Understanding Hedge Funds With Examples: Indeed the popularity of hedge funds has increased vastly in recent years. However, until now, it is still in its initial years, and people are still trying to dip into it. Most people think it to be a complicated investment system, but the reality is it is one of the simplest methods. Also, people wonder who can invest in these funds, how they operate, and many more curious questions.
Today, we’ll try to help you a bit. This basic article on hedge funds shall provide you with all the essential details. We would start with the understanding meaning of the pooled fund, then some eligibility criteria required, and at last, how these funds work! All this shall follow by a conclusion at the end, where we’ll continue our discussion!
Definition of Hedge Funds
If we go by the definition by Wikipedia, then –
“A hedge fund is an investment fund that trades in relatively liquid assets and can make extensive use of more complex trading, portfolio construction and risk management techniques to improve performance, such as short selling, leverage and derivatives.”
Now, let us break it down in simple terms to make it understandable for anyone.
A hedge fund is not an investment fund. Instead, it is a pool of funds invested by some limited number of high net worth people. A pool of funds is when a specific number of persons spend their money into one thing.
Remember, hedge funds mean for people of high net worth and require a minimum amount to invest. A manager or investment adviser handles this pooled fund.
The primary aim of every hedge fund is to earn maximum gains with minimum risk, and that’s how the word ‘hedge’ came. The manager, with the investor’s money, can spend the money wherever he wants, but it must get maximum returns. And, by anywhere we mean anywhere, he can invest in mutual funds, gold, property, stocks, startups, or wherever he wants.
Hedge funds outperform the market, most of the times, because of high this liquidity and can go long as well as short both.
At the end of the year, the manager takes a fixed percent cut from the profits. The most common cut is 20%, and it is not that much small as it sounds. Hedge funds are massive pool investments in hundreds of millions or billions, so a mere 10-15% ROI will get the hedge fund manager thousands of dollars.
These collective pool funds are also referred to as limited partnerships.
Requirements of Hedge Funds
As we told you, not anyone can invest in hedge funds. There are specific requirements set by the financial regulators as to who can invest in these pool funds.
The first eligibility criteria are one must have a minimum net worth of 1 Million Dollars.
If not above, then your annual income must be above $200,000, consecutively for the last two years. Plus, you must have some convincing reason that your this income will continue in the future.
If a married couple wants to spend money, then their combined net worth must be 1 Million dollars or a minimum income of $300,000 per annum, for the last two years.
If you’re not an individual and an organization, then your net worth must be above $5 Million.
Also, remember, there is no government intervention in hedge funds, and it looks like a private entity. Thus, the risk and return both increase here drastically.
Further, there is a minimum investment also required and varied from fund to fund. For instance, a pool fund might need at least 1,000,000 Euros, while the other might start with 50,000 Euros. Usually, the smallest amount for tiny hedge fund firms is 25,000 Euros, in the UK.
How Hedge Fund Firm Works?
To explain this in detail, let’s assume you are the hedge fund manager of an investment firm, XYZ Ltd. Now, the minimum collected investment to start a hedge fund is $100,000.
So, some of the investors get ready to invest, and somehow you manage to collect $1.5 million. For this, you will receive a 20% cut out of the profits after giving a return of 5%.
The 5% return is called hurdle, and it is the minimum gain you will get to your investors. Your portion shall start after it.
Now, to gain the returns, you allocate your money into different investment fields. It could organize or unorganized, financial or non-financial; you can invest in a shop, you think would work. You can invest in a company, property, investment markets, or anywhere, keeping in mind the other factors like risk attached to the spending.
So, let us assume now you made $1,500,000 out of $1,000,000. A pure 50% profit of $500,000 in a year! Now, first, the 5% hurdle gain shall be distributed among investors. And, after that, the remaining profit shall be allocated between you, the manager, and investors in the ratio of 20:80.
In this case, investors will get $25,000 (5%) + 380,000 (475,000 x 80/100) and your income is $95,000 (475000 x 20/100).
A hedge fund is the same as somebody else, with more knowledge and skills (probably), is using your money to invest. In exchange, he charges you some fee. But, remember, not hiring a good adviser or hedge fund manager can turn the table against you too! You must also be wondering how to pick the best hedge fund manager or investment firm. Here is a simple explanation with steps.
Also, do not forget to read these traps hedge funds which you must avoid here!
Remember, hedge funds are riskier than mutual funds and other types of investments as there is no regulatory body on them. Thus, make sure you properly analyze your investing organization. Also, make sure you acquire enough knowledge by reading and watching videos.