How Hedge Funds Work: Are They Right For You?

culled from:lifehack.org:

The modern world is filled with thousands of investment choices. While many investors choose to put their money in stocks, others prefer hedge funds. To decide if this investment option is right for you, it’s important to understand how it works.

You should also know the pros and cons of this investment option. A hedge fund is nothing more than a fancy name for a partnership between investors. It’s the relationship between individual investors and the fund manager. The individual investors are usually called limited partners.

Almost all of the money in the fund comes from the limited partners, and the fund manager handles the money according to a specific strategy.

The major goals of a hedge fund are reduced risk and increased profits. There are some similarities between hedge funds and mutual funds, but they’re entirely different investment vehicles.

What Makes A Hedge Fund Different?

There are some characteristics that make it possible for an investment partnership to be classified as a hedge fund. For example, a typical hedge fund is only available to qualified investors.

One of the requirements for many hedge funds is a net worth that is in excess of one million dollars, which excludes the investor’s primary home. When compared with other investment options, a hedge fund offers much wider investment latitude.

Put simply, hedge funds can invest in virtually anything. Many funds invest in currencies, derivatives, stocks, real estate and land. Mutual funds invest almost exclusively in bonds or stocks.

Hedge funds are known to use borrowed money to greatly increase their returns, which is an example of leverage. Another characteristic of hedge funds is the fee structure, which consists of performance fees and an expense ratio.

How Hedge Funds Work

It’s difficult to say exactly how hedge funds work because they’re all different. Any particular fund might be using any number of investment strategies. In fact, some funds use a combination of strategies.

All hedge funds have a manager, and this individual is responsible for deciding on a certain strategy. In some cases, the manager might choose to short-sell or employ leverage. Maybe the manager will decide to use a strategy that involves derivatives.

The manager must decide on a strategy that he or she thinks will bring very healthy returns. Hedge funds use a number of different strategies.

Arbitrage, short selling, leverage and derivative are some of the most popular. At the end of the day, a hedge fund is supposed to reduce risk and increase returns for investors.

The Benefits of Investing In Hedge Funds

Many people believe that hedge funds are very volatile, but in reality, this isn’t always true. When compared with equity investments and bonds, hedge funds offer several advantages. One of the benefits is the ability to make money when the market is going up or down.

A hedge fund reduces an investor’s overall risk, and it can make money during any market conditions. Another benefit of hedge funds is the wide range of investment strategies that they offer.

Many of these strategies won’t work when used by an individual investor. According to recent studies, hedge funds are significantly more effective at reducing risk and increasing financial gains than other investment options.

Since hedge funds eliminate exits and timing entry, they’re great for long-term investments. An average hedge fund offers investors far more diversification than traditional investment options.

The Downsides

One of the major downsides of investing your money in hedge funds is the sheer lack of information that is available for individual funds.

Since they don’t need to register with the SEC, hedge funds are subject to reporting requirements. At the end of the day, this means investors really need to do their homework before choosing to invest in a particular fund.

A hedge fund offers far less transparency than other investment options. After understanding the pros and cons, it should be much easier to decide if investing in a hedge fund is right for you.