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Hedge funds have attracted investors in recent years, especially during periods of lackluster returns from conventional equity investments.

These funds employ diverse financial instruments and strategies to achieve positive returns, irrespective of market performance.

While hedge funds offer valuable diversification and protection against market volatility, they come with greater complexity and risk compared to other managed funds. Additionally, their high minimum investment limits their suitability to high-net-worth investors.

Read on to explore hedge funds –their types, how they work, how to invest in hedge funds, and valuable tips to consider before investing.

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1. What Is Hedging?

Hedging is an attempt to reduce risk by paying a small price to offset a possible loss in an investment. The main aim of the technique is to protect against the downside risk of a bear market while maximising the return on investment.

2. What Are Hedge Funds?

Hedge funds, also called 'absolute return' funds, only partially rely on market growth to make profits. Instead, they use a variety of arbitrage strategies and derivatives to offer performance potential and diversification benefits.

These funds leverage domestically and internationally to achieve a return rate that is high or above a specific benchmark in most market conditions.

The fund investment comprises debt and equity securities, currencies, derivatives, commodities (gold, silver, oil, etc), and real estate. They are loosely regulated by the SEC and make money from their 2% administration fee and 20% performance fee structure.

3. Can A Regular Person Invest In A Hedge Fund?

Unfortunately, hedge funds aren't accessible to everyone as they are less regulated and riskier than other investment options.

Hedge fund managers and general partners often create high minimum investment requirements. Most hedge funds require a minimum of $100,000 or even as much as $1 million as investment capital.

Such a high investment requirement makes it difficult for individual investors to enter and maintain access to a quality hedge fund. That's why hedge funds are limited to sophisticated investors, often of high net worth.

4. How Do Hedge Funds Work?

Hedge funds work on the exact mechanism as managed funds, wherein the money from individual investors is pooled and managed by experienced fund managers.

The accumulated capital is invested in several "unregulated investment and trading activities" to provide strong returns independent of investors regarding the stock market performance.

Hedge funds implement strategies that capitalise on opportunities, such as:

• Significant company events such as bankruptcies, mergers, etc 

• Macroeconomic events such as political actions, interest rate announcements, etc.

• Pricing inadequacies between similar investment options, such as bonds with similar terms and payments. 

• Incorrect stock valuations, like buying an undervalued stock and selling it at a higher price 

• Trading based on bullish or bearish market trends to gain from rising or falling markets

A fund's strategies may aim to deliver positive or less volatile returns in both uptrend and downtrend markets. It may beat an interest rate or a market index or achieve a standard return with less volatility.

As a hedge fund depends less on conventional assets, such as stocks and bonds, they are an excellent means for portfolio diversification.

Hedge funds Investors usually pay a management fee and a yearly performance fee when the fund outperforms specific targets. The management fee is generally between 1% and 4%, with 2% as standard, and performance fees vary from 20% to 50%, with 20% as standard.

5. Common Hedge Fund Strategies

Hedge fund strategies are classified based on the fund manager's investment style and include fixed-income, equity, and event-driven goals.

• Long/Short: This strategy is based on the expectation of future market movements and could be long or short. It involves long holdings of securities estimated to rise in price with short selling of securities estimated to reduce cost.

• Fixed-Income: This strategy involves taking both long and short positions in fixed-income assets to preserve capital and provide solid returns with minimal volatility.

• Event-Driven: The strategy is independent of market direction and aims at taking advantage of temporary stock mispricing due to important corporate events and transactions such as restructurings, mergers, bankruptcy, and takeovers.

6. Types Of Hedge Funds

Hedge funds are classified based on their features and risks that depend on the following:

• Fund Strategy

• Financial instruments it invests in

• The location of the fund

• The assets include leverage, derivatives, short selling, alternate investments – high-yield bonds, derivatives, unlisted shares, synthetic assets, or other hedge funds.

• Fund manager's skills and knowledge 

The following are the common hedge funds strategies:

Relative Value Funds

Such funds rely heavily on arbitrage. It seeks to exploit temporary inconsistencies in the pricing of similar assets, capitalising on price or spread inefficiencies.

Directional Funds

This investment strategy involves investing in the stock markets and exposes them to market risks. As hedge funds can take "short" positions, directional funds can profit from rising and falling markets, thereby reducing market risk.

Event-Driven

These funds seek investment opportunities in public and corporate events such as mergers and acquisitions, liquidations, and bankruptcies to profit from incorrect market valuations.

Event-driven funds are interested in distressed securities, special situations, and risk arbitrage.

Activist

The hedge fund functions similarly to a private equity fund in this strategy. It acquires a significant holding of a company, takes actions that boost the stock price, and increases the target company's valuation.

These actions could be cost-cutting, restructuring of assets, or change in the board of directors.

Global Macro Funds

These are actively managed funds that trade in the direction of or against general market trends at a global or macroeconomic level. They aim to profit from broad market swings due to economic and political events.

The fund models the performance of national economies and critical sectors within economies by analyzing variables such as currency value, monetary policy, government debt, trade balance, fiscal policy, and unemployment levels.

It makes a profit by identifying improper valuations and predicting the impact of national and international events on these variables.

7. Pros And Cons Of Hedge Funds

Before investing in hedge funds, take a look at their pros and cons:

Pros

• Hedge funds serve a risk-management purpose as their returns are uncorrelated to the fixed-income and equity markets. 

• The fund targets less volatile returns, so it loses less in a downtrend market. 

• Hedge funds expose to a broader segment of asset classes and markets that help in portfolio diversification. It also lessens exposure to downturns in specific markets or asset classes.

• Hedge fund enables investors to get expert advice and enter into complex strategies that may not be possible for standalone investors.

• It invests in a wide array of long-short strategies to take advantage of market movement on both sides.

• Unlike mutual funds, hedge funds have inbuilt asset allocation strategies that help investors cut down on their losses due to a market crash.

• The biggest attraction of hedge funds is that they contribute a return that isn't tied to global bonds and stock markets, thereby diversifying an investor's portfolio. However, without proper execution, it could magnify your losses.

Cons

• Hedge funds pose more complex risks for investors than traditional funds due to the diverse investment strategies, use of leverage, short selling, complex structures, and derivatives. Short selling and derivatives both involve leverage risk. You could lose a lot if markets move against the fund's position. 

• Liquidity risk is another significant downside of hedge fund investing. The fund invests in illiquid investments and assets that do not trade on an open market, making it difficult for investors to redeem units if an asset devalues. Many funds have lock-up periods where investors can't sell their assets for a least a year and can only withdraw at specific intervals, such as bi-annually or quarterly.

• Hedge funds have a more complex structure than other managed funds. It becomes more work to determine how the fund invests your money and the risks involved.

• There are counterparty risks involved when investing in these funds as derivatives are bought 'over the counter' by agreement with another party. There are chances if that party fails to honour the deal.

• The higher investment threshold restricts entry to sophisticated investors with the knowledge to understand and benefit from the employed strategies.

8. Are Hedge Funds Legal In Australia?

Yes. It is legal to operate and invest in hedge funds in Australia.

Considering the complex fund structure, diverse investment strategies, use of leverage, short selling, derivatives, and investment in illiquid assets, ASIC considers hedge funds riskier than traditional funds for investors.

Therefore, it limits hedge funds to only accredited investors and requires a significant upfront minimum investment.

9. Why Do Some People Invest In Hedge Funds?

Hedge funds have gained popularity in recent years, primarily due to their ability to outperform major asset-class benchmarks in low-return environments.

This attracts individuals looking to diversify their investments. Additionally, the fund's distinctive investment assets and unique strategies make it an appealing alternative investment option for many investors

10. What Is The Difference Between an ETF And A Hedge Fund?

Let us look at a hedge fund vs. managed fund:

11. What Does A Hedge Fund Investor Do? 

Investors must do their due diligence before investing in the best hedge funds. Here are some of the investing tips they can follow:

1. Research to find hedge funds that equate with your investing goals, risk tolerance, and time horizons. 

2. Get fund information, including its size, track record, longevity, the minimum required investment, lock-ins, and redemption terms.

3. Assess how their money gets invested

4. Learn the features, benefits, and risks of the fund you plan to invest in 

5. Know the fund's strategy and how it can benefit you

6. Learn about the skill of the fund managers who are the key performance driver of the fund

7. Find out who makes crucial decisions for the fund.

8. Determine whether the fund uses speculative investment or leverage techniques that invest the borrowed money and investors' capital to make investments

9. Does the fund invest in domestic or overseas assets? If overseas, find whether foreign currency risks are hedged.

10. Learn about its medium to long-term performance to determine how it has performed in rising and falling markets.

11. Find out whether the fund uses third-party service providers. If yes, whether they have a license to operate in Australia.

12. Understand how the assets will get valued

13. Check fund-related aspects such as leveraging, derivatives, and short selling.

14. Assess the liquidity of the fund's underlying investment

15. Know the ways to withdraw your money

16. Understand any time restrictions concerning asset redemption.

17. Compare the fund's management and performance fee and whether your investment's returns are proportionate with the risks involved.

Due to being a complex investment with variable risks, you must read the fund's documents and agreements that contain information about the fund. Seeking financial advice is beneficial before investing in the best-performing hedge funds in Australia.

12. How Do You Join A Hedge Fund?

There is an increased demand for hedge funds from institutional investors, especially superannuation funds.

Where in earlier times, the funds were accessible to only the wealthy, the participation of retail investors has increased in recent years. It is because more funds now offer low minimum investment requirements, easier redemption, and shorter or zero initial lock-up periods.

Fund rating agencies are rating a growing number of hedge funds. To join a hedge fund, you can consider master trusts and wraps, FOHF providers, etc.

13. Which Hedge Funds Are Operating In Australia?

Here is a list of hedge funds in Australia:

• K2 Asset Management

• Platinum Asset Management

• Blue Sky

• KKR

• Oaktree Capital

• Point 72

• Lederer Group

• Helmsman Capital

• Bioscience Equity Partners Pty Ltd

• TPG Capital

• TPG Sixth Street Partners

• Clean Energy Finance Corporation

• Ellerston Capital 

• Tribeca Investment Partners

• Bronte Capital

• Alium Capital

14. How Much Money Do You Need To Open A Hedge Fund Account?

Hedge funds aren't for beginner investors or those with low net worth.

The high entry-level price and restrictions of these specialised portfolios suit top fund managers, pensions, institutions, and wealthy individuals.

You must be an institutional investor, an accredited investor, or a pension fund to invest in a hedge fund. Accredited investors should have a minimum net worth of $1 million, which doesn't include the value of their residence or yearly individual incomes above $200,000 ($300,000 if married).

The startup costs to launch a hedge fund are very high. It is beneficial that a hedge fund raises at least $7 million in seed capital before starting. To run the fund and attract other investors, hedge funds typically require at least $100 million in seed capital.

15. How Much Money Can You Make From A Hedge Fund?

Higher returns from hedge funds are not always guaranteed. Since many invest in the same securities available to individual investors and mutual funds, you can typically expect returns similar to those of other managed funds.

Hedge funds employ borrowed money or leverage to amplify their returns. They aim to protect against a declining market, aiming to generate consistent positive returns regardless of overall market conditions.

Choosing a skilled manager or a well-timed strategy can lead to higher returns. Historical data has shown that, compared to larger funds, smaller funds have performed better.

Investing with lesser-known managers who consistently deliver returns can be advantageous, as they tend to bring more flexibility and diversity to their portfolios than larger funds.

It's essential to note that hedge fund returns often exhibit a negative skew, meaning they don't follow symmetrical return patterns.

Additionally, it's crucial to be aware that hedge funds typically charge a significant management fee (around 2%) and a performance fee (typically 20% of profits), which can substantially reduce your overall profit.

Therefore, assessing a hedge fund's potential for substantial returns against its higher fees and specific risks is vital.

Always seek the help of a professional financial advisor before making any investment decision. Investing carries risk. The above are just some general options for educational purposes. All these options come with risk. This is not financial advice.

16. Do Hedge Funds Make Money?

Hedge funds make money by charging performance and management fees.

In a limited partnership, the general partner may charge 1% to 2% of the total assets under management as a management fee and 20% to 30% of performance fees above this amount.

17. How Much Does A Hedge Fund Manager Earn?

Hedge funds are continuously balancing opportunity with risk. The fund manager's skill is critical in determining the returns you achieve from investing in the fund.

According to Finder.com.au, the average hedge fund manager's salary is $134881 annually.

Some of the well-known hedge fund managers are:

• John Meriwether (Long-Term Capital Management)

• Jim Simons (Renaissance Technologies)

• Paul Tudor Jones (Tudor Investment Corporation)

• Ray Dalio (Bridgewater Associates)

• Bill Ackman (Pershing Square Capital Management LP)

• George Soros (Quantum Group of Funds)

• Steve Cohen (Point72 Asset Management)

• David Tepper (Appaloosa Management)

• John Paulson (Paulson & Co.)

• Daniel Och (Och-Ziff Capital Management Group)

18. What Is A Typical Hedge Fund Return?

According to BarclayHedge, the average hedge fund generated 7.2% of net annualised returns with a market correlation of 0.9 and a sharpe ratio of 0.86 over the past five years.

However, the top hedge funds yield a joint annualised return of 15.5%, which is more than twice the industry average, while trailing the S&P 500 by just three percentage points.

19. Conclusion

Investing in hedge funds is risky and needs a high minimum investment or net worth from accredited investors.

For an average investor seeking high returns, investing in index funds that track major indices is a better option.

If you consider making hedge funds a part of your portfolio, ensure you understand the differences in their investment strategies and risk-return trade-off compared to conventional managed fund products.

Do due diligence and ensure your investments perform for you and match your personal investment goals at each stage of your life.

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