The aim of Hedge Funds is to make money on a fund no matter whether the underlying markets go up or down. The managers of the fund are able to make money by being successful in going long or short on the price of a stock, commodity, index, fund or other financial market.
There are a number of key characteristics of hedge funds. In general a hedge fund is an alternative investment that is only accessible by qualified ‘high net worth’ investors or institutions.
Hedge funds are not a form of alternative investment that is generally open to the public. These high level investment vehicles are designed to serve ‘sophisticated investors’, be they institutions or individuals with particularly significant personal assets. They involve pooling capital from a number of investors and this capital is then invested in securities and other investment instruments. Below is a more detailed exploration of this alternative asset.
The Structure of a Hedge Fund
Hedge funds are thought to be named as such due to the fact that the earliest funds attempted to short the market and hedge against the downside risk of a bear market. This would enable investors to ‘hedge’ against the market risk. Nowadays, this is no longer an accurate description of such funds as the number of risky speculative investments made by managers means that hedge funds can actually carry more risk than the general market.
Leverage has also been crucial in forming hedge funds and their current status as use of leverage is not capped by regulators, unlike that of private equity funds. This has started to change in the wake of the 2008 recession but it is still a characteristic and this lack of regulation has been crucial to the success of this alternative investment vehicle as persons and organisations of high net worth have sought liquid investments that offer them flexibility and high potential returns.
The fact that the fund managers often receive incentive fees – a percentage return of any profits the fund makes – further increases the potential for high returns as managers operate with a strong vested interest in delivering. However, some funds will impose fee caps in an effort to prevent fund managers from taking on excess risk for clients while chasing their own high returns.
Returns on Hedge Funds
Hedge funds offer some of the best opportunities for profit, but it must be stressed that they come with inherently high risk and require significant amounts of capital from their investors.
However, for those that are able to access these alternative investments, they can be a great form of diversification due to the fact that most managers will look to balance out the market and aim to deliver a percentage increase regardless of stock market performance. This means that even in a short market, hedge funds should be able to provide their investors with healthy returns.
Most funds will require people to invest in the fund for at least a year – this is known as the lock-up period. Withdrawals also tend to be restricted to quarterly or bi-annual options.