Hedge funds are powerful investment vehicles in the financial world. As compared to other mutual funds, these are not very mainstream. They combine funds from different investors and employ extremely sophisticated techniques to “hedge” risks and produce large profits.
If you wish to know more about hedge funds, you are in the right place. We will cover what a hedge fund is, what its benefits and drawbacks are, and how to choose the ideal one. Let’s get started!
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What is a hedge fund and how does it function?
In the context of investing, hedging refers to protection against risks. A hedge fund employs various hedge fund strategies to generate returns for hedge fund investors regardless of market conditions. They operate with flexibility and are not subject to government regulation, unlike mutual funds. Any asset class like equities, bonds, commodities, and currencies, is acceptable for hedge funds to invest in.
There are several types of hedge funds with their own techniques, for example, global macro, event-driven, relative value, and long/short equity.
So, how do hedge funds work? Usually, an experienced and skilled fund manager with in-depth knowledge manages hedge funds. They frequently invest their funds in a hedge fund and receive compensation according to performance.
Hedge funds are typically alternative investments. They require active management since they are an asset class aiming to “hedge” investor capital against market ups and downs. For this, they frequently use high levels of leverage.
Hedge funds are ideally available to accredited & high networth investors. Although they are unregulated, risky, and expensive investments, hedge funds offer high returns and diversification. To lower risk, they use leverage, arbitrage, hedging, and short selling.
Example of hedge fund:
India Zen Fund is an example of a hedge fund in India. It is an offshore hedge fund managed by Motilal Oswal Asset Management Company, that specialises in equity investments in mid-cap stocks.
Advantages and disadvantages of hedge funds
Hedge funds might come as a double-edged sword since they offer benefits as well as risks for both investors and the financial system.
Let’s start with some of the prevalent advantages of hedge funds:
- High returns: Hedge funds are known to be the financial instruments that generate high returns for their investors, despite the market conditions. They use various strategies to exploit market opportunities and hedge against market risks.
- Diversification: These funds offer diversification benefits for investors, as they have a low or negative correlation with the market and other asset classes. This means that they reduce the overall risk and enhance their risk-adjusted returns.
- Risk management: To minimise their risks, hedge funds might make use of risk management strategies. By maximising returns from particular sources of risk and reward, they use hedging techniques to shield their portfolios from unfavourable market fluctuations.
Now that we have a clear understanding of the benefits, let’s shed some light on the shortcomings of these funds as well.
- High fees: Hedge funds charge high fees for their services, which reduce returns for their investors. These fees are much higher than those charged by mutual funds or other types of funds.
- Lack of transparency: Known as opaque investments, these funds have limited or no disclosure or transparency about their operations and performance. Hedge funds are not regulated by the government and are not required to report or reveal their holdings, strategies, or risks to the public or their investors.
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How to choose the best hedge fund for your portfolio
Now that we have talked about the good and bad sides of hedge funds, let’s see how to choose the perfect hedge fund that best fits your portfolio. Choosing a hedge fund might be challenging, as there are many factors to consider.
Here are some steps that will help you choose a hedge fund easily:
Define your investment objectives
It’s important to know why you want to participate in a hedge fund, what sort of returns and risks you expect, and how long you are willing to invest before you start looking for one. After you have a clear idea of your “why”, you need to gather satisfactory information about the hedge funds that contains details about the fund’s objectives, strategies, fees, and other information.
Compare and contrast the hedge funds
Next, you need to compare the hedge funds that you have shortlisted based on several factors and criteria. You may do this by considering some of the aspects mentioned below.
- Strategy: You need to select a hedge fund that matches your investment goals, risk appetite, and time horizon.
- Performance: Make sure to assess the fund’s performance and compare it with other funds or benchmarks, such as the S&P 500 and the HFRI index, to name a few.
- Fees: Don’t forget to understand the fund’s fee structure and how it affects your returns and incentives.
- Risks: Last but not least, consider the fund’s volatility, leverage, liquidity, transparency, and operational risks, and how the fund mitigates these risks.
Monitor your investment
After you have compared the hedge funds, it’s time to choose the one that best suits your needs and preferences. However, to leverage hedge funds, you need to make sure to monitor your investment and review your performance with the hedge fund regularly.
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Conclusion
Similar to mutual funds, a hedge fund is an established partnership of investors who pool their money under the direction of reputable management organisations. However, the similarities between a hedge fund and a mutual fund end here. To put it briefly, hedge funds are higher-return, relatively riskier investment vehicles than mutual funds.
However, it is always a good idea to make an informed decision and determine whether the hedge fund manager’s plan is effective for you before investing in one.
