Hedge funds have grown in popularity since the beginning of the 21st century. It is basically an investment partnership of a professional fund manager and investors.
The professional fund manager is the general partner and the investors are the limited partners. They pool their money together to create the fund.
The limited partners contribute funding for the assets while the general partner manages it based on the fund’s strategy.
The fund’s purpose is to maximize the investor returns and minimize risks. In a way, hedge funds are very similar to mutual funds. However, hedge funds are generally more aggressive, riskier, and more exclusive than mutual funds.
Hedge Fund Characteristics
Hedge funds have some unique characteristics that distinguish them from other types of pooled investments like mutual funds.
Exclusive to Accredited or Qualified Investors
Investors who invest in the hedge funds have to meet certain net worth requirements. In general, they must have a net worth exceeding $1 million or an annual income that has exceeded $200,000 for the past two years.
Wider Investment Scope
A hedge fund’s investment universe is only limited by its mandate. Simply put, it can invest in practically everything—real estate, derivatives, forex, and other alternative assets.
For comparison, mutual funds often have to stick to stocks or bonds.
Often Employ Leverage
Hedge funds usually use leverage or borrowed money to amplify their returns, which potentially exposes them to a large range of investment risks.
In the subprime meltdown, which was the ignition to the 2009 recession, hedge funds were particularly hit badly because of their increased exposure to collateralized debt obligations and high levels of leverage.
Rather than charging an expense ratio only, hedge funds charge both an expense ratio as well as a performance fee.
The common fee structure is referred to as two-and-twenty, referring to 2% asset management fee and then a 20% cut of any gains generated.
Of course, there are more specific characteristics that define what a hedge fund is. However, since they are considered private investment vehicles that are exclusive to wealthy individuals, hedge funds can practically do what they want—as long as they disclose the strategy to investors.
Types of Hedge Funds
Hedge funds can pursue different degrees of strategies like macro, equity, distressed securities, relative value, and activism.
A macro hedge fund pours money in stocks, bonds, and currencies, attempting to profit from the changes in macroeconomic variables like global interest rates and countries’ economic policies.
Meanwhile, an equity hedge fund can be global or domestic, and it invests in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks and stock indices.
A relative-value hedge fund, on the other hand, takes advantage of the price discrepancy or spread inefficiencies.
There are also hedge fund strategies that include aggressive growth, income, emerging markets, value, and short selling.
Meanwhile, perhaps the most popular approach is the “funds of funds” strategy, in which a hedge funds mixes and matches other hedge funds and other pooled investment instruments.
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