Hedge funds are alternative investment vehicles that operate as investment partnerships between a professional fund manager and investors. The investors contribute funding, while the fund manager manages these funds according to that particular hedge fund’s strategy.
Hedge funds are somewhat similar to mutual funds because they both pool securities. However, unlike mutual funds, hedge funds are not regulated by the Securities and Exchange Commission. Because hedge funds are largely unregulated, they do not offer many of the investor protections that mutual funds and other registered investment products do. Their unregulated status also allows hedge funds to invest in a wider range of securities than mutual funds, including more aggressive, complicated and risky investments.
How Do Hedge Funds Work?
The goal of hedge fund managers is usually to seek absolute positive investment performance, which involves producing targeted returns irrespective of the underlying trends of the stock market. To do this, these managers will use speculative investment strategies - including using leverage, short-selling and hedging techniques.
In an investor alert, FINRA outlines many of these speculative strategies that can be used in hedge funds.
- Short selling, which is defined as the sale of a security you do not own
- Hedging, which involves purchasing a security to offset a potential loss on an investment
- Using arbitrage, or the simultaneous buying and selling of a security in different markets to profit from the difference between the prices
- Using leverage, which is the borrowing of money to increase investment exposure as well as risk
- Concentrating positions in securities of a single issuer or market
- Investing in bankrupt companies, in derivatives, in volatile international markets or in privately issued securities
What are Funds of Hedge Funds?
Funds of hedge funds, which are are pooled investments in several unregistered hedge funds, are an indirect way of investing in hedge funds. While hedge funds are often limited to wealthy and institutional investors, funds of hedge funds are usually more accessible because they require lower minimum investments.
Unlike their underlying hedge funds, funds of hedge funds can be registered SEC products. Despite this, they can still carry the same investment risks as hedge funds.
Funds of hedge funds typically have higher fees than mutual funds, and additionally bear the fees and expenses of the underlying hedge funds as well.
Defining Hedge Fund Risks
Both hedge funds and funds of hedge funds have risks that can be inappropriate for many investors. Investors should be aware that some financial advisers may make exaggerated and misleading claims about these funds in order to lure potential investors.
The risks of investing in hedge funds and funds of hedge funds include the following:
- Unregistered investments. Hedge funds, and the underlying investments of funds of hedge funds, are not subject to the SEC’s registration and disclosure requirements. As a result, hedge funds are not subject to regulations, such as mandatory reporting rules. Without this information, it can be difficult to assess a hedge fund’s performance, which a corrupt hedge fund manager could take advantage of.
- Risky investments. Because hedge fund managers are paid based on the fund’s performance, they have an incentive to maximize positive performance which often leads to riskier investment strategies.
- Illiquidity. Hedge funds, unregulated and regulated, are illiliquid investments, which means that they are subject to restrictions on transferability and resale. However, there are no specific rules on hedge fund pricing, which means that investors may be unable to get back the money they invested if they opt out of the fund.
Recover Your Hedge Fund Investment Losses
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