How does a Hedge Fund work?

A hedge fund is a pool of investors who use high-risk investment techniques. Their aim is to generate high returns and minimize risks. Hedge funds work with different types of assets such as options, stocks, and real estate. Institutional investors and accredited individuals, having access to good capital, use these. Basically, it is an investment fund partnership between investors and a fund manager.

A limited liability company or limited partnership usually covers hedge funds. It operates with minimal or no regulations from SEC (Securities and Exchange Commission). A 2 and 20 rule structure compensates Hedge fund managers. The fund managers charge a management fee of 2 % of the total assets under management. Regardless of how the fund performs, it is compulsory to pay this fee. The fund manager is also paid a performance fee of 20 % of the profits generated. Depending on the withholding duration of the assets under management. After one year, these are usually taxed as long or short-term gains. 

Types of Hedge Funds

The main goal of hedge funds is to maximize returns and minimize risks. But there are different kinds of hedge funds. Each uses a unique strategy for making investment decisions.

1. Long Short Equity Hedge Funds

Equity funds choose short or long positions in stocks. This depends on the fund manager’s predicting that the price of the security will fall short term. Or if his prediction will rise in the short term. A short strategy means you borrow shares and sell them immediately. 

When the price decreases, you can buy the stocks at a lower price. You can then pay your brokerage for the shares you had borrowed. While a long strategy entails buying stocks. And then holding them until the price increases. 

2. Macro Hedge Funds

The macro strategy focuses on international forces and not on the individual company. These may influence the performance of all companies. Then, the interpretation of these forces is complete. This determines how it might affect a particular company. Some of these forces may include political, economic, demographic or social forces. 

3. Event-Driven Hedge Fund

Event-driven hedge fund strategy tries to profit from specific events. For example, mergers, bankruptcy or acquisition that can affect the whole market. Hedge fund managers analyze the probability of an event occurring. They then do a comparison between the current price of the security and its expected price. If the event occurs or if it does not occur.

4. Relative Value Arbitrage Hedge Funds

Relative value arbitrage entails taking advantage of two securities. These are the ones that are similar but there is a discrepancy in the prices. A fund manager buys one security and sells the other security. This is if they believe that the two stocks are inappropriately priced. Stocks that are likely to diverge or converge, use relative value arbitrage strategy.

5. Distressed Debt Hedge Funds

Fund managers can buy debt that includes bank debt or bonds. This usually belongs to the companies that face financial instability or bankruptcy. The owners of the companies are willing to sell it at a lower price. It is because they fear that it might be worthless if the company goes bankrupt. Hedge fund managers buy the debt, then they may decide to restructure the company. This way, the hedge funds look to prevent the company from going bankrupt. And aims to profit from the sale of the bond.

Advantages of Hedge Fund Investing

1. Active Management

Hedge fund managers are experienced experts in investments, investors can enjoy good returns. When it comes to financial management, fund managers are also well versed. Therefore, as an investor, you receive the best information when you enter the market.

2. Diversification

Another major benefit of investing in a hedge fund is a chance to diversify your portfolio. It also reduces risks. This is because it provides different types of investments or funds. Allocation of funds to a different class of assets ensures diversification of risks. These risks are normally associated with the conventional financial market

3. Potentially high gains

Despite the fluctuations in the market, hedge funds aim to acquire high returns. This is because they invest in risky and aggressive positions. These positions usually provide the potential for higher returns.

Disadvantages of Hedge Funds

The use of leverage offers investors offer the potential to make large profits. But they can also face huge losses. So it is only if leveraged investments do not perform well. In comparison to mutual funds, hedge funds are less liquid. So this means that money invested can be locked up in the fund for a long period of time (years).

One of the drawbacks of hedge fund investing is that fund managers charge income-based fees. So this income is the one that the fund generates. It is a part of the managed asset. The fees lower the return that investors earn on investments. For the hedge fund to perform well, it means taking more risks. 

The bottom line of Hedge Funds

Hedge funds provide many elements that may be considered as benefits or drawbacks. It depends on how you look at them. The bottom line is that hedge fund investing is a risky alternative for investment. And while hedge funds provide an avenue for earning great returns, it can also cost you huge losses. Therefore you must take caution and be prepared in terms of how aggressive you want to be. Determine what your goals are and what to invest in before you start investing in a hedge fund. Because by conducting enough research, you can keep your goals in mind when deciding what fits best with disposable capital.