Hedge Funds Are Risky for a Reason
Hedge funds pool investors’ money to invest those funds in financial instruments to make a significant positive return in all kinds of markets. This isn’t easy, but hedge fund managers use a wide set of investment practices that may increase the risk of investment loss. Here’s how they work…
Unlike mutual funds, hedge funds are lightly regulated. They’re not required to register with the SEC; they typically issue securities in “private offerings” – also not registered with the SEC; and they aren’t required to make period reports under the Securities Exchange Act of 1934. Nevertheless they’re subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary duties as other investment advisers.
*Reaching, while hedging, for profits:
Hedge fund managers seek to capture more return while at the same time hedging out many unwanted investment risk. In fact, for many so-called market-neutral hedge funds, the target is to eliminate their portfolio’s sensitivity to the market’s ups and downs. They do this by their ‘hedging’ techniques such as short-selling securities as much as they buy long. Their efforts may mitigate some risks but can add others.
Additionally, hedge fund managers may ‘go long’ on securities they believe will appreciate; they’ll also ‘short-sell’ other securities they expect to fall in value. More than this, they may use financial derivatives and leverage in their strategy as well. Some will invest in non-traditional or illiquid assets, such as loans or private equity. While others may invest in distressed assets or employ arbitrage techniques that attempt to capitalize on merger opportunities or perceived incorrect valuations among closely related securities.
You can see that employing such a wide array of investment strategies makes hedge fund returns strongly dependent on a manager’s investment skills. Such strategies will burden their efforts more than those managing more traditional portfolios as mutual fund managers.
*Goal comparison of hedge funds, traditional funds and index funds:
As said above, the typical hedge fund seeks a positive return in both up and down markets. On the other end of the investment spectrum, the index fund simply seeks to capture whatever that index market returns. And in between these poles, traditionally managed funds try for just a premium over that market return – a somewhat intermediate result between the hedge fund and the index fund.
So, the returns of hedge funds are driven primarily by their managers’ strategies than by simply following the broad market direction. That’s why skill is so important for drumming up profits and that can make risks greater.
If you want to invest in a hedge fund, read its prospectus so you’ll understand the level of risk involved in the fund’s investment strategies. This will ensure you whether it’s suitable to your personal investing goals, time horizons, and risk tolerance.
Remember, outside of the risk that straight incompetence imposes, the higher the potential returns, the higher the risks you must assume.
Shane Flait helps you with your financial legal, tax, and retirement goals.
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