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What is a hedge fund?

You hear about hedge funds all the time, but what is a hedge fund?

If you watch the news or read about current events online, you might have a negative association with the term ‘hedge fund’. In recent years, there have been some major financial disasters related to hedge funds, and more specifically hedge fund managers. While these incidents have garnered a lot of media attention, they should not cast the entire idea of hedge funds in a bad light. The reality is that a hedge fund remains a viable investment option that has the potential for great success when managed properly.

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What is a Hedge Fund?

Before you can decide if investing in a hedge fund is a good idea for your financial goals, you need to understand what they really are. All a hedge fund represents is an investment partnership into which many different investors place money. That pool of money is overseen by the hedge fund manager who will decide on a variety of investments with the goal of bringing a great return to the investors. Hedge fund managers make money by receiving a percentage on the profit that they make for the fund, so their financial success is directly tied to the success of the investments.

While a hedge fund might sound a lot like a mutual fund, there are some important differences. In a mutual fund, the investments are already set when you buy in. For example, you might buy into a mutual fund that owns a collection of energy stocks. You will know what the fund is about, and what sector it is dealing in. With a hedge fund, the investments can be all over the map and are at the discretion of the hedge fund manager.

It might seem like investing your money in a group environment such as a hedge fund would be a good way to minimize risk. After all, the money will be managed by a professional and you will be in the investment with many others. However, the risk of a hedge fund can be high or low depending on the specifics of the fund and how it is established. Some hedge funds can be relatively safe, low-risk investments; others can be highly risky with the potential for huge reward or massive failure.

The Operating Agreement

At its heart, any hedge fund is actually a privately owned company. The company, often organized as an LLC, has the money from the investors placed into it an can from there make investments at the discretion of the manager. The operating agreement that governs the company will determine what kind of investments the manager is free to make. Some hedge funds may limit the manager to lower risk investment opportunities like stocks and bonds. Other hedge funds are opened up to investing in real estate, startup companies, options, futures, etc. Naturally, the potential return from the hedge fund is tied to the risk that is allowed under the operating agreement. Many investors are drawn to the hedge fund idea because of the possibility of huge returns – however, that chance always comes with a downside.

The Money Manager

The success or failure of a hedge fund is tied to the ability, and sometimes luck, of the hedge fund manager. This is the person that will be calling the shots on how the funds money is put into action. The compensation of this manager is calculated as a percentage of the profits that the fund shows for any given year, so they are highly motivated to make the best possible investments for the fund. However, there is a potential trap for hedge fund managers to fall into. Because they are paid a percentage of any profits – let’s say 20% – there is obviously the chance that they can make huge returns. However, they aren’t sharing in the risk of the fund with the investors. If the fund loses some money – or even all of its money – the hedge fund manager does lose any money personally. This simple fact makes most hedge fund managers far more willing to take on risk than a single investor would be who was investing his or her own money.

So is it a good idea to have someone else manage your money when they don’t share the risk? Well, that depends. A hedge fund manager is likely to have a level of knowledge regarding investments and the market that most average investors would not have. Also, they are committed to the full-time management of these investments, where a sole investor probably does not have the time available to manage their own investments on a full-time basis. Because of that, many find the hedge fund appealing as a way to give their money the best chance to earn a huge return.

On the flip side, some investors will forever be wary of trusting their money to someone that doesn’t lose anything if the investment goes bad. Taking risk is a good way to make a lot of money – but it is also a good way to lose it all. Someone that has something to lose in an investment is more likely to take measured risks and not expose their money to propositions that are excessively risky.

Who are Hedge Funds Good For?

That answer will be different for everyone. In general terms, hedge funds are considered risky propositions. While the operating agreement can be structured as to limit risk, most hedge funds exist as aggressive investment vehicles designed to earn big returns by taking chances. If you are an investor that is looking to slowly grow your money over the long term, a hedge fund is not likely to be the best choice for you. If you are someone with diversified investments and have a portion of your money that is designated for bigger risk, a hedge fund could be worth considering. Of course, you will need to carefully examine all of the aspects of the hedge fund – including the manager – before committing any amount of money toward the group investment.

The initial investment to become involved in a hedge fund is often very high. Many funds are only open to extremely rich individuals that can afford to expose their money to high risk and have the resources to invest additional funds if need be. While the specific numbers for a ‘qualified purchaser’ are different from fund to fund, the minimum is often having $5 million in investable assets. That barrier to entry will keep many people away from hedge funds right off the start. If you do find a hedge fund that is within your means and looks attractive to you, it can be considered as an addition to your investment strategy.

You don’t have to be scared off by the media attention that has surrounded hedge funds. There is nothing inherently wrong with hedge funds, despite the problems that some have gotten into. While hedge fund investing in certainly not for everybody, it can be a viable option for some investors. As with all money management decisions, take your time in doing research and consider all possible options before settling on a hedge fund investment.