This article contains:
(Click on a link to jump to the specific section)
- What is a hedge fund?
- Key characteristics of hedge funds
- Historical hedge fund performance
- How to pick a hedge fund
- Benefits of hedge fund investing
- Drawbacks of hedge fund investing
- Two excellent hedge fund investing platforms
Let’s get started.
What Is A Hedge Fund?
A hedge fund is a private investment fund typically structured as a limited partnership that offers asset management services. It is an investment fund that is owned and managed by expert hedge fund managers.
It’s important to note that hedge funds are funded by a private capital pool. This pool usually includes accredited investors, institutional investors, and HNIs, also known as High Net-worth Individuals.
The term hedge is used here to demonstrate that hedge funds focus on strategies that hedge the risks faced by investors.
How do hedge funds do that?
By simultaneously buying and shorting shares in a long-short equity strategy.
Here, hedge funds take a long-short position on securities based on their local or global macro strategy.
In a long position, hedge funds purchase an underpriced asset with an expectation that it’ll increase in value. Whereas, in a short position, they sell overpriced assets that they expect to buy at a lower price later on.
This hedge fund investment strategy allows them to profit from both overvalued and undervalued assets.
Additionally, hedge funds have the option to invest in a wide range of alternative investment strategies. Some of these investment vehicles include cryptocurrency, gold, real estate, derivatives, distressed debt, fine art, and even wine amongst others.
For example: Sommelier Capital Advisors is a hedge fund specializing in wine investing. Furthermore, there are individual hedge funds like Angelo Gordon that focus on investing in real estate.
How does all this help?
By diversifying their portfolio across sectors and different asset classes, they can provide better protection against market downturns.
For example: Renaissance Technologies, one of the best performing investment management firms in the USA uses quantitative analysis and trading activities to invest in the following asset classes across emerging markets:
- Private equity
- U.S. and non-U.S. equities
- Fixed income arbitrage
- Debt instruments
- Foreign exchange
What Is A Hedge Fund Manager?
A hedge fund manager is the investment manager of the hedge fund. A hedge fund’s success and ability to raise funds are largely dependent on the performance of its manager.
A fund manager is the hedge fund’s portfolio manager. They are responsible for determining the asset allocation of a hedge fund.
Hedge fund managers strategically invest the investor’s money into different sectors and asset classes. To keep them motivated, they are paid a performance fee by the investors.
This fee is typically 20% of the fund’s profits.
To maximize their performance fee, a fund manager often follows aggressive strategies and makes speculative investments. They may also use leverage or borrowed money to generate higher returns.
Additionally, to complete their large-scale transactions, hedge fund managers often use a prime broker that assists them with services like cash management and securities lending.
Key Characteristics Of Hedge Funds
Hedge funds have certain characteristics that define what they are.
Four of these characteristics are:
- They’re typically open to “accredited” investors. To invest in hedge funds as an individual, you’ll likely have to be an accredited investor. It is the only legal requirement set by financial market regulators for hedge fund investing.
- They try to invest in a diverse range of asset classes. While an equity fund usually has to stick to equity securities, hedge funds can invest in any asset class.
- They prioritize downturn protection. While hedge funds also aim to provide high returns to investors, their chief goal is downturn protection, i.e, protecting the investors’ money even in times of financial instability.
- They follow a 2-and-20 fee structure. Hedge funds are known for typically following a 2-and-20 fee structure. Here, a 2% management fee (of the AUM) and a 20% performance fee on profits are typically imposed on the investors.
Historical Hedge Fund Performance
From 1999 to the end of 2018, the hedge fund industry beat the market by a narrow margin of only 1.5% annually.
However, in the first decade of this period, i.e, from 1999 to 2009, hedge funds were able to annually outperform the market on average.
This isn’t necessarily down to the outstanding performance of the various hedge funds. During this time frame, the market didn’t generate great returns. Specifically, between late 2007 and 2009, the US stock market plummeted and nearly $8 trillion was wiped out.
However, once the great bull run of the market started post-June 2009, the market rose by 13.5% per year. As a result, hedge funds were not able to outperform the market as well during this period.
This isn’t to say that those hedge funds weren’t successful.
Remember, the primary goal of hedge fund investing is not to beat the market.
Instead, it’s to provide returns to the investors irrespective of the financial market conditions.
How To Pick A Hedge Fund
Investors need to consider some key factors before making any investment decision. This is especially true for typically risky investments like hedge funds.
Some factors to consider are:
- Fund’s AUM (Total Assets Under Management): Evaluating the fund assets (assets invested in) helps investors get an indication of the size of the fund’s operations relative to its competitors.
- Track Record: Investors should always opt for hedge funds that have a proven track record of delivering high returns.
- Minimum Investment: Before investing in a hedge fund, first ensure that you can meet the fund’s minimum investment requirements.
- Redemption Terms: This impacts the liquidity of a hedge fund. For a hedge fund investor looking for a more liquid portfolio, it is important to look for hedge funds with smaller redemption and lock-up periods.
- Fee Obligations: Hedge fund investors need to understand the fees involved. Hedge funds are known for following a 2-and-20 fee structure.
- Relative and Absolute Returns: Investors need to do thorough due diligence of a hedge fund’s valuation based on its past performance and potential. This will help them evaluate the absolute performance of the fund and its relative performance in comparison to other hedge funds.
Benefits Of Hedge Fund Investing
Here are the main benefits of hedge funds for an investor:
- Increased investment flexibility: Hedge funds are less regulated than a traditional financial instrument like an ETF, index fund, or mutual fund. This offers hedge funds increased flexibility in terms of their hedge fund strategy and investment objective to generate returns.
- Portfolio Diversification: Hedge funds typically invest in a range of different asset classes varying from fixed income options to highly volatile assets. This allows them to diversify their portfolio to prevent the portfolio from being adversely affected by specific market risks and volatility.
- Quality downturn protection: Hedge funds are focused on protecting themselves from market downturns by holding a range of diversified asset classes that are typically uncorrelated.
- Access to expert investment managers: Hedge fund investing allows new investors to put their capital into the hands of investment experts with a solid track record.
Drawbacks Of Hedge Fund Investing
Hedge fund investing comes with its unique set of drawbacks such as:
- High Risk: Because of the aggressive hedge fund strategies that are typically employed, hedge funds are often exposed to potentially huge losses. Additionally, many hedge funds use leveraged or borrowed funds to generate higher returns on their investment. In the past, this has often led to many hedge funds going bankrupt.
- Relatively illiquid investments: Investors are often required to lock-in their funds for several years. As a result, hedge funds typically offer less liquidity than a standard mutual fund.
- Large Investment Fees: Most hedge funds charge high fees. The investment fees involve both a performance fee (typically 20% of the profit) as well as a management fee (typically 2% of the AUM paid every year).
- Limited accessibility: A retail investor may find it difficult to invest in hedge funds. This is because hedge funds are typically only open to accredited investors and individuals with very high net-worths.
Fortunately, there are now ways for even non-accredited investors to benefit from the expertise of renowned hedge fund managers and strategies at a fraction of the cost:
Two Excellent Hedge Fund Investing Platforms
If you’re looking to start your hedge fund investing journey, consider investing through one of these two platforms:
Titan Invest is an investment app that enables an individual investor to invest like a hedge fund. It is a financial advisor that integrates robo-advising and personalized investment advisory services to help with your investment decisions.
Currently, Titan offers two investment strategies:
- Titan Flagship: invests in large cap companies
- Titan Opportunities: invests in small and mid-cap companies
The returns are dependent on the performance of the 20 individual stocks held in each investor’s Titan portfolio. Since 2018, the Titan Flagship investment strategy has had an annualized return rate of 17.7%.
For normal accounts, $100. However, if you are investing in an automated deposit account or with a retirement account, the minimum investment is $250 and $500 respectively.
Titan does not charge any performance or trading fees. All deposits and withdrawals made on Titan are free. However, a 1% annual advisory fee is charged if you deposit more than $10,000. If you deposit less than $1000, a $5 monthly fee is charged in lieu of the advisory fee.
CARL allows accredited investors to access sophisticated investment strategies that are usually only accessible to an institutional investor. Using the platform’s built-in risk control measures, investors can create a portfolio that has quality down-market exposure.
With CARL, you can find hedge funds that offer a potential double-digit annual return between 15-25%.
CARL charges a 2% annual management fee. This fee is charged in part each month. Furthermore, the funds on CARL charge a 20% performance fee if they generate over 5% in profit.
Hedge fund investing can offer you increased investment flexibility and access to expertise from experienced investment managers.
And while they do have their drawbacks, they’re still an excellent option for investors who prioritize downturn protection.
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