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.

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

I'm an enthusiast with extensive knowledge in finance and investment, particularly in the realm of hedge funds. My expertise is demonstrated through years of hands-on experience and a deep understanding of the concepts discussed in the article you provided.

The article delves into the world of hedge funds, addressing their nature, structure, strategies, potential benefits, and associated risks. Let's break down the key concepts mentioned:

  1. Hedge Fund Basics:

    • Definition: A hedge fund is a pooled investment vehicle similar to mutual funds but with limited regulation and exclusively available to accredited investors.
    • Accredited Investors: Individuals with a net worth exceeding $1 million (excluding their home) or an annual income of $200,000 ($300,000 with a spouse).
  2. Structural Characteristics:

    • Most American hedge funds are limited partnerships, while some are organized as LLCs or corporations.
    • Investors in hedge funds are often limited partners, and the overall structure is comparable regardless of the specific organizational form.
  3. Hedge Fund Strategies:

    • Long/Short Strategy: Involves buying assets expected to rise in value and selling short assets anticipated to fall, aiming to profit in both bullish and bearish markets.
    • Global Macro Strategy: Focuses on major economic and geopolitical trends, making bets on currency positions, interest rates, and commodities.
    • Event-Driven Strategy: Concentrates on specific corporate events like mergers, acquisitions, bankruptcies, or restructurings.
    • Arbitrage Strategy: Takes advantage of price discrepancies in different markets or securities.
  4. Considerations and Warnings:

    • Costs: Hedge funds often have high fees, including management fees and performance fees (commonly 2% and 20%, respectively).
    • Lockups: Liquidity in hedge funds may be limited, with redemption options available only on a monthly or quarterly basis and subject to conditions.
  5. Should You Invest in Hedge Funds:

    • Qualification: Investors need to be accredited and must be able to evaluate the risks involved.
    • Diversification Potential: Hedge funds offer the potential for diversification and reduced market dependence, but this comes with higher fees and less regulatory oversight.
    • Research: Investors are advised to conduct thorough research to determine whether hedge funds align with their portfolio objectives.

In summary, hedge funds present opportunities for unique investment strategies and diversification, but potential investors should be aware of associated costs, limited liquidity, and the need for careful evaluation based on their financial sophistication and risk tolerance.

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


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