Hedge funds are a diverse class of investments that use unique investment strategies to seek greater-than-average total return with lower levels of risk.
Hedge funds might use many investment tactics not ordinarily available to the managers of regulated mutual funds, including unlimited short-selling, margin trading to leverage price movements, and the unfettered use of derivatives as direct investment vehicles.
There are more than 8,000 hedge funds; they come in all shapes and sizes. The multitude of recognized hedge-fund investment styles and variants might appear confusing to the uninitiated. However, you might find it much simpler to think of funds as falling into one of four major groupings: event driven, market neutral, multinational and niche.
Event-driven funds follow investment strategies designed to profit from a known or forecasted event, such as distressed securities and merger and value opportunities.
Market neutral funds generally attempt to neutralize investors’ exposure to significant changes in portfolio value caused by market risk. These funds divide their assets among investments with complementary risk characteristics so that any force that drives some portfolio assets in one direction will drive other portfolio assets in the opposite direction.
Multinational funds invest in non-U.S. stocks and bonds using strategies such as fundamentals and technical indicators, global macroeconomic or financial market trends, and top-down and bottom-up considerations.
Niche funds follow narrowly defined styles, including sectors, short-selling and market timing. They also can invest in listed futures and options to benefit from expected trends in commodity prices, interest rates or currency exchange markets.
Fund of hedge funds: Through a fund of hedge funds, investors can gain access to a number of hedge funds with a relatively smaller investment. For example, investing in five hedge funds with $1 million minimums would require $5 million. Investing in a fund of hedge funds that invests in those same underlying funds may require only $1 million.
Factors to consider: When considering the differences among these styles you also should keep in mind other common terms relating to hedge-fund investing.
Individual risks include bankruptcy, the effects of competition and changes in technology, among other things.
Market risks indicate the possibility that an entire broad category of assets will gain or lose value simultaneously.
The value of a hedge fund’s assets sometimes can be difficult to ascertain. As some hedge funds invest in highly illiquid securities, they might be hard to value.
Hedge funds do have higher fees than many other investments. Managers typically charge 1-2 percent in fees, plus a performance fee of up to 20 percent of its profits.
Many hedge funds restrict the opportunities to redeem shares and often impose a lock-up period of one year or more after your initial investment.
Hedge funds often engage in speculative investment practices that might increase the risk of investment loss. Hedge funds also can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, might involve complex tax structures and delays in distributing important tax information and are not subject to the same regulatory requirements as mutual funds.
If you are contemplating the use of a hedge fund in your portfolio, consider that hedge funds are complex investments with limited liquidity compared with stocks, bonds or mutual funds.
Work with your financial professional to determine whether they might be right for you. Happy planning.
• Timothy J. Dooley, CFP, is president of Comprehensive Retirement Resources Inc., an independent firm at 201 N. Draper Road, McHenry. Reach him at 815-578-42170.