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Basics of Hedge Funds

Hedge Funds

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Hedge funds can use a wide array of assets to earn more return for investors willing to accept their risk profile. There are hedge funds which capture profit from virtually any instrument, creating vast combinations of risk and return profiles for any prospective investment. Hedge funds typically attempt to acquire higher return with less risk. Risk can never be completely eliminated, and the manager’s investment skill is determined by their ability to earn profit beyond what a level of risk typically delivers. This is known as their “alpha”, the return generated beyond an expected level for an asset, or collection of assets.

Less Regulation, Wider Access

In their search for alpha, hedge fund managers access a wide assortment of investments. This array of assets commonly includes bonds, cash instruments, commodities, convertible instruments, derivatives, equities, forwards, futures, insurance, options, real estate investments, swaps, venture capital, and synthetic possibilities. They have a wide mandate to reach these investments. Hedge funds can use long buys or short sale positions, leverage, and extremely large bets. They may concentrate investments heavily in a single category of assets, or diversify across many asset classes.

These large bets can be made because hedge funds are vastly unregulated in comparison to other fund categories. Hedge funds usually do not need to register with the Commodities Future Trading Commission, Securities and Exchange Commission, or the Financial Industry Regulatory Authority. Their potential aggressiveness is due to the lack of limitations imposed by regulators. Some funds register and submit to oversight by choice, but many do not. It is important to note that this does not allow direct or indirect involvement in fraudulent activity in any way, shape, or form. Additionally, they can only accept investment from certain investor classifications while avoiding regulatory oversight. Hedge funds are only open to individuals with high net worth, also known as “qualified” or “accredited” investors. These investors qualify by earning a specific amount of money: $200k in income a year (more if married), and $1,000,000 in assets or higher. If investors fail to qualify, they may not invest in hedge funds.

Lower Transparency

Hedge funds, as a result of their reduced regulations, are less transparent than mutual funds. You can request any information you desire, but they often won’t tell you anything they aren’t contractually required to disclose. This is understandable: Hedge funds do not like discussing strategy. The more strategy they discuss, the more other hedge funds can discover about their objectives, weaknesses, strengths and strategy. Hedge funds will disclose as little information about investment selection and strategic execution as possible. As a warning, fund managers should never give zero or false information to current or potential investors.

In order to make their hidden strategies acceptable, hedge fund managers typically hold high stakes in their own funds. If hedge fund managers are not willing to substantially expose themselves to the risks of their own trading strategies, you should be careful. If they don’t trust themselves with their own money, neither should you.

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