A hedge fund is an investment fund that uses advanced investment strategies, and invests in just about anything.
Hedge funds don’t generally use the traditional ‘buy, hold, sell’ strategy, but employ alternative strategies like short selling, leveraging, or trading in derivatives on an exchange or in the over-the-counter market.
Hedge funds are usually structured as open mutual fund trusts or limited partnerships, and are issued by way of a private placement using a prospectus exemption, sometimes with an offering memorandum, which offers less investor information than a prospectus. Hedge funds typically require higher minimum investments than regular funds.
The are three main categories of hedge funds:
- Stand-alone hedge funds that depend on the investment decisions of a single fund manager.
- Fund of hedge funds that invests in units of other hedge funds with multiple managers.
- Principal-protected products, which are funds or other financial instruments that allow investors to participate in the returns of the underlying hedge fund, but with a guaranteed return of their original investment at maturity.
What Risks do They Have?
Investing in hedge funds is not for everyone. Unlike mutual funds, most hedge funds are not subject to restrictions on the assets that they hold or the leverage that they use. The level of risk depends on the fund, the types of investments used, and the fund manager’s skill.
The following factors contribute to hedge fund risk:
- Lack of transparency: private entities have few public disclosure requirements.
- Lack of regulation: hedge funds are subject to very little oversight by regulators.
- Risky underlying investments: hedge funds can invest in risky products, such as derivatives, including options, whose value is volatile
- Leveraging: hedge funds often borrow money or trade on margin.
- Short selling: short sellers may misjudge the price of the assets and incur a loss rather than profit.
Can You Sell Them Easily?
Every hedge fund is different. Some hedge funds have liquidity restrictions that may not allow you to sell whenever you want. As a rule, hedge funds are more difficult to sell than traditional mutual funds. Some funds have a ‘lock up’ period, a set period of time when investors cannot sell or redeem shares.
What are the Costs?
Fees are tied primarily to performance. Hedge fund managers typically charge a performance (or incentive) fee in addition to the management fee. Some funds also charge a redemption fee if you withdraw money from the fund.
Read the product disclosure statement to make sure you understand the fees and compensation structures, and to make sure that you are getting value for the fees you are paying.
What are the Expected Types of Returns?
Most hedge funds distribute their profits each year. This is normally reinvested in fund units automatically. In addition to any distribution of profits you may receive, you will make money if you sell your fund for more than you paid.