Friday, June 1, 2012

Hedge Funds Demystified

Hedge Funds

Hedge Funds are investment funds which can invest in a wide variety of instruments. They have emerged as a huge industry in the last decade. For an astute investor, hedge funds have been a boon. For a foolish less informed investor, hedge funds have been a curse. Hedge funds have a variety of characteristics and strategies. It is wise to understand the way hedge funds work before investing in them. Hedge funds have a feature called leverage. Leverage acts in the investors favour if the fund performs well. Hedge funds largely buy and sell leveraged products such as futures, options etc. Hedge funds also employ strategies of short selling. This is one of the reasons why hedge funds may perform well even in extended bearish periods. Only accredited investors have the eligibility to invest in hedge funds. This is to make sure that the investor has the capacity of risk tolerance. Usually these funds require a minimum investment. This amount can be as low as USD 25,000 and up to many millions of dollars.

Hedge Fund Strategies

Hedge funds have emerged as a popular asset class for high net worth investors. This is also a reason why hedge funds have become a part of finance curriculums in prestigious universities. The hedge fund industry is estimated to about a trillion dollar industry. These funds use a lot of varied derivative strategies. A fund with a long short strategy, for instance employs both long and short positions. The percentage of long to short varies based on the fund's perception of market conditions. A Global macro fund has a macroeconomic focus as its strategy. Due to wide range of investment avenues available, hedge funds frequently invest in securities in markets of multiple geographies. It is best to be aware of the hedge fund's strategy before investing. A little research in the strategy of the hedge fund may give the investor a lot of confidence. This will also enable the investor to understand if the fund objectives are suitable to him.

Hedge Fund Types and Fees

Hedge funds can also come in different types. A conventional hedge fund typically invests in financial instruments. However, a Fund of funds invests only in one or more other hedge funds. A fund of fund is perceived to be less risky by many as it is diversified. However it is always recommended that the hedge fund investor understands the kind of funds that are invested in by the fund of funds.
Hedge funds have two types of fees associated with them. These are Management fee and Performance fee. Management is charged on the total investment amount. This fee is charged irrespective of the performance of the fund and utilized towards administration of the fund. Performance fee is charged only when the fund performs well and is in profit. This is given as a motivation for the fund manager to perform better.

Hedge Fund Performance

An investor should learn to understand performance metrics of a fund. Most hedge funds usually follow a benchmark index. The benchmark index is the index which the fund tries to outperform. Most common hedge fund index is Credit Suisse Tremont Index. There can be a wide variety of indices which are strategy specific as well. The month on month return, is another common performance metric found in most monthly reports. Alpha is the excess return over the benchmark index. Sharpe ratio is a superior way to measure return as the returns are normalized for volatility. In other words, Sharpe ratio represents a risk-adjusted return.


Hedge funds offer a wide variety of options for investments. These are a great investment avenue for sophisticated investors. The kind of strategies employed by hedge funds gives ample opportunities for investors to choose better as per investment objectives. The transparency of performance metrics which are published monthly aid an investor to select appropriate funds.

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