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Hedge Funds

Definition: A hedge fund is an unregulated vehicle used to pool and invest wealthy investors’ and institutional money, with the goal of making an absolute profit.

Introduction: Know the manager! Since hedge fund managers are usually given wide latitude in their investment choices, there is the perception that hedge funds are volatile, risky, and leveraged, with uncertain rewards. As with any investment, you need to evaluate each fund individually. Volatility, risks, and rewards vary enormously among funds. Unlike most other investments, managers usually have a large portion of their individual net worth invested in their fund. There’s a general perception that all fund managers are smart, mainly because they deal with high value, complicated transactions. That is not always the case! Investors need to know to whom they are entrusting their money.

Market Size: As of May 2005, there were approximately 8,000 hedged funds, overseeing approximately $1 trillion in assets, up from 4,800 hedge funds and $400 billion of assets four years ago. Over the past four years, hedge funds have averaged a gain of 6.4%, versus a gain of less than 1% for the Dow Jones Industrial Average.

Activities: Hedge funds invest in all types of financial instruments, including but not limited to: equity and debt securities, derivatives, options, puts, calls, futures, currencies, commodities, margin lending, shorting, and various other hedging and arbitrage strategies. Each manager has a different technique, and utilizes different instruments and program trading systems to achieve a profit.

Regulations: Hedge funds are private investments and are not subject to SEC disclosure requirements. They are, however, prohibited from advertising.

Concerns and Risks: Below are some additional facts and drawbacks concerning hedge funds:

·        Investors may be unaware, and unprepared, for the negative consequences and side effects of some of the risky investment strategies that are employed; one can lose his/her entire investment.

·        A significant amount of money is being transferred out of public and regulatory view. A relatively small group of people control significant dollars, and may engage in extremely volatile, risky, leveraged, and complicated financial transactions, with little oversight.

·        The downside risk to the general public is unknown. Pension funds, endowments, insurance companies, brokerage firms and banks all invest in hedge funds.

·        Hedge fund managers receive significant compensation. Normally, funds charge a management fee of 1 to 2%, plus a typical profit sharing arrangement of 20%. Most funds have a high-water mark or loss carry forward provision, where the general partner cannot charge a profit sharing fee if the individual investor has not made money. Additionally, some compensation plans include hurdle rates that must be met before a fund manager can receive profit sharing fees.

·        Investors are normally “accredited investors” - individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth. However, contrary to what most people believe, having money does not make you a savvy and sophisticated investor.

·        Most funds have initial lock-up periods of a few years, where investors are unable to liquidate their investments.

·        There’s the potential for hard to value assets, such as private placement technology deals, to be “underwater” and not valued correctly, nor reported in a transparent fashion.

Benefits: The benefits of a hedge fund are numerous. The returns can be enormous! They can also balance out a portfolio that is too conservatively invested. Theoretically, they can delivery positive returns under all market conditions. They can also provide portfolio diversification; returns may not correlate to the broader debt and equity markets. They can give investors access to highly specialized trading strategies that are not available through mutual funds or brokerage firms. They can give investors hope when all else fails.  

Types of Hedge Funds: Hedge funds vary according to their managers’ strategies, as listed below:

·        Equity Hedge Funds – Stock pickers or micro managers who focus on individual securities and use fundamental analysis to research a company.

·        Event Driven Funds – Opportunistic managers who utilize risk arbitrage and distress debt investing.

·        Income Hedge Funds – Managers interested in generating income/yield for their investors.  

·        Global Asset Allocators – Macro managers who focus on the broad markets and major themes.

·        Relative Value Funds – Market neutral managers who take advantage of price inefficiencies between related securities.

·        Short Selling Funds – Managers who focus on finding overvalued securities to short.

·        Funds of Hedge Funds – An investment company which makes investments in other hedge funds. Some of these funds are registered with the SEC. Fees may be high, and may be paid to the funds of hedge funds, as well as the underlying hedge funds.  

Administration: Most of the hedge funds are set up as (pass-through) limited partnerships; the hedge fund managers being the general partners and the investors being the limited partners. The hedge fund managers may also be set up as corporations to avoid personal liability.  For taxes, annually, hedge funds produce schedule K-1, which reports the income from the fund. Investors then declare the results on their individual tax returns, regardless of whether or not a distribution is paid.

Current Affairs:  The critical issue in the news seems to be: should these funds be regulated? So far, the regulators have not imposed stricter rules on hedge funds. Investors, however, are looking for more transparency, greater liquidity, and reduced fees.

Conclusion: Young adults should be concerned about making prudent investments. Investors need to be extra careful and prudent when investing in hedge funds. 


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