Steeped in mystique and misunderstanding, the question “What is a hedge fund?” is a popular one. Unraveling the mystery is not so difficult, with a bit of research, as well as patience in an attempt to understand the system.
Hedge funds are clusters of private investments led by strategic decisions that are meant to insulate the fund investors from negative market turns. Furthermore, funds are designed to capitalize on positive turns exponentially as well.
There are many ways in which hedge funds differ from other portfolio opportunities. Hedge funds tend to cover a wider range of investments than traditional mutual funds, and may include bonds, commodities, and equities. Long positioning regarding an asset implies a potential increase or upward trend.
A type of internal insurance rests with the fact that hedge fund managers tend to have some of their own money tied-into the assets they currently manage. A manager having skin in the game helps to avoid conflicts of interest, and aids in lending itself toward favorable outcomes financially for all.
As a hedge fund investor, you can expect to contribute fees that enable the status of the fund to be managed. Operational costs, as well as performance fees, are standard for this vehicle. When your hedge fund performs more favorably than it did the prior year, fees will be assessed correspondingly.
Since institutional investments typically include foundations, endowments, and pension plans, hedge fund asset values can reach well into the multi-billion dollar range.
More than half of investment capital in hedge funds is currently institutional, and yet hedge funds are responsible for only just over 1 percent of all assets in funds that institutions own. Worldwide, hedge funds are believed to be responsible for approximately $2 trillion in ever-changing assets.
Regulators set very high standards in qualifying criteria for those who wish to become hedge fund investors. Ironically, however, hedge funds themselves are not restricted in the same way that publicly traded portfolio assets can be. While standard regulations do apply, advisors have much more latitude in their trading positions and abilities.
Hedge fund managers typically become so because they are determined to make money regardless of the state of the market at large. Hedge funds are established in such a way that the manager, who is often also the creator of that particular fund, will always earn a portion of the profits. The hedge fund label was originally selected due to the fact that such an asset portfolio was designed to make money whether or not the market was strong.
Another hedge fund industry differentiator is the compensation formula. Most use a 2 and 20 arrangement in the way that managers are compensated for their efforts. This is to say that such an advisor will receive 2 percent of the assets, and 20 percent of the profits, each year. Therefore, a fund that holds a $1 billion value will yield $20 million for its manager, even without much movement. Of course, investors would not hold their money in such an agreement for too long, so many situations often do require a hurdle rate.
A given 4 percent hurdle rate means that, when an advisor places hedge funds with a growing company, the first 4 percent of the return automatically goes to the investor. The remaining returns, beyond the 4 percent, are usually split with 25 percent landing in the advisor’s pocket and 75 percent reaching the investor.
So when it comes to understanding “what is a hedge fund”, the realization about the very selective criteria for potential investors and lack of public access, provides great insight. Invariably, the strong potential returns for hedge fund managers and investors also cannot be overlooked.