This week, let’s gain a good understanding about “What exactly Hedge Funds are?”, “What they do?” and “Who they cater to?”. Hopefully by the end of this article, you’d associate the term “Hedge Funds” with more than just fancy cars, an elite lifestyle and humungous mansions (that’s what most movies portray right?) Alright, let’s jump right to it!
What are Hedge Funds?
In the most simplest terms, Hedge Funds are like the care-free cousins of Mutual Funds. Why? Well for starters, their baseline mechanics are the same; they pool money from investors, invest the money and make more of it! The “care-free” component however might come from the fact that they are largely unregulated and don’t have to follow all the strict rules established by regulatory bodies (e.g. SEC), which Mutual Funds kinda HAVE to. This gives them the freedom to invest in whatever they fancy; be it fine art, movies, vineyards, real-estate, private companies or risky stocks and bonds.
Did you Know? A Korean based Hedge Fund called “Ryukyung PSG Asset Management Inc.” focused its investments in movies distributed by Korea’s CJ Group (one of them being “Parasite”) and has amassed more than 70% in returns since its launch in July 2018.
Ten Second Definitions:
- Long: Being “long” an asset implies you benefit from it’s price increasing and is equivalent to purchasing the asset.
- Short Selling: Being “short” an asset implies you benefit from it’s price decreasing. Think of this as selling the asset first at a higher price and purchasing it later at a lower price (this process is usually automated by brokerages in case of stocks).
- Hedge: The act of “hedging” your investment portfolio implies reducing the risk of your portfolio by taking offsetting positions. That is, if you are “long” an asset you take a subsequent “short” position in order to offset the risk and cushion your portfolio from adverse price movements.
Why are Hedge Funds called “Hedge” Funds?
Long-long ago, there once lived a man called Alfred Winslow Jones. Well actually not that long ago, it was back in 1949. Anyway, he wanted to try his hand at managing money and investing. He raised a bunch of cash and tried reducing the risk in his investment portfolio by being LONG in some stocks and SHORT in the others. This is called the “Long/Short Equity Strategy”. Using this strategy he managed to “hedge” the risk or cushion the impact of any poor performing investments. That’s where the “Hedge” in Hedge Funds comes from. Now however, Hedge Funds have evolved to incorporate a plethora of different strategies and not just the Long/Short strategy explained above. I’ll cover those in a future post 🙂
Who Can Invest in Hedge Funds?
Since Hedge Funds, follow the “My Life, My Rules” philosophy and are not regulated, the general public cannot invest in them.
In order to invest in a Hedge Fund, you have to be an Accredited Investor. Well that basically means, you have to be a High Net Worth Individual or an Institution and have a certain level of sophistication in terms of structure and income to handle all the risks and uncertainties that come along with investing in Hedge Funds WITHOUT explicit oversight from regulators. So basically, they cater to an extremely small percentage of sophisticated investors.
Fancy Name, Fancy Fees: The “2+20%” Playbook
Well no surprises here, Hedge Funds also charge exuberant fees for managing their clients investments, generally they take 1-2% of the amount invested by the client in the fund, which is called the management fees AND 20% of any profits generated by the fund. Pricey right?
In a future post I’ll go over the different Hedge-Fund Strategies in detail! But for now, I’ve created a little infographic delineating 3 types of Hedge Fund Strategies as an example.
And that’s a wrap for this week! Stay tuned for new articles every week, simplifying Finance for Gen A to Z.
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