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Are Hedge Funds useful for you?

In these times of technology advancements, data-driven markets, desire of investors to gain higher returns and the will of the demographics to take higher than usual risks to churn profits, hedge funds seem to be the best bet for them. Hedge Funds are known for their riskier investments, attracting wealthier investors who are seeking greater returns and willing to take larger bets.

Hedge Funds are private investment partnerships, funds or pools that invest and trade in different markets and instruments. Hedge funds are aggressively managed portfolios that use advanced investment strategies in effort to generate high returns. They hold a diversified portfolio for their investors. The main purpose of hedging is to minimize risk but the main purpose of hedge funds is maximize returns. The name is mostly historical, as the first hedge fund tried to hedge against the downside risk of a bear market, by shorting the market.


HEDGE FUNDS vs. MUTUAL FUNDS

Hedge funds and mutual funds are similar in the sense that both of them are pooled investment vehicle that invest in different instruments. Hedge funds are called “Rich Man’s Mutual Fund” or “Mutual Fund for the HNI” by many. However, that is where the similarities end.

Hedge funds are not regulated i.e. they are not subject to the same regulatory norms as mutual funds. They are setup as a private partnership and can have a limited number of investors unlike mutual funds. Hedge funds cannot advertise themselves to the general public and are open to only a few accredited or qualified individuals i.e. the high net worth individuals. They offer a wide investment latitude as they can invest in anything – equities, commodities, bonds, real estate, currency etc. unlike mutual funds who do not hold such diversified portfolios. Hedge funds can also employ leverage to amplify returns. They can employ any kind of investment strategy unlike mutual funds which usually employ long-only strategy. Hedge funds and mutual funds also differ in their fee structure as hedge funds’ fees are higher than mutual funds. Hedge funds are aggressively managed unlike mutual funds.

HEDGE FUNDS STRUCTURE

Hedge funds typically follow a two-tier structure known as the General-Limited Partnership structure. In this structure, the general partner assumes responsibility for the operations of the fund, while limited partners can make investments into the partnership and are liable only for their paid-in amounts. The typical structure used for the general partner is a limited liability company. The general partner's responsibility is to market and manage the fund and perform any functions necessary in the normal course of business.


HEDGE FUNDS FEES

Hedge funds also differ quite from mutual funds in how their fee structure. Their fee structure is one of the main reasons why talented money managers decide to open their own hedge funds to begin with. Hedge funds often follow the "two and twenty" structure, where managers receive 2% of net asset value managed and 20% of profits, although these fees can also vary among hedge funds.


1) Management Fee

The management fee for a hedge fund is for the same service that the management fee covers in mutual funds. Hedge funds typically charge a management fee of 2% of assets managed also called Assets Under Management (AUM) fee. It can be higher in cases like if the manager is in high demand or has had a very good track record.


2) Incentive Fee

Hedge funds charge an incentive fee of around 20% of the fund profits. It varies from company to company. The purpose of incentive fee is to reward the hedge fund manager for good performance. The incentive fee can be collected by a manager only when the high-water mark is cleared. A high-water mark is the highest peak in value that a fund has reached. The high-water mark ensures the manager does not get paid large sums for poor performance. If the manager loses money over a period, he must get the fund above the high-water mark before receiving a performance bonus. High-water mark ensures that investors do not have to pay performance fees for poor performance, but more importantly, it guarantees that investors do not pay performance-based fees twice for the same amount of performance.

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