The name “hedge fund” is derived from the fact that hedge funds often seek to increase gains and, at the same time, offset losses by using a variety of sophisticated investment methods. By nature, hedge funds have wide investment latitude, which means they can invest in anything that their goals can encompass.
What investment strategies do hedge funds use?
Within hedge funds, fund managers raise money from outside investors and then invest it according to whatever strategy they have promised to use. Hedge funds typically use long-short strategies, which invest in some balance of long positions (buying stocks) and short positions (selling stocks with borrowed money, then buying them back later when their price has fallen). But, in reality, hedge funds use various strategies to achieve their goals.
The main strategies that hedge funds employ include macro, equity, and relative value. A macro hedge fund invests in stocks, bonds and currencies in the hope of making profits from changes in macroeconomic variables such as global interest rates and national economic policies. An equity hedge fund, which can be either global or country-specific, invests in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices. A relative value hedge fund capitalizes on price or spread inefficiencies.
There are hedge funds that specialize in “long-only” equities, which mean that they only buy common stocks and never sell short. Other hedge funds engage in private equity – the buying of entirely privately held businesses, often taking them over, improving their operations and later sponsoring an initial public offering. There are also hedge funds that trade junk bonds (high-yield, high-risk securities that are typically issued by a company seeking to raise capital quickly for financing a takeover).
In addition, many hedge funds invest in derivatives –contracts to buy or sell another security at a specified price. Futures and options are considered derivatives. Many hedge funds also use an investment technique called leverage – investing with borrowed money – a strategy that can significantly increase return potential but also comes with greater risk of loss. There are even hedge funds that put money to work in specialized asset classes such as patents and music rights.
Aside from these, another popular strategy is the “fund of funds” approach, wherein a hedge fund blends other hedge funds and other pooled investment vehicles together, with an aim to provide a more stable long-term return on investment than those of any of the individual funds.
What else should you know about hedge funds?
Below is a compilation of the things that are essential to know about investing in hedge funds:
Only accredited investors are eligible to invest in hedge funds due to government regulations that make it highly unlikely for hedge fund managers to admit them to the partnership or firm unless they qualify. Even if managers were inclined to make an exception, they can only admit up to 35 non-accredited investors – and managers generally reserve those slots for family members and close friends.
Many hedge funds limit the number of redemptions investors can make in a year. This is because they may not be able to sell their underlying investments easily. Once investors have made a redemption request, it could take up to 90 days before they get their money.
Most hedge funds seek to generate returns over a “lockup period,” a specific period during which investors cannot sell their shares.
Investors will pay tax on any capital gains they make when they sell their investment. They will also pay an annual tax on any distributions they receive from the fund. Most hedge funds will reinvest investors’ distributions to buy additional shares.
If people invest in a hedge fund of funds, they will pay twice – they will pay fees on the fund they buy as well as on the underlying funds. As such, before they invest, they should consider these extra costs against the benefit of spreading their risk across a number of hedge funds.
Some hedge funds may be eligible for registered retirement savings plans (RRSPs) or registered retirement income funds (RRIFs), but that does not make them a good choice for retirement savings.
Nearly all hedge funds feature a “high water mark.” It means that the performance fee (typically 20%) only applies to any profits the hedge fund makes after it has recovered losses from previous years. As such, it prevents fund managers from “double dipping” (collecting double benefits) or being rewarded for poor performance.
The goal of hedge funds is to maximize returns, and fund managers use different strategies to achieve this. There are times when the strategies they use are highly risky. On investors’ end, they should consult a financial expert to be able to understand both the potential gains and losses they may incur when they invest in hedge funds.