Hedge funds are investment funds that try to beat a specific market benchmark (or "find alpha") for their investors.
How can I use hedge funds when I invest?
- You can invest directly in funds managed by hedge funds. However, usually, you'll need to be an "accredited investor" to be able to do this – it depends on your country. This is because hedge funds often use aggressive and high leverage investment strategies which might not be palatable for everyday, inexperienced investors.
- While historically hedge funds have earned outstanding returns, this comes at a cost. Hedge funds charge an annual asset management fee that is 2% of its total asset under management (AUM). On top of that, investors are charged a standard performance fee (usually 20%) of profits. Moreover, as hedge fund managers actively take up long and short positions frequently, it increases overall transaction costs and creates taxable gains that may reduce the fund's returns. To avoid these tax burdens, the hedge fund manager will pass these costs to the investors. Thus, even though you may stand to earn significant returns by investing in hedge funds, the high fees may take up a substantial portion of your returns in the long-run.
- Partially due to these costs, even hedge funds that manage to beat the market tend to underperform the market once all fees are considered. For example, the average "post-fees" annual hedge fund return over the past decade has been 13.6%, lower than the average yearly return of the S&P 500, at 16.5%. Some researchers also argue that markets are becoming more efficient, leading to less asset mispricing. This makes it harder for hedge fund managers to identify undervalued stocks to long and overvalued stocks to short. However, other researchers also argue that the market itself has been distorted by passive investment funds ("buy the index") and quantitative easing ("stimulus"), which could lead to an opportunity for hedge funds if and when these distortions are resolved.
Debt to Equity Ratio
Used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity.
Profit is the financial benefit realized when revenue from a business is higher than the costs and taxes involved in operating that business.
Alternative investment class composed of funds that invest directly in private companies or that buy public companies and take them private
Time of declining economic activity, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and sales.
A stimulus package is a coordinated effort by the government to increase spending and investment to "stimulate" an economy out of a downturn.
Shorting a stock
Trading strategy that tries to take advantage of the decline in a stock price by borrowing a stock and sell it now while planning to repurchase it later for a lower price.
Market-capitalization-weighted index tracking the performance of the 500 largest U.S. companies