Hedge funds might seem like a complicated issue, but once you know your stuff, you’ll definitely want to invest. To learn more, read on…
COVID-19 has changed the way we look at everything. Investing in property, business and funds stays stable most of the time, but when a global incident happens, we have to re-evaluate the market.
You may have looked into investing in hedge funds before and decided against it, but now is the time to look again. If you want to get involved in hedge fund formation, this article will help you decide whether it’s a good investment or not.
In this post, we’ll be covering what hedge funds are, how they work, as well as the benefits and drawbacks of them under normal circumstances. We’ll also look into how they look in our current COVID-19 era so, if you want to discover more, you came to the right place…
What are Hedge Funds?
This section will act as a sort of ‘hedge funds for beginners’ so, if you already know what they are, you can move past this section and read on from ‘benefits and drawbacks’. So, what is a hedge fund in simple terms?
A hedge fund isn’t a specific type of investment, it’s actually a pooled investment, where money is collected from multiple investors. It’s then professionally managed by one company, and is designed purely to make a return.
These funds use different investment strategies, and are classified using various investment styles. Between different styles there is diversity in the level of risk to your investment.
What Are the Requirements to Invest in a Hedge Fund?
To invest in a hedge fund, you have to meet a certain income and net worth requirement, which varies depending on the level set by the hedge fund manager. They are legally set up as private investment limited partnerships open to a limited number of investors.
Investments in hedge funds usually require investors to keep their money in them for a year, known as a lock-up period. Then, after that initial period, withdrawals can only be made either quarterly or bi-annually.
It’s only worth investing in one of these funds if you have a lot of money to invest because they have a Two and Twenty fee structure. This means they charge two percent for asset management and 20 percent of your overall profits as a fee.
How do Hedge Funds Work?
There are many different types of hedge funds that all work in slightly different ways. We’ll give a more general overview here, and if you want a more in-depth analysis on the different specialisms, you can look at this hedge fund Investopedia article.
The way a hedge fund works is a hedge fund manager raises money from outside investors, and invests it using the promised hedge fund strategy. Some of those strategies are:
- Long-only equities, where the manager only buys common stock and never sells short.
- Private equity, which involves buying entire private businesses, taking them over, improving their operations, and then sponsoring a public offering.
- Trade junk bonds, which are high risk, high yield bonds that can go badly if invested in by someone who doesn’t know what they’re doing.
- Specialise in real estate, where prices tend to go up over time and risk is relatively low.
- Invest in special asset classes, such as patents and music rights.
This isn’t an extensive list of hedge fund strategies, but it gives you a general idea of how a hedge fund manager might invest your money. The primary goal is to make a return on its investments, but how exactly do they accomplish that?
How Returns Are Made in Hedge Funds
Let’s imagine that you’ve started a hedge fund. An investor comes along with £100,000 and you have to make a return on it. You can use one of the above strategies to make the money, either buying private businesses and making them profitable, trading high risk bonds, investing in stocks, mutual funds, real estates or start-ups.
Your purpose every day is to make a profit on the initial investment. If you make an additional £100,000 in the first year, doubling the initial investment, based on the Two and Twenty fee structure, the first two percent goes to the investor, leaving £98,000 to split 20-80.
20 percent of the profits, £19,600, would go to you and 80 percent, £78,400, plus their two percent hurdle rate, £2,000, would go to the investor. Therefore, in the investment of a hedge fund, the majority of the return would go to the investor.
Because hedge funds are actually a pooled investment, there would be other investors looking to make money from the same fund. But, that’s the beauty of it; the more people that invest, the more likely you are to make a profit.
One thing to bear in mind when you invest in a hedge fund is that they are not subject to the rules that protect everyday investors. This makes them riskier than other investment options. So, on that note, it’s time to discuss the potential benefits and drawbacks of investing in hedge funds.
Benefits and Drawbacks of Hedge Funds
Benefits of Hedge Funds
Unlike mutual funds – a type of investment consisting of a portfolio of stocks, bonds and other securities – hedge funds are much more flexible. People don’t trade them publicly, so there are no bodies regulating their performance. This means that hedge funds can use unregulated strategies, like short selling, derivatives, and leverage.
For those of you who’ve seen The Big Short, you probably have an idea of what short selling is. It’s an investment strategy that profits from the declining price of stock, security or bonds, basically like betting against their success.
Aggressive Investment Strategy
Adopting more aggressive investment strategies makes it more likely for you to get a high return. These are the same strategies listed in the flexibility benefit above.
With leverage strategy, for example, investors will borrow and trade money on top of the capital they gain from the investment. This gives them a higher chance to make gains but also to make losses, so it’s important that the hedge fund employs complex risk management tools to reduce the risk of these investments.
Expert Advice and Transparency
Hedge fund managers are fantastic at investing your money, but they are also great with financial management. This means that, when you come to a hedge fund with your investment, they will be able to give you lots of information on where your investment will go and share future plans for your investment with you.
They are also good with disclosure, so you’ll never be in the dark with how your money is being spent.
Drawbacks of Hedge Funds
Hedge Fund Fees
The Two and Twenty system is a good motivator for your hedge fund manager to make a return on your investment, because they get a 20 percent cut. However, 20 percent of your money is a lot. What’s more, if the hedge fund isn’t making as much money as you’d hoped, it could take a long time for you to see a return on your investment with the fund taking a significant chunk.
Risk and Returns
This is a counter version of the high-risk-high-reward benefit we mentioned earlier. Hedge funds often rely on taking big risks to get the return their investors were hoping for when they parted with their money.
For example, in 2011, hedge funds were falling behind the market with a 4.8 percent fallout. So, it’s really down to whether you’re up for taking the risk.
Hedge Funds in the COVID-19 Era
The coronavirus pandemic has changed everything. All the strategies hedge funds used up until now have changed and, in many cases, they need to adopt new ones for this new era.
One of the tenets for 2020 was to favour active management of funds over passive management. This is even more important now, as medium and short-term opportunities must be closely managed by the hedge funds.
Hedge funds are flexible, and in the best position to find new areas to invest money, such as convertible bonds which shows signs for high reward, low risk trades. Because of the relative volatility of the markets, now might not be the best time to invest. It’s probably better to invest your money when the markets are more stable.
However, if you are looking to invest your money regardless, then a hedge fund would probably be the way to go. The fact that hedge fund managers stand to make a large amount of personal wealth off your investment means that the best minds in the investment field reside there.
These people are resilient, flexible and are already finding new areas to invest money and make a profit. There’s also the fact that hedge funds aren’t regulated by a specific body and are able to short sell. At the start of the crisis one London hedge fund made £2.4bn betting against the market.
If businesses continue to fail, and the hedge funds are able to spot their downfall before it takes place, shorting is one strategy that will continue to make money.
Thinking of Investing?
Here, we’ve provided a general overview of what hedge funds are, and some of their biggest risks during the COVID-19 era. Because hedge funds are so diversified, they won’t all react to the coronavirus pandemic the same way.
Every hedge fund manager will do everything they can to make a profit, regardless of how the markets look. However, the less savvy hedge fund managers might not make it. So, before taking the plunge, be sure you’re investing in someone reliable and savvy.
Interesting related article: “What does Investment mean?“