What Is a Hedge Fund And Should I Invest In One? (2024)

Hedge funds. The words evoke mental images of pirates in designer suits … of backroom deals over cigars and single malt … or of Gordon Gekko's iconic line from the 1987 movie Wall Street: "Greed is good."

But what exactly is a hedge fund, and why should you consider investing in one?

Let's start with the basics. A hedge fund is a pooled investment vehicle, similar in principle to the mutual funds you'd find in your company 401(k) plan. Multiple investors contribute their cash to the fund, and it is run professionally by a manager or a team of managers.

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But while mutual funds are highly regulated and available to the general public, hedge funds are loosely regulated and thus limited to "accredited investors." The definition of who exactly qualifies as an accredited investor is evolving, but for our purposes here we can summarize them as a person with a net worth excluding their home of $1 million or an annual income of $200,000 (or $300,000 including their spouse). The rationale here is that a high-net-worth or high-income person should have the financial sophistication to accept the higher potential risk that comes with lack of regulation.

To keep it simple, you can think of a hedge fund as a private mutual fund available only to wealthy people.

Structurally, most American hedge funds are limited partnerships, and the investors are limited partners. Some hedge funds are organized as LLCs (limited liability companies), and many offshore or non-U.S. hedge funds are structured as corporations. But the look and feel to the investor tends to be very similar across the board.

What do hedge funds do?

There is a common perception that hedge fund managers are high-risk gunslingers, and some of the high-profile managers you see on TV match that description. For example, Pershing Square's Bill Ackman fits that mold. He tends to run a concentrated portfolio with large positions in just a handful of stocks.

But many hedge funds are distinctly conservative and pursue low-volatility strategies. Even the name "hedge fund" implies hedging, or risk reduction.

There are literally infinite strategies that hedge funds can pursue, and some combine different ones into "multi-strategy" portfolios. But here are some of the more common strategies you're likely to see in a hedge fund:

Long/Short: A long/short strategy is a relative value strategy in which a manager buys assets they believe will rise in value and sells short strategies that they believe will fall. For example, a manager might be long Microsoft (MSFT) and short Apple (AAPL) in the belief that Microsoft will perform better than Apple regardless of which direction the general market moves. This strategy aims to profit from both rising and falling markets.

Global Macro: Global macro funds take a big-picture approach, making bets on major economic and geopolitical trends. These bets can include currency positions, interest rate plays, and commodity investments. The legendary George Soros was the prototypical global macro manager, as his most famous trade was "bankrupting" the Bank of England by shorting the British pound in the early 1990s.

Event-Driven: Event-driven hedge funds focus on specific corporate events, such as mergers and acquisitions, bankruptcies or restructurings. These are closely related to "activist" funds that buy controlling positions in companies in order to force changes to management or the board of directors.

Arbitrage: Arbitrage strategies involve taking advantage of price discrepancies in different markets or securities. For example, a manager could buy gold in London and sell it in Shanghai if gold were trading cheaper in London.

Be careful with hedge funds

There are a few warnings that come along with investments in hedge funds.

The first is cost. Hedge funds often have high fees. A 2% management fee and 20% performance fee are not uncommon. Of course, those fees might be absolutely justified if the manager is doing something unique and the returns are within your expectations even after paying the fees. But if the manager is executing a strategy you could just as easily replicate in an exchange-traded fund (ETF) or mutual fund, it's hard to justify paying a premium.

You should also be aware of potential lockups. Unlike mutual funds, which generally have daily liquidity, and ETFs, which can be sold any time the market is open, hedge funds may only offer liquidity on a monthly or quarterly basis, and even this can be subject to conditions.

Should you invest in hedge funds?

Hedge funds earn their keep by offering strategies that are hard to find in the world of regulated mutual funds and ETFs. But should you invest in them?

That question is going to depend on several factors. To start, you have to qualify by being an accredited investor. And along those same lines, you should be able to properly evaluate the risks involved. If you don't understand the strategy or aren't comfortable reading the often dense legal documents or auditor reports, then you should probably walk away.

Assuming you qualify and are reasonably able to evaluate them, the right fund or funds can potentially add real diversification to your portfolio and lessen your dependence on the market. Adding strategies to your portfolio with a low correlation to your existing strategies can lower your overall risk and improve your returns.

Hedge funds offer the potential for high returns and diversification benefits, but they also come at the cost of higher fees and less regulatory oversight. As with any investment, you should do your own research to determine whether they make sense for your portfolio.

Related content

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  • How to Find the Best Mutual Funds for Beginners
  • Best Blue Chip Stocks: 21 Hedge Fund Top Picks

As an enthusiast with a profound understanding of hedge funds, let me delve into the concepts and intricacies discussed in the provided article. My expertise in finance and investment analysis positions me well to decipher and communicate the nuances of hedge funds.

The article starts by introducing the notion of hedge funds, often associated with high finance and exclusive dealings. It contrasts them with mutual funds, highlighting the fundamental difference in regulation and accessibility. The assertion that hedge funds are loosely regulated and limited to accredited investors is a crucial point, showcasing the exclusive nature of these investment vehicles.

The term "accredited investor" is touched upon, emphasizing the financial thresholds—net worth and income—that define eligibility. This criterion aims to ensure that only individuals with a certain level of financial sophistication can participate, acknowledging the higher potential risks associated with less regulation.

The structural aspects of hedge funds are then outlined, mentioning their common form as limited partnerships in the U.S., though some may be organized as LLCs or corporations. This structural information is vital for understanding the legal and operational framework within which hedge funds operate.

The article addresses the common perception of hedge fund managers as high-risk individuals, citing examples such as Bill Ackman, known for concentrated portfolios. However, it also counters this stereotype by highlighting that many hedge funds pursue conservative, low-volatility strategies, aligning with the risk-reduction connotation of the term "hedge."

Several hedge fund strategies are introduced, providing a glimpse into the diverse approaches these funds can take. Notable strategies include long/short, global macro, event-driven, and arbitrage. Each strategy is briefly explained, offering a broad understanding of the range of investment approaches within the hedge fund universe.

The article concludes with warnings and considerations for potential investors. High fees, including management and performance fees, are flagged as a significant factor to weigh. The concept of lockups, wherein hedge funds may restrict liquidity to monthly or quarterly intervals, is also introduced as a potential limitation.

The crucial question of whether one should invest in hedge funds is posed, highlighting the need for investors to be accredited, understand the associated risks, and be capable of evaluating complex legal and auditor reports. The article concludes by emphasizing that, if appropriately chosen, hedge funds can provide diversification and potentially enhance portfolio performance, but investors should conduct thorough research.

In summary, this article provides a comprehensive overview of hedge funds, covering their definition, regulatory landscape, structural variations, common strategies, associated risks, and the considerations investors should bear in mind when contemplating hedge fund investments.

What Is a Hedge Fund And Should I Invest In One? (2024)


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