Hedge Fund Definition: Strategy, Investing, Tips, & Fees


Simply put, you can say that a hedge fund is something you use if you want to protect your savings or a portfolio.

So, what is a hedge fund?

Hedge funds are a collective name for a group of special funds with freer investment rules. This means that the manager has the opportunity to use different investment strategies and invest in more financial instruments than traditional funds (such as equity, fixed income and index funds) can do. The hedge fund’s goal is precisely to create an uncorrelated return over time, regardless of market development and stock market situation.

The word “hedge” means to protect or secure.

That’s how it works

Hedge fund portfolios are often dynamic and complex with many different holdings.

In addition to equities, the hedge fund’s holdings may also consist of bonds, commodities, currencies and derivatives such as options, futures and swaps.

They are also free to use both short selling and mortgaging.

The fund’s results are largely affected by the manager’s unique competence and experience (they usually talk about skill-based management).

Hedge as a placement strategy

Hedge can be understood as a way to protect your savings. In other words, what you strive to protect is your capital you have invested.

The protection works by reducing the probability of losing money due to market movements, which in other cases can affect the value of the capital and the return you get.

Instead of having a market-dependent return, they try to create a return that can exist regardless of the market’s ups and downs.

How do hedge funds make money?

A hedge fund aims to make as much money as possible. A common arrangement is that the hedge fund receives 2% of the total assets per year and 20% of the profit that exceeds a certain predetermined level.

In this way, the hedge fund has a clear incentive to reach the set growth. There are examples of hedge funds that have paid significantly more.

Warren Buffett’s fund, which was also a form of hedge fund, took between 25 and 50% of the profits.

But then he also went in and covered up for losses for his shareholders and exposed himself to a risk that few others would be willing to take.

Investing in hedge funds

There are many different hedge funds with different orientations, strategies and risk levels to choose from. If you want to invest in a hedge fund, the easiest way to do this is through your bank or online broker.

There you can either buy units in a hedge fund or in a fund-of-fund (ie a fund that invests its fund units in several other hedge funds).

Many hedge funds have high deposit requirements, but there are also those that have lower minimum amounts and are suitable for small savers.

It may be good to know that hedge funds are usually traded per month or quarter, but it has become increasingly common with daily trading even among these funds.

It is not possible to save in hedge funds via the PPM system.

Hedge funds are so-called actively managed and charge higher fees than traditional funds. The fees usually consist of an annual fee (a fixed fee) and a performance-based remuneration.

This means that the fees may vary depending on the hedge fund’s earnings development.

Many funds use the so-called high watermark principle, which means that if the fund has decreased in value, no performance fee is charged until the fund’s value has reached the same level again.

The idea is that it will give the manager an incentive to deliver excess returns.

What distinguishes hedge funds from other funds?

The goal with hedge funds is to have a stable or increasing value. The main thing is that there is no decrease in value in the hedge funds.

This means that the hedge funds are based on themselves and their own conditions, rather than comparing themselves with the returns in other funds or indexes.

One thing that is strived for when it comes to hedge funds is that the value is affected as little as possible by the other financial markets.

For several other types of funds, there may be an inherent effort to reach specific and specific return targets.

Here, a comparison is often made with other indexes and funds, where one tries to achieve a higher return than other corresponding funds.

Whether the funds are successful or not is based on this on how the funds stand in relation to a benchmark index.

The goal here may be that the fund should never decrease in value more than the index with which it has been put in a comparative perspective.

Key figures for comparison

When comparing hedge funds, different key figures can be used. To get an idea of ​​the risk level, you can, among other things, compare the standard deviation – the higher the figure, the higher the fund’s risk profile.

There is also a lot of talk about a fund’s Sharpe quota.

This measures the excess return (usually above the risk-free interest rate) divided by its standard deviation. It is usually said that a high value is preferable to a lower one, as the measure in principle measures return per unit of risk.

However, I would like to point out that the measure has its shortcomings.

For example, if you have a fund that delivers around 1% every month, then the Sharpe ratio will be very high because the return barely deviates from its average return (in this case 1%).

Another fund may also have a return of 1% during 9 of 12 months, but manages to give a full 5% for the other 3 months.

Its standard deviation will be much higher, which penalizes its Sharpe ratio.

The disadvantage is that positive outcomes that deviate from means punish the Sharpe ratio as much as negative ones of the same size.

My point is that most people would probably have preferred deviations from means, given that they are positive.

It is only the excess return on the downside that you want to avoid. For those interested, I can suggest another better key figure to use to compare hedge funds, namely the Sortino quota.

Hedge funds and correlation with the financial markets

In order for a hedge fund to have achieved its intended purpose, it is required both that there is no reduction in the value of the capital, but also that the correlation with the other financial markets is as small as possible.

The reason for this is for hedge funds to be able to be an alternative to other investment methods, as most other investment opportunities tend to correlate directly or indirectly with the financial markets.

Fees for hedge funds

Hedge fund managers often charge a fee when using hedge funds. The fee can be performance-based and can be taken from the added value created in the funds, but it can also be based on a fixed amount.

The reason why the managers charge a fee is because the management of hedge funds is active.

Criticism of hedge funds

Criticism that has been directed at hedge funds is, among other things, that high minimum amounts may be required to be able to use the hedge fund and that it can be difficult to know whether they actually live up to what they are tasked with achieving.

Critics believe that hedge funds can rarely stay stable in times of economic crises and stock market crashes, which also means it can be an uncertain investment.

As the return from hedge funds often depends on the manager’s approach, competence and strategies, it can also be difficult to predict what the outcome of an investment will be.

This is something that applies to most investments, but it can still be important to be aware that the manager has a fairly central role when it comes to hedge funds.

The goal here can be that the fund should never go down more in value than the index with which it has been put in a comparative perspective.

Conclusion

Tips for investing in hedge funds

Many people may find investing in hedge funds complex and expensive. I think that hedge funds can be a good complement that spreads the risks (diversification) in the portfolio, especially in more volatile times.

Holdings in uncorrelated assets, for example through a hedge fund, reduce the total risk in a long-term portfolio.

In order for the fund to be a complement to the portfolio and reduce the risk, however, it is important to know that the fund really delivers uncorrelated returns to the stock market.

As with other types of investments, it is important to read carefully and know what you are investing your savings in. My tip is to choose a hedge fund with care!

A hedge fund may not be for the beginner, but an alternative for the slightly more experienced investor who wants to diversify their portfolio with a shock absorber in slightly more troubled trading times.

Kevin

Hi, my name is Kevin and I am a weightlifter, now part time blogger. Keep in mind that I dont have any fancy degrees or operate some high-end business company. I am just a dude from Sweden who loves to learn new things, especially new things on how I can inqrease my wealth. And now I have the opportunity to share that knowledge back to you.

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