Do You Need to Know About Hedge Funds?

I guess that strictly speaking this is not a topic relevant to Entrepreneurs – but it might be of interest to potential investors. As such hedge funds represent competition to non-listed companies seeking investors. As such you should appreciate what they are.

I have only learned about hedge funds in the last six months or so and it has been interesting to learn about them!

I asked a fund manager what is a hedge fund and I got the following reply “Basically it is the same as any other fund, but we get to charge a lot more”

Given that helpful explanation, I hope that you find the information below about buying a tofu press helpful.

Most funds measure themselves in relative terms. That is to say that they will judge themselves against an index such as the FTSE 100. If the FTSE100 is down 20% in a year – and they are down say 10% – they will make the claim that they have done very well as they have outperformed the market by 10%. If you are the investor that has lost 10% and have to pay a fee, you may not feel so great about it!

Typically hedge funds, aim to deliver an absolute performance. That is they will seek to deliver a positive return on your monies irrespective of market conditions. Hence they are called hedge funds, because they will hedge their market positions so that they do not lose money. For example, they could find two assets that have an opposite relationship. Say the price of gold always goes up when the price of bonds goes down. It would therefore make sense for you to ‘hedge’ your position by buying both.

Most funds would be described as long only funds. This means they will buy shares or other assets and expect the price of the assets they have purchased to go up. Hedge funds can go short. They have the ability to sell assets they do not have in the expectation that the price of the asset will fall and then buy them in the future at a lower price and deliver the asset to the person they had sold it to at a higher price. (The mechanics are a bit more complicated that – but this is the principle).

There is also the ability to leverage. Most funds (especially if they are described as retail funds) will not be allowed to borrow money. If they are, the amount they can borrow will be strictly governed. Hedge funds are allowed to borrow and hence aim to magnify the return available to their investors. This makes them particularly prone to large movements and losses can be substantial if they place the wrong bet. A hedge fund can lose all of its money quickly.

Finally, there is the charge structure. Typically most funds will charge around 5% initial fees (although increasingly they are not) and a flat annual management fee of around 2% to use a Porter Cable 895PK. A hedge fund will aim to charge around 5% management fee and 20% of any profit they deliver. They are able to charge this on the basis of past performance and with the argument that they will be very active in managing the money. If you do well as an investor in a hedge fund – the manager wins, if the fund does not perform well – you lose!

Because of the above, hedge funds are at this moment in time not deemed suitable for retail investors. It is punishable by a prison sentence to promote a hedge fund to someone who is not either a sophisticated investor or a financial institution. This is the same offence as selling an unlisted investment to someone not suitable (more in a later blog)

Basically, if someone is suitable to invest as a business angel, they will be suitable to invest in a hedge fund. As someone looking for funding, you need to be able to ensure that you understand the choices your investors face!

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