Advantages And Disadvantages Of Hedge Funds

Advantages And Disadvantages Of Hedge Funds

When considering investing in hedge funds, remember that there are pros and cons to including such funds within your overall portfolio. You can easily be enticed into a poor hedge fund investment if you don’t understand that beyond the seemingly sound risk management tools and statistical analysis many unstable and unpredictable events may exist. On the flip side, if you’re equally as uneducated, you may miss out on huge positive investment opportunities by neglecting the advantages a hedge fund investment can bring to you. Below is a rundown of some of the more important advantages and disadvantages of hedge funds.

Advantages

Aggressive Investment Strategies

One advantage to hedge funds is the aggressive strategies used by investors in order to get a high return. For example, some aggressive investment strategies that can operate both on the U.S. and international financial markets are called leverage, derivative, and long and short. Thus, as an example of a leverage strategy, investors will borrow and trade money on top of the capital they gain. This strategy can enhance return, but the chance for big gains must be measured alongside the potential for huge loss, and so those using this strategy will also employ complex risk management tools to reduce possible associated risk.

Huge Gains

One other advantage to hedge funds is the large amount of money that can be made by utilizing them within your portfolio. The aim of hedge funds is to acquire a high-return despite what market fluctuations are occurring at any given period. For example, one type of hedge fund strategy is called a “global macro” approach. This strategy attempts to take a large position in commodities, stocks, bonds, etc., by forecasting what investment opportunities one can take in relation to what may happen in future global economic events. This is done in order to create the largest return with the least amount of risk.

Expert Advice

There is a very good reason why those working in hedge fund investing, such as a hedge fund manager, are paid handsomely. Aside from just the big gains that can be made on such investments, these individuals are extremely experienced and knowledgeable in matters of financial investment; thus when you invest in hedge funds you are getting expert advice as to not only which hedge funds to use, but when (anticipated market fluctuations) and where (domestic versus international), which can easily ensure you a greater chance of receiving a large return on your investment.

Hands up for the stock market.

Disadvantages

Large Investment Fees

One major disadvantage of hedge funds, and a highly criticized one as well, is the often high fees one must pay in order to invest in hedge funds. For example, hedge fund investors typically charge both a performance fee on top of a management fee. A management fee is usually 2% of the net value of the fund, and is paid typically every month. Regarding performance fees, they are typically 20% of whatever the fund earns in any given year. Performance fees are mainly used to motivate managers to create as big of a profit as they can.

Standard Deviation

Another disadvantage to hedge funds is the use of the statistical tool known as the standard deviation. This is a very common tool used to anticipate the risk in investing in a particular hedge fund. So, the standard deviation measures the volatility of possible gains, expressed as a certain percentage per year. The statistic can provide a good measure of potential variation in gains during the year, however the downside is that the standard deviation cannot indicate the overall big picture of the risk of return; mainly because hedge funds do not operate under a bell-curve, or normally-distributed rate of return.

Downside Capture

The downside capture is a risk management measure used to assess what level of correlation a hedge fund has to a specific market when that particular market is on the decline. The smaller the downside capture measure of a fund, the better equipped the hedge fund is to handle a market decline. However, the disadvantage is that all funds are compared to a unified benchmark for the market. So, if a hedge fund manager uses a wildly different style of investing than the benchmark, the downside capture ratio may, for example, show that the fund is under-performing the benchmark, even if the market index generates high returns.

Drawdown

The drawdown is basically a statistic that provides an estimation in the overall rate of return on an investment compared to that investment’s most recent highest return, a peak-to-valley ratio. The disadvantage to this measure is related to the disadvantage that the standard deviation has with a hedge fund, mainly that hedge funds do not operate very consistently and predictably in order for the standard deviation, and thus the drawdown, to be very useful.

Leverage

Leverage is an investment measure that’s often overlooked as being the main factor in hedge funds acquiring large losses. Basically, when leverage rises, any downsides in investment returns are magnified, often causing the hedge fund to sell off its assets at a cheap price. Leverage is typically a main reason why so many hedge funds go bankrupt.

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