A hedge fund is an alternative investment vehicle that is only available to advanced investors like individuals with significant assets and institutions.
Just like mutual funds, hedge funds are also pools of underlying securities, however, there are differences between these two investment vehicles.
1. No SEC regulations
Currently, hedge funds are not regulated by the SEC (US Securities and Exchange Commission), which is an overseeing entity of the financial industry. Whereas hedge funds are not regulated, mutual funds are. However, there are indications that regulations may soon be coming for hedge funds.
Because hedge funds are fairly unregulated, they are able to invest in more securities than mutual funds can. While there are numerous hedge funds that do invest in more traditional securities, like commodities, real estate, stocks, and bonds, they are known best for using more risky and sophisticated techniques and investments.
2. Long-short strategies
Typically, hedge funds utilize long-short strategies, which creates some kind of balance between long positions (buying stocks) and short positions (selling stocks with borrowed money and then buying them back later after the price falls).
3. Use of leverage
Many of the hedge funds use an investment technique called leverage. Basically, it’s all about investing with money that is borrowed. This strategy could considerably increase your potential return, but it also creates a larger risk of loss.
The name hedge fund is a derivative of the fact that hedge funds often attempt to increase gains and offset the losses by hedging their investments using a number of sophisticated methods.
4. Not so much liquidity
Usually, hedge funds are not as liquid as mutual funds, which means it can be harder to sell your shares. Mutual funds have a per-share price (net asset value) which is calculated on a daily basis, so you can sell your shares at any time.
In contrast, the majority of hedge funds look to generate returns over a specified period of time, which is called a lockup period, and during this time, investors can’t sell their shares. Private equity funds are similar to hedge funds, but they are even more illiquid, tending to invest in startup companies.
5. Unique compensation model
Hedge fund managers are generally compensated in a different way than mutual fund managers, who are paid fees, in spite of the performance of the fund. Hedge fund managers receive a percentage of the returns they earn for the investor, plus they earn a management fee, that usually ranges from 1% to 4% of the net asset value of the fund.
That concerns investors who are irritated when they have to pay fees to a mutual fund manager that’s performing poorly. However, this compensation structure could result in hedge fund managers investing assertively to achieve higher returns, and this increases investor risk.
Are hedge funds worth it?
Because of these factors, hedge funds are generally open only to a limited number of investors. The US laws require all hedge fund investors to be accredited. This means they have to earn a minimum annual income, and they must have a net worth of greater than $1 million, along with having significant investment knowledge.
Over the years, the attractiveness of these alternative investment vehicles has waxed and waned. During the 2007-2008 credit crisis, many of the hedge funds got closed. The Bernard L. Madoff Investment Securities, for example, landed up being a massive fraud.
However, despite recent challenges, hedge funds keep offering investors a solid alternative to traditional investment funds. This alternative brings the possibility of higher returns that are not correlated to the stock and bond market, so hedge funds are likely here to stay.
Need more advice? Don’t hesitate to check out our complete guide to investing into stocks and bonds and learn how to anticipate market movements and navigate the trading field.