the assets within the fund towards securities with prices moving in the opposite way of that fund’s core holdings. Theoretically speaking, if the prices of those core holdings go down, then the prices of the stocks or securities serving as hedges should go up. Because of this, the hedge may offset any potential losses within the core holdings.
For instance, hedge funds that concentrate on a cyclical industry, like travel, could invest some portion of their assets within noncyclical sectors like energy, seeking to use any positive returns of noncyclical stocks so that any potential losses within the cyclical stocks may be offset or mitigated.
The Risks of Hedge Funds
Hedge funds tend to be risky when compared to most ETFs or mutual funds. Outsized risks are taken to accomplish outsized gains. A lot of them even use leverage so that their gains are further multiplied. They’re not all that constrained within their investment picks too and give themselves the freedom to acquire big positions within alternative investments.
The Regulatory Landscape of Hedge Funds
Compared to other well-known investment vehicles, hedge funds face less regulation from the SEC, i.e., Securities and Exchange Commission. The SEC only needs hedge funds to register if they have private funds worth over $150 million or manage at least one fund or more.
The United States is not the only country where hedge funds operate in, obviously, and so the ones that don’t will likely follow their own home country’s regulations.
Funds that have $500 million or more of assets under management will need to file quarterly, reporting the details surrounding their liabilities and assets.
However, in May 2023, measures were adopted by the SEC, forcing more information disclosure on the part of large hedge funds through its Form PF, which is the form mainly used for reporting confidential events.
The Structure of Hedge Funds
A lot of hedge funds tend to be structured similarly to limited partnerships, and there are several key players within this group.
Investors
The first and most obvious group is investors. Here, if you want to invest in such funds, you have to be an accredited investor or have a high net worth, which should exceed $1 million.
Executing Brokers
Executing brokers are tasked with processing and completing the investments of the hedge fund. They’ll ensure that all things are compliant with the procedure or policy that applies to them.
Prime Brokers
These are a unique kind of brokers who’ll help with completing large investment transactions for the fund.
Investment Managers
Investment managers are the ones making the decisions underlying those hedge funds, such as choosing where capital is to be allocated and managing market risks.
The Different Kinds of Hedge Funds You’ll See
Hedge funds carefully select and assess the investments that are most likely to produce the highest profits. Outlined below are four main types of hedge funds you may come across or explore.
Global Macro Hedge Funds
Global macro hedge funds employ macroeconomic factors coupled with financial conditions such as inflation rates and real exchange rates so that profits may be made with market swings.
Equity Hedge Funds
Equity hedge funds, on the other hand, invest in both domestic and global stocks that provide protection against possible downturns within equity markets. Here, selling of overvalued stock indices or stocks takes place.
Relative Value Hedge Funds
Relative value hedge funds produce greater profits by utilizing spread inefficiencies or price differences of related stocks.
Activist Hedge Funds
As for activist hedge funds, well, they invest in firms that take actions according to the demands they set, like asking them to cut their costs, changing the board of directors, or restructuring their assets.
What to Look for When Considering Hedge Funds
Before you start investing in hedge funds, there are some criteria you should be on the lookout for when picking what best suits your needs.
For one, you could start by reading the offering memorandum or prospectus of the company to comprehend the location, fund manager fees, what strategies they use, any conflict of interest the manager has, what kind of investments they tend to make, etc. If you have a hard time getting the hang of this, you could always consider asking financial advisors for help.
The second thing you can do is see what type of investment strategies the fund is using, whether it’s a single strategy or a diversification strategy, as it will help you identify funds that match your risk tolerance.
Another obvious thing you could do is look if there is any data available on the fund’s past performance. Make sure it’s from a source that’s as unbiased as possible, and see if its performance has been consistent.
Conclusion
Hedge funds can become quite complex to grasp at times with the various strategies, tax regulations, characteristics, controversies, and whatnot. But if you feel like making some investments and you can handle the requirements, then the potential for a good income source is truly there.
