Hedge Fund models

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What is a 'Hedge Fund?'

A hedge fund is an alternative investment that uses pooled funds. These use a range of different strategies to generate active return, or alpha, for investors. Hedge funds can be managed aggressively, or they can use derivatives and leverage in both home and international markets with the aim of generating high returns. Hedge funds can usually only be accessed by accredited investors because they have less SEC regulations compared to other funds. The hedge fund industry has been set apart from other investment vehicles because hedge funds face less regulation.

Each hedge fund is built with the aim of taking advantage of specific identifiable market opportunities. They are usually classified according to investment style due to their use of different investment strategies. This is a wide range of risk attributes and investments amongst styles.

In legal terms, hedge funds are usually configured as private investment limited partnerships that require a large initial minimum investment and are open to a limited number of accredited investors. Hedge funds require investors to keep their money within the fund for a minimum of one year, meaning that investments in hedge funds are illiquid. This period of a year is known as the lock-up period. Withdrawals are also limited to certain intervals, which could be quarterly or bi-annually.

Unique Hedge Fund Characteristics

  1. They’re open only to qualified or accredited investors: Accredited or qualified investors are classed as individuals that have had an annual income of over $200,000 for the last two years, or that have a net worth of over $1 million, which excludes their primary residence. Hedge funds can only take money from such individuals. The SEC considers qualified investors as the only people suitable to handle the potential risks that come with a wider investment mandate.

  2. Wider investment latitude is offered by hedge funds in comparison to other funds: The only thing an investment fund’s universe is limited by is its mandate. A hedge fund is able to invest in basically anything, whether this is real estate, land, derivatives, stocks, or currencies. In contrast, mutual funds are essentially limited to bonds or stocks, and are majority long-only.

  3. They employ leverage often: It is not uncommon that hedge funds will use loaned money to amplify their returns. As seen during 2008’s financial crisis, leverage is als able to wipe out hedge funds.

  4. Fee structure: As opposed to charging only an expense ratio, hedge funds charge a performance fee as well as an expense ratio. The fee structure is known as ‘Two and Twenty.’ A 2% fee is charged for asset management, and 20% is cut from any gains that are generated.

There are more characteristics that are unique to hedge funds, but in general, hedge funds are allowed to pretty much do what they like because they are private investment vehicles and because they only permit wealthy individuals to invest. This applies as long as they are transparent regarding their strategy, and disclose it upfront to investors. This may sound risky, and sometimes it is a risk. Some of the largest financial blow-ups have been where hedge funds were involved. However, the flexibility of hedge funds has led to some fantastic long-term returns being produced from some highly talented money managers.

The objective of hedge funds is to maximize the ROI, despite the term ‘hedging’ meaning the attempt to reduce risk. The name of the hedge fund is down to historical roots, due to the first hedge funds attempting to short the market by hedging against the downside risk of a bear market. These days, hedge funds use many different strategies, so it would be inaccurate to say that hedge funds are only used to hedge risk. Actually, because of the fact that speculative investments are made by hedge fund managers, these funds can in fact carry more risk than the overall market.

Risks of Hedge Funds

  1. They can be exposed to potentially large losses due to a concentrated investment strategy

  2. Investors are typically required to lock up their money for a number of years.

  3. Use of borrowed money or leverage can lead to significant loss what could have been a minor loss.

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