world_travel_japan_295341_l.jpgIn business parlance, you often encounter the term hedge funds. It is an accumulated amount of capital given by various accredited investors only. An accredited investor could be a wealthy individual or a group of individuals organized under corporate laws.

The U.S. Securities Act of 1933 states that an individual could qualify as an accredited investor only if he has a net worth of at least one million US dollars. A single individual who made at least $200,000 in each of the last two years can also qualify as an accredited investor provided that he is expecting to earn the same amount during the current year. A married individual must earn an amount of $300,00 dollars in each of the last two years for him to qualify as an accredited investor.

However, this amount is a combined total of his and his spouse’s earnings. Hedge funds are usually free from any direct regulation under the Securities and Exchange Commission (SEC) because of the restrictions in its investors.

Performance Fee

In a hedge fund company, the general partner usually manages the money and receives a higher percentage of his own net worth that is invested in the fund. In this set-up, the money manager can utilize a variety of ways or investment techniques to invest the money. Most of these techniques are not normally permitted in other type of funds. The money manager can borrow money, use arbitrage, sell short or use trade options and bonds.

If you invest in a hedge fund, there is a very good possibility that you receive extraordinary gains from your investment and there is only very minimal risk. This is because a hedge funds can use a variety of investment and risk management skills to get impressive gains regardless of the direction of the market. Hedge funds are mostly invested in securities that are publicly traded.

A hedge fund charges a performance fee from the investors. Performance fees give money managers a share of the gains. This is because when an investment has gained impressive profits, the investors are only very willing to pay the money manager more generously. Thus, the performance fee for those who are able to manage hedge funds very well could be very handsome. The performance fee is usually 20% of the gross returns of an investment.

These returns include the unrealized and actually realized trading profits. Performance fees can be an advantage for an investor since the manager will surely use all means available for gains. However, it could also be a disadvantage since managers often take higher risks, sometimes excessively high risks, just to gain profits. Aside from performance fee, managers are also given management fees. Manage fee is usually 1.5% to 4.0% of assets under the management. In some hedge fund companies, a manager will not receive his incentive fees if the value of the fund does not exceed its previous highest net asset value. This “previous highest net asset value” becomes the high water mark for the manager to surpass.

Legal Structure

In order to have a deeper understanding of hedge funds, it is important that we understand its legal structure first. Hedge funds operate under the principle of limited partnership. In the U.S, limited partnerships often receive favorable tax treatment. As mentioned above, only accredited investors are allowed to invest. Hedge funds SEC unregistered.

The hedge fund manager is usually registered as the corporate entity with the investors as members or limited partners. Most hedge funds in the US are domiciled. This means that the legal residence is offshore, in countries not related to the manager, investors of base of operations of the fund. This is purposely done so that only investors are taxable and not the hedge fund itself.

A hedge fund manager can use a variety of investment strategies in order to increase profit. Each strategy offer varying degrees of risk and return. There are about 14 major strategies employed by hedge fund managers. One of the most common is the global macro strategy.

For a manger to use this strategy he must have vast knowledge of global trends in interest rate, government polities, relationship between governments of different countries where funds are invested, and movement in the general flow of funds. Arbitrage is another common strategy employed by most hedge fund managers. This strategy makes use of the difference in market prices. Since this transaction involves only positive cash flow, it is considered a risk-free strategy.

Cash Merger Arbitrage

A manager can sell short equities that are expected to decrease in value so he could buy long equities that are forecasted to increase in value. This could be a very good strategy since it decreases volatility and risk for hedge funds. Cash merger arbitrage is another hedge fund strategy. An acquirer will propose to buy the shares of a certain company for a certain amount in cash. While waiting for the merger to be completed, the stocks of the company where the share is bought generally trades below the price of the purchase. So the hedge fund manager will take advantage of this and buy the stocks from the target company while the price is still low. A stock for stock merger can also be used as a strategy. This involves excanging stocks between an acquirer and the target company.

Although considered to be a very risky strategy, investing or acquiring distressed securities can be a very profitable venture if the manager has more than the average know-how when it comes to saving companies from bankruptcy. Distressed securities are securities of a corporation that is heading toward bankruptcy or in default, under bankruptcy protection.

Those who invest in distressed securities often try to avert bankruptcy by restructuring debts, narrowing focus and implementing plans to turn the tide around. An investor can also invest new capital to a distressed company in form of equity or debt.

Hedge funds can be very beneficial in many ways. When you add hedge funds in a balanced portfolio, the overall risk of that protfolio is reduced and the volatility of hedge funds increase the returns. It also diversifies the means of investment for a protfolio. This diversity is not often seen in traditional investments. Hedge funds eliminate the need to time accurately the entry and exit from markets providing an ideal long-term investment solution.

Many of the strategies used by the managers to increase profit have the abiltiy to generate positive returns. This is irregardless of the rising and falling of equity and bond markets.

Many of the investment strategies used by hedge fund managers are uncorrelated with each other. This provides investors with a very effective way of meeting their investment objectives since they have a wide rage of investment strategies to choose from. Most importantly, it has been proven through academic and market research that hedge funds have higher returns and lower risk all in all.