As the financial markets continue to experience volatility and uncertainty, high-value investors are now turning to hedge funds to explore asset classes that are not available in conventional portfolios. According to a recent study by research firm Preqin, hedge funds reached an all-time-high of 3.995bn in assets under management at the end of 2020.
However, as with most investments, a hedge fund involves substantial risks, and it’s up to the prospective investor to conduct due diligence and understand how the industry works before going all in.
We understand how daunting it can be to navigate the hedge-fund landscape. Luckily, we go over several key things you should know before injecting your cash into this investment vehicle.
What’s a Hedge Fund?
A hedge fund is an alternative investment partnership that uses private capital pooled from investors to chase various investment strategies and earn returns for limited partners. Put otherwise, these are managed portfolios that take advantage of aggressive investment strategies (e.g., debt-based, investing, short selling, and leverage), as well as other investment types (e.g., real estate, stocks, and bonds) to earn returns.
Hedge funds require riskier strategies to realize a return on investments—regardless of the market conditions. They comprise limited partners who invest pool funds together, and a hedge-fund manager who makes all the daily investment decisions.
Due to their pivotal role in money management, hedge-fund managers must have specialized skills and business acumen in investment and finance matters.
Are Hedge Funds Right for You?
While hedge funds have proven to be solid alternative investments that guarantee returns—no matter how the market is fairing—they are not for everyone. Besides being complex and intricate, they also involve higher than usual risks. Therefore, before you decide to invest in them, there are a few factors you should consider.
Be Sure You Are a Qualified Investor
Hedge funds are top-dollar investments, and this factor alone knocks out most would-be investors. First, prospective investors need to be qualified to invest in hedge funds. For example, they must meet the following minimum financial requirements:
- Having a net worth of at least $1M (not including the value of their primary residence)
- Having an annual personal income of $200K (or $300K as a married couple) for the previous two years and reasonable expectations to meet this same threshold in the subsequent year.
Second, hedge funds come with high minimum-investment requirements. Most managers require investors to put down liquid cash ranging from $100K – $5M or more.
How Long Will You Need to Put Your Money Aside?
Typically, hedge funds invest in illiquid assets. This means it may take longer before you can redeem your invested cash. Once you commit your funds to a hedge fund, you will have to wait for a predefined period to elapse before you can cash out. This may span from three months to two years.
What does this mean? Before jumping on the hedge-fund bandwagon, be sure that you can put aside some funds without stalling your other projects or worse still, being unable to meet your basics.
How Much Risk Can You Tolerate?
Hedge-fund risks vary considerably from one management company to the next. Even so, they come with higher risks than conventional investment strategies like bonds and stocks). The reason behind it is that most techniques that hedge funds leverage to get returns are high risk. These include borrowing, investing in illiquid assets such as real estate, and investing in derivatives.
Additionally, hedge funds charge higher fees, as compared to other more active management strategies. So, as a prospective investor, you must evaluate whether you can tolerate risks of such magnitude.
How to Find the Right Hedge-Fund Manager
When selecting an investment vehicle like a hedge fund, the most integral decision is finding the right hedge-fund manager.
Here are a few questions to ask potential hedge-fund managers:
What do their minimums, fee structures, and lock-up terms look like?
A trustworthy manager must be clear about the minimum amount of funds you need to put in the hedge, fees charged, and how long the funds will be locked up. Overall, they need to be transparent and ready to provide any crucial information you want to know.
How much leverage does the fund employ?
You must also seek to understand how much leverage a hedge fund uses to chase returns. While management companies seek leverage to amplify returns, this may magnify losses and increase risks if something goes wrong. A competent manager must expound upon how much leverage the company intends to use and must be willing to show investors how to mitigate risks associated with this strategy.
What Type of Service Provider Does the Fund Use?
To run a successful hedge fund, management companies need to partner with or buy expertise from various service providers. A hedge-fund manager must divulge vital information about the service providers onboard to help investors scrutinize them.
How Much Money Does the Company Have in the Fund?
Before you invest in a hedge fund, seek to understand how much money the company has in the fund. This will help you evaluate their financial muscle, which is a good indicator of whether they can deliver on their promises.
How Often Do They Send Reports and Communicate with Investors?
All reputable managers strive to keep investors in the loop about anything significant taking place in the hedge fund. Before signing on those dotted lines, inquire to know how often your manager sends performance reports, brokerage statements, audited financials, and more.
Also, get to know the methods they use to communicate as well as how often they communicate with investors. Finally, they need to clarify if you are allowed to alter the terms or details of your investment after the fact.
Some of the best hedge-fund managers we’ve seen automate reporting and most communications with investors. For example, some of the world’s biggest names now use MetaTrader 5 for hedge funds to create and manage their investors’ accounts from a single place. This all-in-one platform allows investors to log on to a simple dashboard where they can monitor current developments via PC or mobile.
But that’s not all! All reports are available on demand which helps to save time for both the hedge-manager and investor. Most importantly, this tool makes it easy for investors to apply to have their investments altered as they deem appropriate.
Needless to say, if you can find a hedge-funds manager that implements this or similar tool in their operations, you’re sure to have your work (and maybe troubles) reduced by a huge margin!
Ready To Take The Leap?
Although hedge funds are often considered to be risky, expensive, and underachieving, they can be effective investment vehicles to help investors diversify their portfolios when managed correctly. However, due to their complex nature, investors must perform due diligence to ensure that they choose the right hedge-fund company and manager.We hope this article has given you a few important insights to help you venture into this ever- growing market of the financial landscape on the right foot!
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