Hedge Funds

Articles on Hedge Funds

An article about Hedge Funds
Why you should sell hedge funds short and how to do it.

Hedge Fund Overview

I. Introduction

The term hedge fund usually refers to private investment vehicles that seek above-average returns through active portfolio management. Hedge funds tend to be skill-based investment strategies that attempt to obtain returns based on the unique skill or strategy of the trader. These returns are considered "absolute," as they do not depend on the relative long-term return of underlying traditional stock and bond markets.

Investors are attracted to hedge funds for a variety of reasons. This includes their potential to deliver positive returns under all market conditions, low correlation to traditional asset classes, and access to highly specialized strategies not typically available through traditional money management.

Hedge funds are largely unregulated by U.S. security laws and are strictly prohibited from advertising. As a result, hedge funds today are offered as private investment partnerships, generally with fewer than 100 affluent investors or institutional clients. Not all hedge funds are appropriate for all prospective investors: most hedge funds are available only to persons who meet specific financial requirements. Prior to investment, the law requires that the hedge fund determine the investor's suitability (i.e. is the hedge fund appropriate to the investor's risk tolerance, investment goals, and investment experience).

II. Benefits

A primary benefit of hedge funds is the low correlation many strategies have to traditional investments. While past performance is not indicative of future results, hedge fund strategies historically offer returns independent from the performance of stock and bond markets. In fact, they aim to diversify away from traditional "long-only" equity strategies and deliver positive returns under all market environments.

III. Risks

Alternative investment products, including hedge funds and managed futures, involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor's interest in alternative investments, and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products often execute a substantial portion of their trades on non-U.S. exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in U.S. markets. Additionally, alternative investments often entail commodity trading, which involves substantial risk of loss.

IV. How To Invest

With an estimated 6000 hedge funds managing in excess of $550 billion, most investors today are questioning where to begin. Many investors attempt to conduct their own due diligence and invest directly with specific managers, while others take advantage of professional hedge fund consultant firms to research, advise and monitor their investments.

Investing with a hedge fund manager involves a complex evaluation process. Identifying the best managers can be very difficult. Hedge fund managers are not required, and in many cases not allowed, to advertise or report performance data to any central authority. As a result, many of the top hedge fund managers are not listed in commercially available databases.

Hedge fund consultants can greatly assist in this process. Research specialists, with access to this data, screen the universe of hedge funds in search of high quality candidates for further analysis. They perform qualitative, on-site evaluations and review a manager's background, financial statements and corporate documentation in an attempt to identify a competitive advantage. This process often includes a quantitative review focused on the performance statistics related to volatility, consistency, and peer comparisons.

Consultants help investors define their investment profile and offer their clients a unique range of comprehensive hedge fund solutions. They then help clients monitor their investments to compare performance with their original investment parameters. They may advise a client to redirect their investment allocations as a result of changing market conditions, some asset classes outperforming others, or a change in the investor's objectives.

V. Conclusion

While there are risks involved, and hedge funds are not suitable for all investors, there is a compelling argument for the inclusion of hedge funds in a traditional investment portfolio. Many hedge funds can offer enhanced portfolio performance under various market conditions. It is hedge fund managers' flexibility and skill-based strategies that make this investment class inherently attractive. However, investors need to approach these investments with the necessary information to make an informed decision. Researching and evaluating hedge funds presents a host of challenges to even the most sophisticated investor. Through an appropriate allocation, hedge funds can be an attractive addition to a well-diversified portfolio designed to deliver positive returns while attempting to reduce volatility and risk.