Hedge funds are privately-run firms managed by expert fund managers and whose source of funds come from selected high net worth individuals,  pension schemes, and other specifically sourced investors.

Regulation D of the Securities and Exchange Commission (SEC) prohibits these entities from raising capital publicly. However, they can sell fractions of ownership to investors without following the SEC procedures. The underlying factor about them is that they take on relatively high-risk investments in return for potentially larger profit margins.

Key features of hedge funds

1) Hedge funds are managed by skilled fund managers. They must satisfy their investors that they can invest their money prudently and return profits worth the risk is taken. The managers, therefore, employ various strategies to ensure that they meet their clients’ expectations.

There are no specific strategies followed universally by hedge funds, but they generally focus on diversifying their portfolio, putting money in niche markets/products, and taking up high-risk-high return ventures. The managers are under no obligation to explain the finer details of their strategies to investors but must inform them on the basic approach to be taken.

2) Hedge funds generally direct most of their investments towards assets with weak links to the traditional market oscillations. For example, they will prefer breakthrough startups over stocks among other related approaches.

3) They charge a conventional 2% as an annual management fee as well as a 20% cut from profits. The common phrase used for these two charges is “2 and 20”.

4) The funds target potential investors and reach out to them, pitch their investment strategy and persuade them to inject capital. This means that not everyone can invest in a hedge fund. Notably, high net worth is a key requirement in this ecosystem.

5) They have defined pick-up periods for all the capital invested. During this period, investors cannot recall their money. These periods range between one and three months.

More on lock-up periods

This is the period of housekeeping and building the foundation for the next investment. It is meant to give fund managers adequate time to set the investment strategy in motion and create the momentum needed to propel it higher. 

In addition, these periods are necessary to allow the funds to manage liquidity and remain stable. The length of the lock-up should be proportional to the nature of the investment. Long-term investments generally require longer lock-up times.

Types of Hedge Funds

1. Open-ended

These operate like companies, with shares being issued periodically to investors depending on the amount of money they have injected into the fund. Investors get their rewards in the form of profits accrued by each share held.

2. Closed-end hedge funds

These have a fixed number of shares, which do not change over time. Instead of issuing new shares, the value of each share increases over time, and earnings are proportionate to the shares held.

3. Relative Value hedge funds

These focus on holding long positions for stocks whose prices they project to rise while at the same time going short on stocks of “substitute” companies in the same sector, whose performances they expect to decline.

4. Distressed Hedge Funds

These hedge funds’ target markets are companies and other entities that are in financial distress but have the potential of performing well once they get bailed out. Their extent of involvement may go as far as helping the companies return to life in exchange for owning part of their shares.

The “discriminatory” aspect of hedge funds

As intimated above, hedge funds are quite selective when it comes to the type of investors they want. Not only must these investors have a certain level of financial capacity, but in most instances, the investors must be ideologically compatible with their investment strategy.

This, therefore, means that from time to time, fund managers and other executives get to decide which investors to keep and which ones to cut loose. In the end, many people may not make the cut to invest in their preferred hedge funds. This has led to criticism of the business model adopted by hedge funds.

Pros

  • The freedom enjoyed by fund managers enables them to employ largely unrestricted strategies while investing. Other investment entities do not enjoy such freedoms, and it gives hedge funds a great advantage even when market conditions are unfavorable.
  • The diverse nature of hedge fund portfolios ensures that there is a favorable balance between risk is taken and potential rewards. This makes them worthwhile investment destinations.
  • They are run by highly skilled managers as well as investment managers who can adequately advise investors. This minimizes room for wrong decisions.

Cons

  • They have a high affinity for high-risk ventures, which may lead to large losses if a strategy fails.
  • Some investors are turned off by long lock-in periods, even in instances where the floated investment strategies are attractive.
  • The use of leverage is common among these firms, but it can exponentially increase losses when interests are factored in.

Bottom line

Hedge funds are good investment schemes. However, they have underlying restrictions as to the type of investors who can invest in them. If you get it right with them, they have the advantage of the freedom of operations and can potentially give you back your investment in exponential proportions.