What are Hedge Funds?

An option for the super rich?

What are hedge funds? A description of a hedge fund is an aggressively managed private investment fund that charges a performance fee in addition to the usual mutual fund fees and is typically open to only a limited range of qualified investors.

Hedge funds are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.

So to find the best hedge fund one needs to be confident that the (hopefully positive) performance of the fund is due to the skill of the fund manager (since that is what you are paying extra for), and is not just related to the fortuitous movement in the market.

Hedge fund directories such as the hedge fund directory HedgeFund.Net provide information on the wide range of funds available, including value funds, that is, funds that follow a value investing approach.

Types of Hedge Funds

When asking the question what are hedge funds,the types of hedge funds available are many and varied and include the following list of hedge funds ...

  • energy hedge funds
  • FOREX hedge funds
  • fund of hedge funds
  • fixed income hedge funds
  • real estate hedge funds
  • private hedge funds
  • software hedge funds
- to give an indication of the diversity.

I do not invest in this type of fund as such, but in absolute return funds that share some of the characteristics of hedge funds, such as short selling and which also adopt a value investing approach. They do not require as large an initial investment - typically $25,000.

The term 'absolute return' refers to the approach which attempts to produce a positive return, irrespective of the direction that the market is taking at any point in time.

As the portfolio of an absolute return fund is the product of individual stock picks, it is not uncommon to have constituents that differ significantly from traditional benchmarks such as the MSCI (Morgan Stanley Capital International) index.

I invest in those absolute return funds with a value investing approach that involves buying undervalued companies and holding them until they become overvalued.

Characteristics of Hedge Funds

Because the regulation of hedge funds provides an an exemption from the types of regulation that otherwise apply to mutual funds, these funds commonly include any investment fund that brokerage firms or investment advisers invest in that are riskier investments than a public fund.

Hedge fund strategies can include greater use of complex investment strategies such as short selling, entering into futures, swaps and other derivative contracts and leverage.

This helps to answer the question - what are hedge funds?

Their investment activities are limited only by the contracts governing the particular fund.

Hedge Fund Risk

As their name implies, hedge funds often seek to offset potential risk by hedging their investments using a variety of methods, most notably short selling.

Most funds are designed and sold on the premise that they will make a profit regardless of market conditions. Losses are not supposed to happen. However, fund collapses do occur.

Being outside the regulatory regime that applies to retail funds greatly reduces the information that this type of fund is legally required to make public. So they have acquired a reputation for secrecy.

Their sway over markets is potentially substantial as they control funds amounting to hundreds of billions of dollars.

This is magnified by leverage. As a result, there is ongoing debate as to whether they should be more thoroughly regulated.

Legally, they are most often set up as private investment partnerships that are open to a limited number of hedge fund investors and require a very large initial minimum investment.

Investments in this type of fund are illiquid as they often have lock-up policies or 'gates' that require investors to keep their money in the fund for at least one year.

Some investors learned this the hard way when a number of funds were hit hard in the recent market turmoil and they were not able to withdraw all their money when they wanted to.

Also, it cannot be assumed that all these funds offer diversity as some target specific markets. Some funds provide diversity by adopting a 'fund-of-funds' approach where a fund invests in a variety of other funds. A cynical observer (in this case including me) could regard this as a 'one-fee-on-top-of-another-fee' approach.

Unlike mutual funds, they are unregulated for the most part because they cater to so-called sophisticated investors who must have assets of at least $US1 million or have an income exceeding $US200,000 in each of the two most recent years.

In Summary ...

Hedge funds can be thought of as mutual funds for the super rich and are not normally available to the average investor.

I access absolute return funds with a value investing approach as these funds offer good returns across the market cycle but tend to do less better in over-heated markets because they use hedging and short selling techniques.

When choosing an absolute return fund, I like to see the operators of the fund having significant amounts of their own money invested in the fund.

So to answer the question - what are hedge funds, the answer is hedge fund investments cover a wide variety of investment areas with regulation that is not as restricted as mutual funds.

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