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Advantages and Disadvantages of Hedge Funds

October 17th, 2012 by editor

Hedge Funds:

In case of hedge funds, the returns that are generated have an extremely low correlation with the traditional form of asset classes. This low correlation gives a diversification advantage to the investment portfolio. This, in short, means that all the asset classes will not react in a similar manner to the varying market conditions.

Another similar investment option is the real estate. Several investors opt to go in for real estate investments with the hope that its value will appreciate with time and will not be affected by adverse market conditions.

As most of the hedge funds that are professionally managed have a low correlation with the market conditions, they tend to stabilize the investment portfolio irrespective of the market ups and downs. Hence, having hedge funds as part of your portfolio is a good way to manage your asset allocation. Mutual funds also offer the benefit of diversification by investing in different stocks, but they are subject to the risk of market volatility and the returns will thus tend to vary as per the market conditions. Hedge funds, however, can eliminate this risk as they tend to be a little aloof from the market conditions. Thus, relatively less volatility is another great advantage of investing in hedge funds.

Hedge funds are a type of alternative investments. It has been noticed by institutional investors that by making alternative investments as part of the investment portfolio, the volatility of the entire portfolio can be substantially reduced. Low volatility indicates greater stability and security of the returns on investment. It has been observed that Dow Jones Industrial Average as well as other indices of the market tend to display great volatility. However, a portfolio which is diversified with the help of hedge funds will have much less variations.

When the correlation to market conditions is less and there is less volatility, it does not in any way imply that the performance of the hedge funds will be reduced or will not be up to the mark. In fact, contrary to this belief, many high-net-worth individuals consider investment in hedge funds as a way of maximizing their returns on investment. These individuals consider hedge funds as aggressive investment options that generate excellent returns. The hedge funds play an important role not only in diversifying the portfolio but also in stabilizing it.

Hedge funds may offer several benefits, but they cannot be considered as an ideal investment option due to the additional fees involved for getting professional advice on managing the funds. The hedge fund managers have all the skills and expertise to manage the funds in an appropriate manner and charge high fees for the same. Thus, before investing in hedge funds make sure that you are aware of the fees charged by the fund manager and the value provided by him in managing the investment portfolio.

Advantages of Hedge Funds

1. Investors who are in a position to pay large amount of money for investing can consider investing in hedge funds, Hedge funds offer the benefit of the best investment strategies and the possibility of earning good profits even in adverse market conditions.

2. Based on the investment strategy that is applied for the hedge fund investments, these investments tend to bear very less correlation in the form of asset classes such as stocks and bonds. The hedge fund investments may not essentially be able to beat the market, but they are designed in a manner that they can limit the amount of losses.

3. Hedge funds also do not have any kind of restrictions like that of mutual funds, for instance, the limitation of investment in a particular stock to not more than 10% of entire portfolio. Thus, hedge funds can invest larger amounts in individual stocks increasing the diversification benefit to maximize returns.

4. The fee-schedule for hedge funds also offers a great advantage as it is performance based. There is usually a constant fee based on the percentage of various assets involved in case of hedge funds which is 1-2% on an annual basis. There is also an incentive fee which is charged that is around 10% - 20% of the profits. Thus, as the manager tends to earn from the fees charged, the objectives of the fund manager will be aligned with those of the investor to earn highest returns on the investment.

Disadvantages of Hedge Funds

1. Hedge funds are managed by professional fund managers and the investment decisions tend to depend a lot on the skills and expertise of this fund manager. If the manager of the hedge fund is not skilled enough or lacks the necessary experience to take the right investment decisions, the portfolio may not generate good returns.

2. There is no strict regulation on hedge funds of the SEC. Hence, there tends to be a greater amount of risk involved in these private offerings as compared to the public offerings.

3. As the hedge funds are private in nature, there exists a restriction on the number of investors. It is also quite difficult to find managers with a good track record. You usually need more than $5 million to invest and find fund managers with successful track record.

4. Another disadvantage of hedge funds is that there is no access to monthly reporting or monthly redemptions.

5. Hedge funds tend to invest in security offerings that are private in nature and may be difficult to value on an accurate basis. Thus, the value of the investment may not be the same as that represented on the periodic hedge fund statement.

Posted in Hedge Funds category.