Hedge Funds
What is a hedge fund?
Hedge funds are a privately run form of absolute return fund that are managed in a fairly aggressive way to maximise returns.
An absolute return fund is one that aims to provide a consistent and positive return each and every year regardless of market movements.
Hedge funds were traditionally only available to professional or institutional investors although are now more widely available to the public, all be it still to a limited number of investors.
Unlike normal retail funds (i.e. available to the public) hedge funds can invest in a wide range of investments including shares, bonds, currencies, futures, options and debt instruments.
The use of debt instruments is important because one of the ways in which hedge funds differ from unit trust, for example, is that they can borrow money. Borrowing money to invest together with the money already invested in the fund can significantly increase the risk associated with the fund.
As in the name hedge funds can use a variety of methods to hedge their investments against adverse market movement. However these techniques such as short selling have also been used to provide a source of additional gains and therefore have served to further increase the risk associated with these funds.
Hedge fund managers will typically use a mixture of investment management techniques, invest in a variation of asset class sectors and geographical regions and use different types of investments to gain optimal performance for their fund.
Advantages of hedge funds...
Fund managers can use aggressive strategies and, as their name suggests, hedge their bets against movements in the markets.
The fundamental aim of these types of funds is to provide a positive return year on year regardless of movements in the markets.
Disadvantages of hedge funds...
Hedge funds are considered a high risk investment and remain suitable for experienced investors or those with a financial planner or larger amounts to invest.
One of their key charateristics and a source of much crticism for hedge funds has been their ability to charge a performance fee.
Hedge funds are already known to charge significant annual management fees. It is not uncommon for funds to charge anywhere up to 4% per annum with the typical fee being around 2% per annum.
However it is their performance fee that can be as high as 50% of the gains made that could leave investors, who are taking all the risk, wondering where their profit has gone.
Although managers benefit personally from gains made, they do not suffer financially in the same way when their fund makes losses. Some have criticised this remuneration structure saying that it encourages fund managers to take excessive risks.
