Open the Wall Street Journal and we guarantee it won’t be long before you come across an article about hedge funds. If you’re not an experienced investor or you don’t work in the finance industry, the term may go right over your head. Investing lingo can be difficult to grasp, so we’ve got a comprehensive answer to this question: What is a hedge fund?
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How Hedge Funds Work
A hedge fund is a partnership of investors that use high-risk investing techniques in an attempt to generate high rates of return. Hedge funds can work with many different kinds of assets, including stocks, options and real estate. Normally, they’re used by institutions and individuals who have a high net worth and access to lots of capital.
Once investors (or limited partners) add their money to a fund, the hedge fund manager picks the strategy that he or she thinks will yield the most money.
Types of Hedge Funds
There are many different kinds of hedge funds and each one uses a unique investment strategy. Here are a few popular hedge fund classes:
Investing in long-short funds usually involves buying and selling stocks in an attempt to outperform the rest of the market and hopefully generate large returns. By taking either a long or a short position, you’re betting on stock prices.
To go long on a security means to buy it because you believe that its value will increase. Going short means that you plan to sell a stock, expecting its price to decrease. You could then repurchase that stock at its lower value and make money off of it.
Market-neutral funds are a type of long-short fund. What distinguishes this type of fund from others is that market-neutral fund managers seek to protect their portfolios from the rise and fall of prices in the general market. Your strategy would be to either invest in an equal number of securities in long and short positions or take steps to bring your relative risk level closer to zero.
With event-driven funds, you’re trying to profit off of specific events that could affect the whole market. For instance, if you think that the price of a security will rise following a major earthquake, you might decide to buy into a stock and sell it later on. You could use the same strategy if there’s political instability or economic turmoil that leads to mergers and company buyouts.
Related Article: How Does the Stock Market Work?
Hedge Fund Fees
It can cost quite a bit to invest in a hedge fund. Typically, hedge funds charge a 2% management fee. If the hedge fund has done well in the past, that fee could be a lot higher.
In addition to the management fee, you’ll likely be responsible for paying the manager of your hedge fund an incentive fee. Typically, it ranges from 10% to 20% but sometimes it can go up to 50% if the manager has done a good job.
Investments generally must reach a certain return rate before you’re hit with the incentive fee. So if the fund is losing money, you likely won’t be forced to pay an additional fee on top of your negative return.
Advantages of Hedge Fund Investing
Many hedge funds use leverage when conducting trades, which means that they make investments using borrowed money. What’s appealing about this move is that it has the potential to leave investors with higher rates of return.
Another appealing element of hedge funds is that they’re not subject to the same strict SEC rules that mutual funds are. That means that hedge funds have more flexibility with regard to their investment strategies.
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Disadvantages of Hedge Fund Investing
Using leverage has the potential to create huge returns. But if a leveraged investment doesn’t perform well, the fund (and its investors) could face enormous losses.
Hedge funds are also less liquid than mutual funds, meaning that your money could be locked up in the fund for a longer period of time. What’s more, hedge funds typically charge high fees so if you’re new to investing, a hedge fund is probably not your best bet.
Many of the unique features of hedge funds can be viewed as pros or cons, depending on how you look at them. The bottom line is that hedge funds are risky alternative investment vehicles. They can result in substantial gains, but there’s also the potential for big losses.
Hedge funds are not for everyone. You’ll want to be sure to do your research before choosing to invest in one. One thing is certain however – after reading this article you will never again need to ask, “What is a hedge fund?”
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