2. Balanced Fund Vs. Independent Stock and Bond Funds
3. Investment Expense Ratios
Hedge funds generally invest in assets and asset classes that are not highly correlated with the U.S. stock market or bond markets. As such, they are useful for "hedging" more conventional investments. While the Investment Company Act of 1940 restricts what conventional diversified mutual funds can invest in, hedge funds generally have no such limitations as unregistered securities and are free to employ large amounts of borrowed money -- or "leverage" -- to make investments. Some hedge funds do this, particularly when they are investing in areas where price movements are small.
How Leverage Works
When an investor or a fund borrows money to invest in a given asset and invests that money along with its own money, returns are magnified. For example, if the fund invested $1 million in XYZ stock and borrowed $1 million to invest in XYZ, and XYZ rose by 10 percent, then the investor would actually realize a 20 percent return, disregarding the costs of carrying the loan. But leverage works both ways: If XYZ lost 10 percent, the fund would lose 20 percent, since the loan must still be repaid in full. If XYZ loses 50 percent, the fund's investment in the company would be wiped out.
As mentioned, hedge funds vary widely in their leverage practices. Some assets, such as certain kinds of derivatives and covered call options, are leveraged by their very nature and don't necessarily involve a huge debt position. It's not unusual for a hedge fund to be leveraged between 100 and 500 percent, however, depending on the asset class. Leverage up to 10 times is not unheard of, though that would mean that a 10 percent decline in the leveraged part of the investment portfolio would wipe out investors' equity altogether. A recent survey from the United Kingdom Financial Authority finds that the average hedge fund was leveraged about 2.5 times.
Long Term Capital Management
One extreme instance of leverage was Long Term Capital Management, a hedge fund founded by several Nobel prize-winning economists. This fund sought to exploit small arbitrage opportunities in currency markets by "going long" in one market and "selling short" the same asset in another, where the same thing was priced differently on a different exchange. In theory, one or both positions must gain as the price anomaly disappeared. LTCM borrowed a huge amount of money, perhaps leveraging to 25 to 1, to magnify these small price movements to levels meaningful to investors. But when things didn't go as planned, in 1998, LTCM defaulted on the loans and threatened to take a number of lenders down with it in a chain reaction. The U.S. Treasury Department and Federal Reserve, along with Warren Buffett, chairman of Berkshire Hathaway, organized a bailout.
Because many hedge funds can be volatile and invest in narrow niches, the Securities and Exchange Commission does not believe they are suitable for retail investors. Hedge fund salespeople are prohibited from soliciting shares to individuals who are not "accredited investors," defined as a corporation or an individual with at least $1 million in net worth or verifiable income of at least $200,000 per year ($300,000 for married couples).
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.
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Hedge funds use leverage in a variety of ways, but the most common is to borrow on margin to increase the magnitude or "bet" on their investment. Futures contracts operate on margin and are popular with hedge funds. But leverage works both ways, it magnifies the gains, but also the losses.
Relative value funds are also inclined to use derivatives because the mispriced securities they are seeking can be hidden within complex derivatives that combine several underlying assets. Hedge funds leverage the capital they invest by buying securities on margin and engaging in collateralized borrowing.
With respect to establishing a U.S. hedge fund, average hedge fund startup costs range from $50,000 to $100,000, and first- year operational costs usually total $75,000 to $150,000.
It is not uncommon for a hedge fund to require at least $100,000 or even as much as $1 million to participate. Unlike mutual funds, hedge funds avoid many of the regulations and requirements within the Securities Act of 1933.
While traditional hedge funds that go long or short on stocks based on data analysis by people leveraged roughly two times their books, equity quantitative and multi-strategy hedge funds were at 4.5 and 3.1 times, according to a JPMorgan estimate.
Many hedge funds seek to profit in all kinds of markets by using leverage (in other words, borrowing to increase investment exposure as well as risk), short-selling and other speculative investment practices that are not often used by mutual funds.
A hedge fund raises its capital from a variety of sources, including high net worth individuals, corporations, foundations, endowments, and pension funds.
First, the hedge fund mortality rate in this sample is estimated at 8.43 per cent per year which is twice the size of those reported in mutual fund studies. We find that 59 per cent of hedge funds at the start of the sample do not survive the full sample period.
Getting a hedge fund up and running is a bit more challenging than forming a corporation or a limited liability company (LLC) for a private business. It involves navigating investment compliance laws, and you'll need professional legal help at some point along the way.
Most hedge and private equity funds target a net IRR of 15% for their investors (after fees). This provides their investors with a meaningful premium over historical average stock market returns of 8%.
BlackRock manages US$38bn across a broad range of hedge fund strategies. With over 20 years of proven experience, the depth and breadth of our platform has evolved into a comprehensive toolkit of 30+ strategies.
The fee structure for these funds comprises two components. A management fee typically below 2% and a performance fee of 20%. Therefore, to invest in hedge mutual funds, the minimum investment fund required is ₹1 crore per investor, while the entire fund must have a minimum corpus of ₹20 crore.
Overall, the consensus is that hedge funds will continue to grow but will adapt to lower fees, greater use of technology, and increased access to retail investors.
Hedge funds share several risks as other investment classes are broadly classified as Liquidity Risk and Manager Risk. Liquidity refers to how quickly security can be converted into cash. Funds generally employ a lock-up period during which an investor cannot withdraw money or exit the Fund.
The hedge fund borrows the same number of securities from a security lender and contracts to retransfer an equivalent number of the same securities at some point in the future to the lender.
Simply stated, a hedge fund buying on margin has no cash, but would like to buy a security that it expects to appreciate in the future. It therefore borrows some money from a broker and exchanges it for the security. Naturally, the broker will ask for some kind of collateral to secure the loan (see Figure 5.3).
While hedge funds are only lightly regulated and carry high inherent risks, funds of hedge funds are thought to offer security because professional managers are picking the hedge funds that make up the pools.
Regulatory bodies are under obligation to investigate the fund and the manager in question. Depending on the extent of the losses, investors may lose all their money, or recover a portion of their investment. On top of investment losses, investors may be obliged to pay tax on realized losses.
Hedge funds are less regulated than mutual funds, but are only allowed to manage the money of “accredited investors” — institutions, endowments, or wealthy investors who meet specific minimum wealth/income requirements (not mom-and-pop investors).
Introduction: My name is Geoffrey Lueilwitz, I am a zealous, encouraging, sparkling, enchanting, graceful, faithful, nice person who loves writing and wants to share my knowledge and understanding with you.
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