193: What is a Hedge Fund?

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Learn what a hedge fund is and why they are often preferred by millionaires and billionaires.

Have you checked out the Creating Wealth podcast yet with Jason Hartman? It’s full of amazing information and over 700 podcasts about real estate investing. If you like this podcast, you’ll like that one too.

Hedge funds are an interesting topic and generally misunderstood by the general public.

They are for sophisticated and high net worth investors, who are known as “accredited investors.” They have more than a $1 million net worth excluding their home, or they make $300,000 and are experienced investors.

Hedge funds invest in many types of securities, but they are unregulated by the Securities and Exchange Commission (SEC).

You are familiar with mutual funds in your 401(k) which are pools of money that invest for a particular objective and in a particular type of security. For example, a large cap mutual fund may invest in the S & P 500, which are the 500 stocks with the largest capitalization (share price x number of shares outstanding). Hedge funds can invest long or short (listen to the next episode for an explanation of what “short” means).

Hedge funds may also invest in options and futures, which are also known as “derivatives”. Options are a bet on a stock’s direction, but you don’t own the underlying stock. For example, a “call” option on Amazon is a bet the price will go up, but you don’t own shares of Amazon’s stock.

Many hedge funds use leverage and borrow money to increase their returns. That of course increases the risk of loss and must be used carefully.

Unlike mutual funds which can be liquidated daily, a hedge fund has limitations to when you can access your funds and usually has the funds “locked up” for a period of 90 days at a time. At the end of the 90 days you can tender your shares and liquidate some or all of them.

They also can charge fees differently than mutual funds. While mutual funds earn fees regardless of performance, hedge funds may charge a fee like 1% – 2% of the assets and also a percentage of the gains they make, like 25% of the profits.

Many top mutual fund managers have left mutual fund companies to run hedge funds because if they are good investors, they can make a lot of money. Hedge fund managers have even made $1 billion in one year.

There are different investment objectives of hedge funds, but the idea is to take less risk and provide higher returns. Because they can make money whether the market goes up or down (as opposed to mutual funds that only make money when market go up), they should be able to “hedge” risk and provide a higher return.

There are some common objectives of hedge funds such as Activist, Convertible Arbitrage, Emerging Markets, Equity Long Short, Fixed Income, Fund of Funds, Options Strategy, Statistical Arbitrage, and Macro.

Each of those invest differently. A hedge fund can pretty much invest in whatever they want wherever they want without their hands tied by regulators.

It can get pretty complicated and that’s why we had the hedge fund bailout after 1998 because a Nobel Prize winning investing model called Black Scholes worked on paper, but failed miserably in reality and had to be bailed out by major banks for $3.5 billion. If you want to read more details about Long Term Capital and the bailout, click here.

Hedge funds are performing poorly and are the worst performing asset class in 2016. So what is going on? They need volatility to be able to make money in a long or short strategy and the markets have been uncharacteristically un-volatile plus the stock market has only returned about 5% year to date.

With so many underperforming, there are likely to be a lot of hedge funds closing their doors in the near future.

So don’t feel like you’re missing out on anything. At this moment, you’re not!

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