Hedge funds remain a mystery for many people outside of the banking and financial realms. If you’re miles away from a central exchange or business center, you probably haven’t heard of the term yet or didn’t care much to search it online. The fact of the matter is, hedge funds can be an essential chunk of a well-diversified investment portfolio and knowing what the underlying entity does and how it operates can help you make more informed investing decisions.
Hedge Fund in a Nutshell
Hedge funds are similar to mutual funds, which is basically an investment program that pools together investor capital to be traded in diversified markets. What’s different, however, is the style of investing that each fund exercises as well as the prerequisites for joining as an investor. Typically, hedge funds will only high net worth individuals, such as those with at least $1 million to invest in the fund. Hedge funds are also notorious for implementing very aggressive trading strategies that take on greater levels of risk in exchange for higher payout potential.
Structure of a Hedge Fund
The typical hedge fund will be divided into two tiers – a General Partner and a Limited Partner, or investors. As a rule of thumb, general/limited partnerships must comprise of at least one General Partner and one Limited Partner. Due to an SEC regulation, albeit, hedge funds can only have a maximum of 99 investors.
More than that will require the hedge fund to register with the SEC, which means more red tape and more oversight of operations. The second tier of the structure is the general partnership, which is structured as an LLC. The amount of investor risk is limited to the amount of their capital invested in the fund. The general partner’s duties is to grow and manage the fund and perform any tasks necessary to keep the fund afloat.
Hedge fund managers usually charge higher fees over time than their mutual fund counterparts. In fact, their fee structure is one of the primary factors why talented managers decide to start their own fund. Not only are the management fees higher for hedge funds, but they also charge investors additional fees, such as an Incentive Fee, that mutual funds don’t even ask for. Incentive fees can vary between hedge funds, ranging from as low as 10 percent of the fund’s yearly profits to as high as 50 percent. While this sounds ridiculous, the incentive fee is only collected if the manager is able to exceed the previous high, known in the industry as the High Water Mark.
It’s important to note that hedge funds do not allow daily capital withdrawal. Liquidity is limited compared to what mutual funds offer its clients. Some hedge funds will have monthly subscriptions and redemption dates while others only allow you to withdraw capital on a quarterly basis. These strict pullout schedules are necessary to ensure the fund doesn’t get hit severely when a big investor decides to withdraw his/her capital.
Melissa Ko is the Managing Member of Covepoint Capital Advisors, LLC and serves as the Chief Investment Officer of its flagship, the Covepoint Emerging Markets Macro Fund. Please visit https://about.me/melissako, https://melissakoblog.wordpress.com/, http://melissakocovepoint.tumblr.com/, and http://www.slideshare.net/MelissaKo1 to learn more!