Despite its exclusivity, hedge funds have increased in popularity and earned a place in many investors’ portfolios; however, the investment option can still be confusing to some.

Since informed investors make better decisions, here’s a quick guide to help beginners navigate the complexity of hedge funds.

What exactly are hedge funds?

Hedge funds are managed investment schemes that aim to maximise returns. What makes them different from other actively managed funds is its exclusivity—hedge funds are not open to all investors.

These funds are only open to a small number of qualified investors who can invest a large sum as a minimum initial investment—anywhere from $100,000 to $1 million or more, depending on the fund.

Hedge fund managers have the freedom to select any type of asset as investment no matter how risky it is—as long as it is within the objectives of the fund.

Managers charge according to a fee structure which sees them paid an asset management fee plus a share on investment gains. The typical fee structure, known as ‘two and twenty’ means the managers will receive two per cent of the assets plus 20 per cent of the gains annually. This is the same structure that pushed notable investor Warren Buffett to make his $1 million bet against hedge funds.

At present, there are other fee structures for hedge funds, such as the ‘one and twenty’ or those that eliminate asset fees, but the latter is still very rare.

Typical hedge fund strategies

Fund managers employ various active management strategies in order to maximise investment returns.

Here are some of them:

• Leveraging
• Short selling
• Buying alternative assets

Leveraging
Fund managers may gain more assets by leveraging or borrowing money to invest. Doing so allows the fund to benefit from gains from the ‘borrowed’ assets but it also exposes the investors to greater loss if their speculation about the investment’s value is wrong.

Short selling
Short selling is one of the common strategies used by hedge fund managers. This technique involves borrowing a security or asset to sell at current market value. The hope is that the fund manager would be able to purchase a similar security or asset for a lower price at a later time to ‘repay’ what they borrowed.

For instance, the fund manager may borrow 100,000 units of Company A shares worth $1 million to sell in the secondary market at market value. When the fund is due to return the borrowed shares, the manager would have to purchase and hand over 1000,000 units of Company A shares regardless of its current market price.

If the value of the shares falls, the fund would make a profit from the difference in selling and buying price but the fund could also suffer loss if the value of shares increased.

Buying alternative assets
Managers aiming for greater returns may take advantage of investments in other markets, unlisted securities or high-yield debt securities such as junk bonds. They may also invest in other hedge funds to manage risk exposure.

What information to look for in hedge funds

Just like any investment, investors should read the product disclosure statement (PDS) to understand what they are getting their money into. They should specifically look into who the fund manager is, how experienced they are at investing and managing other people’s money and how effective they are at employing the strategies indicated in the PDS.

Management fees should also be taken into consideration. Fees can take a big portion of the investment returns, especially for fixed fees that are charged regardless of performance.

While historical performance is no indication of future returns, it’s still prudent to learn if the manager’s selected investments can actually yield the expected or promised returns in the medium and long-term—a performance period of about five to 10 years.

Investors should also consider the complexity of the fund structure because, if they cannot understand the investment, it’s better to steer clear from it. It’s better to invest in something the investors are confident about and actually have knowledge in. Any confusion may increase liquidity risk without the investors realising it.

Hedge fund risks

Hedge funds are seen as high-risk investments because of its tendency to hold high-risk or ‘less stable’ assets in exchange for high yield.

Here are some of the risks these funds commonly face:

• Leverage
• Liquidity
• Structure complexity

Leverage
Many funds use short selling and derivatives and these expose the funds to leverage risk if the manager’s speculation is inaccurate. Any flaw in employing strategies that involve borrowing to invest could negatively impact a fund’s finances.

Liquidity
Most hedge funds require investors to lock in their money for a fixed period before allowing them to liquidate a portion of their principal investment. Likewise, some funds also invest in unlisted securities and funds, making valuation and trading more difficult.

In both instances, investors do not have the advantage of liquidating their investment when they actually need it.

Structure complexity
As with any product, it is recommended that investors refrain from investing if they do not understand how the fund works or how their money will be used. Since some hedge funds have more complex structures, investors could lose much, if not all, their investment if the manager takes on too much risk.

Should hedge funds be avoided?

Noted investor Warren Buffett bet a million dollars against the performance of hedge funds a decade ago and won, but that doesn’t mean they’re not good investments.

Those who are undecided on hedge funds for their portfolios may wish to consider separating hedge fund myths from truths or they could simply seek the advice of licensed professionals to clarify any confusion.

This information has been sourced from Nest Egg.