Hedge funds, at least on the surface, appear similar to mutual funds. In reality, however, the only real similarity is that both combine and invest contributions from multiple investors in an attempt to realize a profit. Unlike more conservative mutual fund investments, hedge funds use different and more flexible investment strategies and rely heavily on speculation in the pursuit of investment goals. Although their risky nature and investor accreditation requirements make hedge fund investing unwise -- and unavailable -- for all but wealthy and seasoned investors, it can be interesting and enlightening to get information about another side of investing.
Hedge funds represent a significant departure from traditional investing. Although some do place a portion of investment funds in traditional asset classes such as stocks, bonds and real estate, many invest in derivative securities such as futures, forwards, options and swaps. Derivatives are part of what creates the “hedge” in hedge fund investing. To hedge means to invest in two securities you expect to move in opposite directions, one of which is the investment and the other a type of investment “insurance.” According to the theory behind hedging, if the investment you are hedging against increases in value your profit will be reduced. On the other hand, if the investment loses money your hedge should also reduce investment losses.
Hedging is risky not only in theory but also with regard to its use of speculative investment techniques. Leveraging and short-selling, both of which also contribute to the “hedge” in hedge fund investing, are two of the most common. Leveraging increases “buying power” through investing with borrowed money, and while it has the potential to significantly increase returns, leveraging can also increase losses if the investment loses money. Short-selling is a complicated and risky investment technique in which an investor “borrows and then sells stock he doesn’t really own based on the belief that the price of the stock will fall in the near future. When the price drops, the investor buys the stock at the lower price, pockets the profit and “returns” the shares to the original owner. On the other hand, if stock prices do not fall, the investor is locked in and must still purchase the stock at its current market value.
Lack of liquidity can make it difficult to impossible for investors to get out and cut losses. This is because most hedge funds have an initial “lockup period” of at least one year, during which time investors can’t redeem or cash in their shares. After the lockup period ends, many allow redemption only at specific times, such as monthly, quarterly or annually. Hedge funds can be even less liquid if managers take advantage of their authority to suspend redemptions -- when, for example, the market is performing poorly.
Hedge Funds and the SEC
Although the U.S. Securities and Exchange Commission does require hedge fund managers to abide by anti-fraud laws and also holds hedge fund managers legally responsible for the funds they manage, the SEC does not for the most part regulate the hedge fund industry. Lack of regulation can make it difficult to accurately assess hedge fund performance and makes valuation difficult. The SEC also has no say in how hedge fund managers are compensated and warns that a compensation structure consisting of a percentage of investment returns and a management fee of 1 percent to 4 percent of the net asset value of the fund can lead to overly aggressive investing that increases investment risks.
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