Hedge funds have developed a bad reputation in the mainstream media which is largely unjustified.
In reality, they can be a very attractive and useful type of investment for high net worth investors – although they can be significantly riskier than traditional asset classes and are not an area to dabble in without specialist investment advice.
How it works
Hedge funds are another type of collective investment vehicle – like mutual funds or Real Estate Investment Trusts – where a group of investors pool their money together for a professional investment manager to run. Hedge funds are managed on very much more entrepreneurial lines than mainstream collectives, however, and will usually have smaller number of larger investors. Hedge funds tend to deploy highly-specialised (and often closely-guarded) investment strategies which allow their managers to be very nimble in capitalising on the investment opportunities they see. These vehicles aim to achieve higher returns than you would expect with traditional asset classes and performance which is uncorrelated to investments like stocks and shares.
Some hedge funds do indeed achieve stellar returns, hence the rock-star status of the best managers and the large investments that are usually required to get into these vehicles. Yet hedge funds are unpredictable and underperformance is also rife. Past performance is probably no guarantee of future gains; indeed, the cyclical nature of economics entails that it probably won’t be. Hedge fund are among the riskier investments, so should only form a small part of your portfolio typically. Choosing the right fit for your risk profile and the rest of your investments is imperative. You should ask a prospective wealth manager if they have specialist expertise in alternatives if you are thinking about hedge funds or private equity investments.
When you invest in a hedge fund, you are usually expected to make a large initial investment that you may not be able to touch for at least a year. Hedge funds (and private equity) are known for being illiquid investments and should not be a destination for money you might need to access quickly. Some hedge funds may be open-ended, and allow further investments or withdrawals at certain times, although the events surrounding the financial crisis highlighted the need to appreciate “gating” strictures.
Your wealth manager will be practised at reading the “fine print” on hedge fund literature and will appraise you of everything you need to know. Investment due diligence is a big part of wealth management services the higher up the wealth scale you go and as more esoteric investments come into play.
The value of your investment is calculated as a share of the fund’s net value. You will usually be charged two fees: a management fee (around 2% of your investment per annum) and a performance fee, which can be much higher (up to 50% of the profits). “Two and twenty” was long the industry’s standard, but that is under pressure now.
There are many types of investment strategies that investors considering hedge funds need to appreciate too.
Types of hedge fund investment strategies
Event-driven – here, the hedge fund manager capitalises on market movements caused by wider events like political unrest, environmental incidents and business deals.
Macro – a hedge fund strategy based on a house view of a particular market or sector which is informed by macroeconomic forecasts.
Market-neutral– a type of “buy and hold” vehicle which also hedges against anticipated market movements.
Long-short – a strategy where long and short positions are both used in an attempt to use the talent of the manager to outperform the markets.
Hedge funds can invest in virtually any asset class. There are also a several other factors to consider. Among them are:
- the sector or sectors the fund invests in
- the asset classes the fund invests in
- whether decisions are discretionary or determined by an algorithm
- whether decisions are event-driven or based on wider economic factors
- the amount of diversification in the fund’s holdings
- the amount of “skin in the game” the investment manager has: they often invest alongside their investors to a significant degree
Summary
This is just a small sample of the pros and cons potential hedge fund investors need to consider. Hedge funds are probably the preserve of larger investors, but they are by no-means closed to ordinary people. A carefully chosen hedge fund investment might form a very useful part of your portfolio. Your wealth manager will help you weigh up your choices.
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