Hedge funds are alternative investments made available to special investors like large institutions and individuals with big assets. They use pooled funds which employ different means to earn active returns for investors. These pools of underlying securities offer flexibility in investment. This investment vehicle may be managed aggressively or use leverage and derivatives to generate high returns both in local and foreign markets. Currently, hedge funds are not regulated by United States Securities Exchange.
This allows hedge funds to invest in a wider pool of securities than mutual funds. They are capable of investing in traditional securities like stock, real estate, bonds, and commodities. They are designed to take advantage of certain market opportunities using differentsophisticated and risky strategies. The law identifies them as private investments with limited partnerships, a limited number of accredited investors and usually requires large sums for an initial investment. Investors are required to keep their funds for at least year after which withdrawals are made quarterly or bi-annually.
Basic Characteristics of Hedge Funds
Hedge funds are available to qualified investors based on minimum annual income. This is an amount not less than 0.2 million dollars in the last two years or a 1 million dollars net worth. The securities and exchange commission is responsible for establishing whether investors are capable of handling risks.Hedge funds offer a wide range of investment including land, currencies, stocks, real estates, among others. They also use borrowed money to increase returns as leverage. Hedge funds charge both a performance fee and an expense ratio. Fees are provided as 2 and 20 percent for management and a cut for any gains respectively. These flexible and high-return investment vehicles are available to wealthy investors but are very risky.
How They Work
Hedge funds use long to short strategies where investors can buy stock in the former, sell stock with borrowed money and buy later when the price falls in the latter. Most of them invest in derivatives based on buying and selling another security for a given price. They use an investment technique called leverage where borrowed money is used for investment which the aim of increasing returns, but very risky at the same time. Leverage is one way in which hedge funds seek to increase gains and offset losses by hedging investments using complex methods. Some common strategies are convertible, emerging markets, activist, arbitrage, fixed income, equity long-short, options strategy, funds of funds, macro and statistical arbitrage.
Investors always find it hard to sell their shares since they generate income over a lock-up period. This is different to mutual funds which have a net asset value calculated each day allowing investors to sell shares at any time. The compensation of hedge fund managers also varies from that of mutual funds managers. Hedge fund managers receive a percentage of returns earned from investors and a small management fee usually 1 to 4 percent of the net asset value. This is convenient to investors when faced with poorly performing managers. The level of risk depends on management skills and the strategy adopted by the manager.
In conclusion, hedge funds are open to a limited number of investors. The law demands accreditation of investors with a requirement of minimum annual income. They must have a net worth of 1 million dollars and adequate investment knowledge. There are many strategies for investment, but they are sophisticated and risky in nature. Investors are sometimes faced with challenges but hedge funds but continue to offer an alternative form of investment with long-term returns. They have a future due to minimal regulation, low management fee and a potential for high returns means.