Hedge Funds – Buffer for the Market or Bummer for the People?
In 2021, Gamestop and hedge funds hit the headlines as regular folks trapped them in a short squeeze. During the pandemic, people thought the rich investors were profiting from failing companies like this video game retail store. That’s why they bought a lot of its stock.
The hedge funds place short positions on such companies to earn as their stock prices plummet. However, regular folks held on to their shares to keep the prices up. As a result, these investment companies lost significant sums of money.
People see hedge funds as a way for the rich to profit from the poor, but is that truly the case? We will explore this by elaborating on what a hedge fund is. Later, you’ll know their true purpose, and you might just be interested in investing in one yourself.
What exactly is a hedge fund?
It may sound like a savings account for renovating a home’s garden plants, but it has a more important purpose. It all started with a former Fortune magazine writer and sociologist.
In the 1940s, Alfred Winslow Jones created a “hedge” by short-selling stocks he thought would soon decline in value. The method was meant to protect against market fluctuations.
This was a revolutionary method at the time, but it’s now one of the most basic hedge fund investing strategies. The modern hedge fund has significant differences from the one that Jones started.
The US Securities and Exchange Commission defines a hedge fund as a pool of money from investors that it allocates on all sorts of assets.
Private companies manage this sum of money with their expert investors, with the hedge fund manager as the head. Their objectives determine the investment strategy that they will use.
The types of hedge funds
- Open-ended hedge funds constantly issue shares to investors. Also, it allows periodic withdrawals based on the net asset value of each share.
- Close-ended hedge funds issue a set number of shares via an initial offering. After that, they will not issue new ones even if investor demand is high.
- Shares of listed hedge funds are in stock exchanges so that non-accredited investors may purchase shares.
Hedge fund manager strategies
- Global macro strategies – The team in charge of the fund invest based on major global economic trends like interest rates, economic cycles, and demographic changes. This typically involves trading options contracts, equities, currencies, bonds, and futures.
- Directional strategies – The fund manager bets on where the market is going in the long run. Aside from market movements, this also involves looking at trends or inconsistencies.
- Event-driven hedge fund strategies – The manager looks for investment opportunities in corporate exchanges such as consolidations, liquidations, acquisitions, and bankruptcy.
- Relative value arbitrage strategies – The hedge funds aim to exploit price inconsistencies between different securities. The hedge fund managers expect these prices to drift apart or draw near each other over time.
- Long/short strategies – They involve hedge fund managers setting up long and short positions for two securities in the same field. As a result, the hedge fund gets to make money no matter if the prices go up or down.
- Capital structure strategies – A hedge fund may find an opportunity in the mispricing of securities in the capital structure of a business. For example, the fund manager can place a short position on its debt and a long position on its equity. If the company’s debt is overvalued, the strategy expects this difference to close in on each other in the long run.
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How do hedge funds make money?
Managers often charge high fees for their services. They charge an asset management fee that usually ranges from 1% to 2%.
Also, hedge fund investors have to pay a performance fee, typically 20% of the hedge fund’s profit. Hedge funds charge more depending on how much risk the managers are taking.
You can see why people think they’re just for the rich. It doesn’t help that you have to be an accredited investor for most funds. We’ll discuss the requirements for it later.
What are the benefits of a hedge fund?
- The best thing about hedge funds is that they allow investors to make money no matter how the market performs. The strategies we discussed make this possible.
- You can create a balanced portfolio with hedge funds, so you can minimize risks and expand your returns on investment.
- Investors can create the right strategy for any market condition.
- What’s more, they can access the services of skilled institutional investors.
What are the risks of a hedge fund?
- The wrong strategy could cause massive losses.
- Most hedge funds require you to lock in your money for a few years. If your investment isn’t turning out well, you can’t pull your funds out until that lock-in period ends.
- Leverage can increase a hedge fund’s earnings as it allows people to invest as if they have more money. Unfortunately, this could magnify the losses too.
Are hedge funds bad?
The hedge fund industry experienced a shake-up because of the recent Gamestop debacle. Americans thought that these investment methods allowed the rich to take advantage of the poor.
A Harris Poll survey from 2021 found that 27% of US citizens hedge funds for the Gamestop short squeeze. When interviewed, people revealed that they held the game company’s stock out of spite.
They said that it was like the rich were “looking down their noses” at regular Americans. They believed it was unfair to profit while ordinary folks struggled to make ends meet.
It’s easy for regular people to assume that since accredited investors often make more than they do. Here are the criteria that people have to meet:
- A person must show that he has an earned annual income of $200,000 for the past two calendar years. Meanwhile, it’s $300,000 for married couples.
- That income must be equal or higher in the year that a person or married couple applies.
- What’s more, people can become accredited investors by having a net worth of $1 million or more. This doesn’t include the assets connected to their primary residence.
This keeps the average Joe from investing in hedge funds. As a result, they may believe that these funds are just for the rich. However, they might not notice the good that hedge funds bring.
Nowadays, hedge funds are mostly pension funds, charitable investments, and university endowments. Contrary to popular belief, they’re not just for profit.
Some hedge funds can help people secure their retirement. Others can maintain funding for a school or contribute to a humanitarian cause.
What’s more, they assume risks on behalf of the investors who cannot handle it themselves. Hedge funds can be helpful, so you just have to choose the right ones.
How to choose the right hedge fund
If you invest in other assets, you’ll know how much work goes into building a portfolio. Expect a similar difficulty in finding the best hedge funds. Here are the steps you must take:
#1. Search for the best hedge funds.
Start by reading about their prospectus and collateral related to performance and marketing. The former is a document that hedge funds must submit to the SEC.
This will help you learn about its investment strategies and the risks associated with them. Your goal is to find the one that matches your investment objectives.
This can be tricky if you’re doing this alone. It’s best to ask for a financial advisor’s assistance. That way, they can offer professional advice about your portfolio.
#2. Check the fund’s assets.
Not all hedge funds are equal, as some may contain risky assets. For example, it may contain investment vehicles that are difficult to sell and price.
#3. Understand your payment obligations.
Remember that you will have to pay 1% to 2% of the total assets for the management fee. Also, you will have to pay an extra 20% for the performance fee.
Many hedge fund managers may take greater risks to make money instead of just relying on the 20% fee. This is something you should consider if you want a low-risk approach.
#4. Know when you can redeem your money.
If you recall, hedge funds have a lock-in period for investors. You won’t be able to get your money back until it ends. The market might not perform as you expected during that time.
Once that happens, you’ll have no choice but to accept the losses. Also, the hedge fund will only let investors redeem shares four times per year.
#5. Look for the best hedge fund managers.
A hedge fund manager led a group that oversees these investment instruments. That’s why you have to pick the best one. You can do this by looking at their Form ADV.
This document shows information about a hedge fund, such as its investment strategies and past disciplinary actions. You can find those on the SEC’s Investment Advisor Public Disclosure (IAPD) website.
Assets similar to hedge funds
If you don’t meet the requirements to become an accredited investor, don’t worry. You may invest in various assets that work like hedge funds. Here are some great examples:
Mutual funds
These contain a wide range of assets such as stocks and bonds. Their market price remains constant throughout a trading day. Some mutual funds are actively managed, meaning they try to beat market indexes like the Dow Jones Industrial Index.
Exchange-traded funds or ETFs
These also have baskets of assets similar to a mutual fund. However, it behaves like a stock, so the value may fluctuate during a trading day.
They are also keeping up with the times. Some of them contain cryptocurrencies. For example, the Proshares Bitcoin ETF is the first crypto ETF.
Index funds
These contain a wide range of assets such as stocks and bonds. Unlike mutual funds, they follow a certain market index like the S&P 500 to match its performance.
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Final thoughts
Many people assume that hedge funds give an unfair advantage to a few people. Yet, they could also benefit the masses by protecting pension funds or funding charities.
It’s hard to meet the requirements to become a hedge fund investor. Fortunately, you can find so many alternative investment options out there.
Note that this article is not meant to provide investment advice. If you’re planning to add hedge funds to your portfolio, seek assistance from a financial advisor.
