What Is A Hedge Fund?
I’m sure you’ve seen the term “Hedge Fund” used in your research about Wall Street, but what exactly is a “Hedge Fund” and how is it different from any other fund? More importantly, how can you benefit from this?
A Hedge Fund is a private investment partnership. It is usually offered to a limited number of investors and typically requires a significant initial minimum investment. Normally, Hedge Funds are only open to institutional or otherwise accredited investors, and typically these investors are required to keep their money in the fund for a minimum period, usually one year.
A Hedge Fund resembles a mutual fund in the way the investments are pooled and managed. But because they are lightly regulated private funds, they can, and do use unconventional investment strategies.
For example, conventional funds are usually limited to either buying stocks or bonds. They have to go long, they are not allowed to go short, use options, or other advanced investment tactics. Hedge Funds are not limited in this manner, they can, and do, use these strategies with the intent of making higher returns. Hedge Funds have the ability to “short” the market if they believe that it is going to drop in value, which gives them the ability to profit when the market is decreasing in value.
Hedging is a strategy designed to reduce risk. And when the Hedge Funds came about in the 1950’s, they were designed to reduce the amount of risk in a bear market. Now, a hedge fund is primarily designed to make a higher return on investment by taking advantage of market volatility. In fact, because of the speculative strategies that are used, Hedge Funds can be riskier than the overall market.
The majority of investors in a Hedge Fund must be accredited, and typically must earn a minimum annual income and have a net worth in excess of one million dollars. Because the Hedge Fund allow only qualified or accredited investors, they are allowed exemptions that Mutual Funds are not allowed. Hedge Funds are not offered to the general public, therefore, they have fewer government regulations.
The Hedge Fund manager makes investment decisions based on the strategy outlined in the offering documents. Some Hedge Funds will charge both a management fee and a performance fee. The management fee is usually computed as a percentage of assets being managed, and the performance fee is computed as a percentage of the profits. Sometimes the performance fee must obtain a minimum percentage increase before it is allowed. Other funds charge no fees until the funds pass specific performance goals.
Mutual funds are required to disclose their activities to third parties. However, Hedge Funds do not have this requirement. Because of the secrecy and lack of regulation, Hedge Funds are viewed with suspension and are often the target of criticism. Regulators in the US have tried to place restrictions on Hedge Funds, but have been unsuccessful, partly because of the courts and partly by the off shore locations. A significant number of Hedge Funds are located in Burmuda, the Cayman Islands and other locations with more relaxed banking and investment regulations.
Some people have stated that Hedge Funds are little more than exclusive, high-fee mutual funds, and that the fund manager is rewarded more for churning the account than for high long term returns.
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