A hedge fund is similar to a mutual fund. However, a hedge fund is usually involved in investments that carry higher risk and higher returns. While a hedge fund might engage in hedging transactions they do not necessarily do so as they employ other risk management techniques.
How Do Hedge Fund Investments Work?
Like a mutual fund, a hedge fund is a pooled investment fund. The investor invests in the fund, not the catalog of underlying investments held by the fund. It is distinguished from mutual funds by its ability to make more complex (and risky) trading techniques such as short sales, high leverage, and derivatives.
Usually, hedge fund investments are the domain of institutional investors, high net worth individuals, and others considered to be sophisticated (accredited) investors.
The hedge fund is offered and assembled by a fund manager. The manager is typically paid a fee (e.g. 2% of net asset value) and an annual performance fee (e.g 20% of the fund’s increase in net asset value.
The fund aims to invest in relatively liquid assets. Investors have the flexibility to invest more and withdraw frequently.
Advantages of Hedge Fund Investments
- Hedge fund investors have more flexibility than other funds. They can benefit from a wider variety of investment techniques such as short sales and derivatives.
- They are not usually traded publicly so they are less transparent and less restricted by regulators.
- Hedge funds typically engage in aggressive investment practices which bring higher rates of return.
- The fund can make extensive use of leverage.
- Hedge funds offer much diversification of your portfolio thereby spreading risk.
- Fund managers offer knowledge, know-how, and experience not shared by most investors.
Disadvantages of Hedge Fund Investments
- Fees are much higher than mutual funds. The hedge fund manager’s 2% management fee and 20% performance fee are much greater than mutual fund managers. Mutual fund managers generally earn a 2% management fee only.
- A hedge fund manager’s performance fee motivates them to take more risks at the investor’s expense.
- A hedge fund investor entrusts his or her money to a manager and must take care to invest only in funds with managers who have a proven track record.