Hedge Funds – Pros and Cons
October 24, 2012 8:05 am in Hedging and Hedge Funds
Before you start looking at hedge funds as your ticket to financial nirvana, it would be useful to understand the arguments both for, and against investing in hedge funds. As they say, buyers beware!
Hedge Funds – The Arguments “Against”
One of the most common grounds for criticising hedge funds is their high cost to the investor. Apart from a basic account fee, investors also have to shell out performance fee. Taken together, these charges could be very high, sometimes as high as 50%! In the case of a Fund of Funds, another layer of fees is added to the charges incurred on the underlying funds.
Hedge funds are not easily accessible to the average retail investor, and their doors are only open usually to well-heeled, “accredited” investors who are financially savvy and able to weather the risks of investing in a hedge fund. These investors are able to meet the criteria of a minimum size of investment (which can be very high) and agree to lock-in periods for extended lengths of time.
Hedge funds are usually cagey about publicly disclosing their trading strategies and portfolios. So the average investor, used to a far greater transparency such as in mutual funds, may find it difficult to get as much information as he may desire. Often these strategies are highly complex and proprietary, and very difficult to understand.
The low level of accountability results in frequent cases of fraud, such as the alleged activities of Bernie Madoff. The investor may find it difficult to conduct a suitable due diligence, and hence may lose money to con artists and fraudsters.
Hedge funds are loosely regulated and do not need to register themselves with the SEC, and hence are not required to submit periodic returns which may highlight problems in advance, and allow an investor to bail out in time. Protection available to investors such as for bank deposits is not available on hedge fund investors.
Typically, a hedge fund uses borrowed capital or utilises derivatives to magnify the possible gains on its strategies. Called “leveraging,” this also inflicts huge losses if the bets go wrong. Hedge funds are therefore not suitable for investors who do not have the stomach for such gut-wrenching losses.
Hedge Funds – The Arguments “For”
Hedge funds are able to operate much more flexibly compared to other vehicles, and can therefore generate returns higher than the market and other more conservative avenues such as mutual funds and ETFs. A competent hedge fund manager may generate returns that would be above average even after the higher fee component.
The high fees may be looked at from another angle – the performance fees/bonus is actually an incentive to the manager to earn greater returns, with the investor being the resultant beneficiary.
Hedge funds, as their name suggests, can effectively ‘hedge’ risks and volatility, and therefore may manage competently the higher leverage in their control. In such a situation the investor is in a situation where risk is controlled but the door to higher returns is nevertheless open.
A hedge fund can offer a diversity of investment strategies that an individual investor would not be able to implement by himself. As the hedge fund may deploy a specialist manager for each such strategy or investment pool, the investor has access to a cross-section of expertise.
There, now you have both sides of the coin for Pros and Cons of Hedge Funds!
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