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What Are Hedge Funds?

New to the world of finance? Study up on the strand vernacular and finally know the answer to your thoughts, "What are hedge funds?"

Hedge funds feature in the news nearly everyday about their trading activity or influence in the world of finance. Demand for their services have skyrocketed as of late, with investors eyeing the return back to volatility as hedge funds window of opportunity. Many large sovereign wealth and pension funds invest part of their money in hedge funds to balance out their portfolio. If you are new to investing, studying finance or economics, and are wondering, "What are hedge funds?"—read further. 

How do hedge funds work?

A hedge fund is pool of money managed by a team of investors. Depending on the fund, the hedge fund manager invests in it according to whatever strategy they think will maximize positive returns. For each type of financial investing, there is a hedge fund that specializes in that area—like those that only buy stocks, trade junk bonds, and sell short. There are even funds that take large stakes in public or private companies, then improve operations, or break them apart and sell piece-meal style. The essential purpose of all hedge funds are to eliminate risk while gaining a return on investments—exemplifying a paradox. Managers are expected to preform the impossible, since there is no reward or yield unless there is risk. When they do succeed, they are handsomely rewarded. However, history dictates that managers fail to live up to this maxim.

The Titular Function of Hedge Funds

The early formations of hedge funds used to be more typical; they held a series of long and short positions and investments so that their positions were hedged. The initial structure of investments ensured that investors made money whether the overall market was up or down. However, hedge funds are no longer confined to their titular origin story.

Don't hedge fund managers make a ton of money?

Managers are paid based on the terms or conditions found in the operating agreement. A popular method of determining compensation is the "2 and 20," which means that hedge fund managers receive 2 percent of net assets per year plus 20 percent of profits. Other managers are paid only by taking a cut of the profits. Warren Buffet set a precedent that few other managers are yet to follow, he took 25 percent to 50 percent of the profits but agreed to cover losses to varying degrees. Smart investors who want to hedge their money in a fund would be joyous to hear such a promise by their hedge fund manager.

The most successful hedge fund managers make a staggering amount of money; Forbes determined the top earning manager of 2017 made $2 billion, with the next four performers making over $1 billion. Last place in the winner's circle of the top 25 earned a paltry $200 million. While averages for hedge fund managers are drastically lower at $350,000 per year, the finance industry still rakes in significant salaries every year.

Who can invest in hedge funds?

Investing in hedge funds is a game for the wealthy. The only people that are eligible for investing in hedge funds are "accredited investors." The Securities and Exchange Commission (SEC) created rules as to who can be involved to minimize the risk for investors because the returns for hedge funds is often erratic. To be an "accredited investor," one must satisfy some of the criteria:

  • A person must have an income exceeding $200,000 in each of the two most recent years, or a joint income with a spouse exceeding $300,000
  • A trust with assets in excess of $5 million
  • Net worth that exceeds $1 million
  • A corporation or partnership with assets exceeding $5 million

Pools of investors stay relatively small. A recent piece of legislation by the SEC, the JOBS act, increased the number of accredited investors that hedge funds can accept. While it may sound attractive to invest in a hedge fund, it is rather infeasible for the average person.

The Difference Between a Mutual Fund Versus a Hedge Fund

While both funds offer investors baskets of asset classes and asset management, their differences overshadow the similarities. Hedge funds typically pursue far more aggressive strategies and have greater flexibility; investors must 'lock up' their money with the fund for some period of time, and have a aim for absolute return regardless of overall market performance. Aggressive strategies that hedge funds pursue are trading on borrowed money, shorting stocks, and derivatives—and these are just a few of the ways that hedge funds deal with market volatility. Mutual funds can have unlimited investors, pursue a more regimented strategy or strategies, aim for returns relative to the overall market performance, and investors can sell at any time. There are also fewer securities regulations on hedge funds than mutual funds.

Hedge funds maintain an air of secrecy.

Hedge funds are structured to avoid the prying eyes and regulation of the SEC. They are not required to publicly disclose their investment strategies or activities, except for general disclosure requirements. Investors can either get a more personal report about the fund's strategy through detailed discussions, or get very limited transparency from managers. A lack of transparency in the past led to horrific financial disasters such as Bernard Madoff running a $50 billion Ponzi scheme, explained more in depth here.

Investing in hedge funds is a game with few winners.

Some of the legendary hedge fund managers like George Soros, James Simons, Ray Dalio, and John Paulson have reaped massive financial gains and are, or were, the managers of the biggest hedge funds in the world. However, the narrative does not support the massive fervor for their demand. There are currently $3.3 trillion assets under management by hedge funds. But on average, their performance does not justify their performance fee structure. A report from Hedge Fund Research says that funds gained 8.5 percent in 2017. On an asset-weighted basis, the gains were 6.5 percent, still the best annual performance since 2013. While hedge funds may have won a few battles, they certainly lost the war—their performance lagged behind indexes such as the Standard & Poor's 500 Index with a return of 21.8 percent last year.

The Consensus of What Hedge Funds Are

Hedge funds offer high wealth investors an opportunity to diversify their investment portfolio with a strategic wealth advisor. For any one type of investing, there are likely specific hedge funds that specializes in it. Investors are also becoming more demanding from funds, they are requiring greater transparency and lower fees. With a greater number of hedge funds coming onto the market every year, the question of "what are hedge funds" becomes more difficult due to their varying structures and strategies. While it is great to understand their purpose and role in the world of finance, it is more probably prudent to invest like Warren Buffet and put money in a low-cost index fund.

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