What Are Hedge Funds?

Hedge funds are a riskier portfolio of assets that are usually used by more sophisticated investors. They differ from mutual funds because the fund manager will often use riskier and more aggressive investment strategies such as highly leveraged positions and the use of derivatives.  

Hedge funds tend to be more exclusive because they usually require a large upfront investment. In addition, they are less liquid than mutual funds since hedge fund contracts usually require that the investor lock in their funds for at least one year.

In most cases, hedge funds are not regulated because they are only available to advanced investors. However, the investors in the fund are required to have proper accreditation.

Strategies

Global Macro

Investors that engage in this particular strategy will calculate their position in the currency, equity and bond markets based on what they believe will occur in the global financial markets. Historical data will be used in order to predict future movements in the financial markets.

Directional

This strategy will closely consider market movements and current trends when making investment decisions. Directional investors will tend to focus on specific regions or sectors.

Event Driven

This strategy is slightly opportunistic and aims to take advantage of certain events as they occur. For example, this strategy seeks investing opportunities when there are mergers and acquisitions or bankruptcies.

Relative Value

The relative value strategy compares the values of similar or related securities and seeks price discrepancies. The prices between comparable assets can vary due to pricing errors, and if this is the case the investor can earn a profit.

Risk

Risk Management

Despite the complicated investing techniques, hedge fund investors are believed to have the most sophisticated risk management strategies. In some cases, risk officers may be involved. Although they do not take part in any investment activities, they monitor best risk practices and ensure that they are being followed. Many different models are used to measure risk. The exact type that is used will depend on the investors and the fund manager.

Transparency

Hedge funds are not as transparent as other funds available in the markets because they do not require any form of public disclosure from the investors. In addition, hedge fund managers do not receive as much oversight and scrutiny as mutual fund managers.

Fees

Hedge fund fees will typically consist of performance fees. As the name suggests, the amount that must be paid depends on the amount earned by the hedge fund throughout the calendar year. In the United States, they can be as low as ten percent or as high as fifty percent.

In addition, the investor will usually be required to pay a management fee. This fee is calculated based on the fund’s total value of assets in the fund less any liabilities. These fees will also range depending on the hedge fund managers.

Remuneration

Portfolio managers will be compensated based on the performance fees. Since the management fees will typically only cover the costs associated with managing the fund, the portfolio managers rely on the performance fees as personal profit.