Seven things to know before investing in a Hedge fund (simplified explanation)

The word "hedge" means to protect money in times of uncertainty, while a fund refers to a pool of funds. Originally, hedge funds were investments created to safeguard funds. But, as time went by, they got riskier due to the different investment strategies they employed in their investments.

Hedge funds refer to pool investment vehicles that collate different sums of money from individuals and invest in the financial market. They are alternative investments that use market opportunities to their advantage.

As time went on, hedge funds got riskier, and they started taking bets on both long and short directions of the financial market. Then, they started betting on companies to fail, which led to people losing a lot of money because they were taking outrageous risks. As a result, the hedge funds started getting a bad name for the initial purpose of creation.

Hedge funds take funds from their clients and invest them in the financial markets. Because of the risk involved, an average person isn't allowed to invest in a hedge fund—only accredited investors understand the risk involved and how to operate the financial market. But on the other hand, the financial regulatory bodies are less bored with what the hedge fund company is doing because it's taking money from people who know and understand the risks.

The regulatory bodies guiding the activities of the mutual fund make their investment safer or less risky and ensure they can only invest in the long term. In contrast, hedge funds can take higher risks and possible bets on companies, financial securities, or instruments.

Regulations

Hedge funds are not as regulated as their counterparts in the financial markets, which must abide by the relevant financial regulatory laws. However, unlike the mutual funds, which the relevant regulators regulate, hedge funds require little or no regulation from the Securities and Exchange Commission (SEC), which enforces the nation's securities laws, and the Financial Conduct Authority (FCA) is the financial market regulator.

Risk management

Because of the risk involved, only certified professional investors can invest in hedge funds. They take a high level of risk which can mean big returns or big losses. Hedge funds are known to take investment positions or bets in both directions. They can also take on negative bets.

For example, suppose they think a company is performing very poorly. In that case, they can negatively invest in that company by creating bets that assume that the company will perform poorly over the next few months or years. If their prediction is correct, they make incredible gains, but if not, they make a huge loss, which is why an average person is not allowed to participate in hedge funds.

Marketing

Because of fewer regulations, hedge funds can't market themselves or their services. For example, they are not at liberty to place advertisements in magazines or appear in financial shows or programs. Mutual funds are free to advertise their services. Unfortunately, hedge funds can't embark on marketing irrespective of their investment track record.

Public funds

Hedge funds are not permitted to take money from the public. Only an Accredited Investor can invest in a hedge fund. A hedge fund requires this restriction because investing in the hedge fund requires a certain understanding of how investment in the hedge funds works and knowledge of the risk involved. In addition, because they are not fully regulated, the general public can't invest in them. This restriction is to prevent average individuals from losing their hard-earned money.

Transparency

Hedge fund firms are not transparent due to their few disclosure requirements. Moreover, because they are less regulated by the relevant financial bodies, these private entities are not subject to much regulatory oversight. As a result, their managers are prone to taking higher risks or changing their investment style to make higher returns or inadequate declaration of returns (fraud).

The US and EU introduced new regulations in 2010 which require managers to report more information, which has eradicated the transparency challenge faced in the hedge fund industry. In addition, the continuous influence of institutional investors has opened a greater door for transparency in hedge funds.

Leverage

To maximize their returns, hedge fund firms invest with borrowed money. However, this provides a more significant risk because the loss would be bigger if the market went the opposite way. So, when they take leverage and try to maximize their returns by borrowing money, the potential risk is higher.

For example, suppose all their clients invest $500,000, and the hedge fund company borrows another $1,500,000 to make $2,000,000 with the hope of maximizing higher returns if they make a profit on the investment. They pay their clients and refund the borrowed funds with interest from profits made. Still, if they make a loss, it is enough to make the hedge fund company go bankrupt.

Fees and Remunerations

A hedge fund differs from traditional mutual funds because the management company gets a profit percentage. After all, it takes many risks, and the managers need compensation as motivation. As a result, they charge pretty high fees compared to the rest of the investments in the financial market.

Their standard charges for management fees and performance fees are 2% and 20%, respectively. The management fee is charged annually but calculated and paid monthly or quarterly. This fee covers the manager's running or operating costs. For example, if you invest $200,000 in a hedge fund, the management fee will be $4,000 annually. In contrast, the performance fee is the incentive the manager gets when they exceed the agreed return on investment.

For example, if the agreed rate of return is 5%, and any profit made above 5%, the manager charges 20% of the extra profit. The performance fee gives the hedge fund manager the morale to outperform or try to get the best possible returns. Although, this fee varies with the different hedge fund companies.

People who can invest in hedge funds

A hedge fund is known to be risky, so the investment is not open to an average individual. Here is a list of a few criteria that every investor must fulfill before investing. They must:

• Be an accredited investor who knows and understands where they want to invest their money.
• Be an individual or organizational investor with a high net worth.
• Be an investor with a minimum of $1,000 to invest in the hedge fund.

Conclusion

Many investors prefer hedge funds because when the rest of the asset classes are given 1% or 2% in times of low return in the financial markets, the hedge fund firm provides between 5% to 15% return on investment. Any investor willing to take the risk and knows such risks suit their risk appetite can pursue those higher returns at the risk of potentially losing all their funds.

Unaccredited average individuals who wish to invest in hedge funds can invest indirectly by buying stocks of a financial firm that operates hedge funds.

Ultimately, It is essential to know why you're applying to a given hedge fund, which area you're interested in specifically, and why you want to invest.