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Home > Asset Management Checklists > Hedge Funds: Understanding the Risks and Returns

Asset Management Checklists

Hedge Funds: Understanding the Risks and Returns


Checklist Description

This checklist outlines the ways in which hedge funds operate, and their risks and returns.

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Definition

Although hedge funds seem to have hit the headlines only recently, the first of these funds was actually started in 1949.

Hedge funds are normally run by small teams of portfolio managers, traders, and analysts, investing private pools of capital with few restrictions as to the areas in which they can speculate. Hedge funds benefit from limited regulation and are not required to make periodic reports to the Securities & Exchange Commission (SEC) under the Securities and Exchange Act of 1934. In order to be exempt from direct regulation, a hedge fund must be open to a limited number of accredited investors.

Hedge funds use a wide array of strategies, and sometimes are not “hedged” against the market at all. Many, but not all, of these funds aim to produce much higher returns than other investment vehicles, and markets with high volatility are often preferred, as they sometimes yield the highest returns (but also the greatest risks).

Hedge funds have the advantage that they can employ a large number of strategies and can invest in more areas than other investments. They may use leverage, short-selling, asset-backed lending, arbitrage, or a variety of other techniques in order to gain maximum returns for investors.

Hedge fund managers normally earn both a management fee and a performance or incentive fee. Performance fees are intended to be an inducement for the investment managers to produce the greatest returns they can. Typical fees are a management fee of 2% of the fund’s net asset value per annum and a performance fee of 20% of the fund’s profits. Fees are payable from the fund to the investment manager, and are taken directly from the assets that the backer holds in the fund.

A hedge fund can apply a high watermark to an investor’s money, where the manager will only receive performance fees, on the invested money, when its value is greater than its previous greatest value.

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Advantages

  • Hedge funds can make use of a larger number of strategies and can invest in many more areas than with traditional investment products.

  • Performance fees, calculated as a percentage of the fund’s profits, act as an incentive for managers to perform above average.

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Disadvantages

  • To make money and not disclose strategies, hedge funds are of necessity very secretive, with few public disclosure requirements. This makes it difficult for investors to assess how well or badly their fund managers are doing.

  • Some, though not all, hedge funds borrow and speculate with (leverage) sums that are many times larger than the initial investment. This is fine when the investment works, but it can mean that the fund folds if it doesn’t.

  • When a hedge fund uses short selling as an investment strategy, rather than as a hedging strategy, it can experience very high losses if the market turns against it.

  • The SEC and other securities regulators generally have limited ability to check routinely on hedge fund activities.

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Action Checklist

  • Before investing in hedge funds, you should be aware of the risks as well as the rewards: Leverage amplifies profits but also losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns but, as in poker, you shouldn’t sit down at the table if you can’t afford to lose.

  • Qualify and quantify in financial terms how the failure of the fund could impact on your life or business.

  • Seek the advice of specialists and always ask for a second opinion. There are over 10,000 hedge funds in existence, with close to $3 trillion in assets under management; separating the wood from the trees can be a difficult and risky process.

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Dos and Don’ts

Do

  • Seek advice, preferably from a specialist in the industry who has some years of experience and has seen both the good and the bad.

  • Involve your lawyers and accountants in the evaluation of both the risks and the potential benefits of investing in a hedge fund.

Don’t

  • Don’t jump or be pushed into a decision. Take time to do your research before deciding.

  • Don’t follow tips or the sheep—sleep on it before you make your move.

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Further reading

Books:

  • Black, Keith H. Managing a Hedge Fund: A Complete Guide to Trading, Business Strategies, Operations, and Regulations. New York: McGraw-Hill Professional, 2004.
  • Lhabitant, François-Serge. Handbook of Hedge Funds. Chichester, UK: Wiley, 2006.
  • Nicholas, Joseph G. Investing in Hedge Funds. New York: Bloomberg Press, 2005.
  • Ridley, Matthew. How to Invest in Hedge Funds: An Investment Professional’s Guide. London: Kogan Page, 2004.

Article:

  • Sender, Henny, and Javier Blas. “Hedge funds turn to gold.” Financial Times (March 8, 2009). Online at: tinyurl.com/bux3hl

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