To evaluate a hedge fund, investors can use a number of tools, including Morningstar. These tools identify the universe of funds that use similar strategies and analyze their performance. They will also reveal many statistics, which are usually broken down into deciles and quartiles. A common threshold for selecting hedge funds is exceeding the 50th percentile across all metrics. These guidelines will filter out most funds that fall below that threshold. Here are some guidelines to follow when selecting a hedge fund.
A hedge fund strategy consists of the specific financial techniques used to achieve a particular investment objective. A common technique is short selling, in which investors sell a security without actually holding it and buy it back at a lower price. Other strategies may involve derivatives or leverage, in which a fund borrows money to increase its effective portfolio size. A few examples of these types of strategies are listed below:
An important consideration in investing in a hedge fund is the fees involved. There are usually fees associated with asset management, which can be as high as 2% of the total assets under management. A performance fee that can reach 20% of the hedge fund’s profit can also motivate a manager to take more risks to maximize profits. Hedge funds may also impose limitations on how often investors can withdraw their money and impose a lock-up period of one year.
Unlike mutual funds, hedge funds are less liquid. Because of the high amount of leverage, they often require investors to lock their money up for several years. Similarly, losses that occur in one investment can quickly turn into large ones. Because they are so heavily leveraged and borrowed, hedge funds may be a great option for speculative investors, but average investors should stick with a balanced portfolio of index funds. Besides providing the flexibility to customize investment strategies to suit their objectives, hedge funds are also an excellent way to lower overall risk.
The risks associated with hedge funds are substantial. Because they invest in illiquid assets, lockup periods often apply. Withdrawals are often subject to a notice period before the funds are repaid. In some cases, lockup periods can be as long as a year. The key is to invest responsibly and carefully, as hedge funds are likely to make huge losses. Hedging is one way to reduce risk, but it does require investors to put up their money for several years.
Besides raising capital from accredited and institutional investors, a hedge fund uses that money to invest in financial assets. The idea is to find alternative investments, like stocks, bonds, and commodities. Hedge funds also use various investment strategies, such as short-selling stocks or derivatives, as well as betting on mergers and spin-offs to increase profits. A hedge fund is different from a mutual fund, because the manager can make more informed decisions.