An investor looking to make a profit on the financial markets has a wide array of choices. The equity (stock) markets are one of the most popular methods, with thousands of stocks listed on exchanges across the world. Equities are vulnerable to the fluctuations of the market, so an important strategy to protect an investor’s capital is to diversify his portfolio. One type of investment that utilizes diversification is a mutual fund. This type of fund can be used to invest in different types of financial instruments, such as stocks or bonds. The portfolio of a mutual fund is made up of pooled funds from the investors who have invested capital in the fund. The fund is professionally managed by a fund manager, who decides how to invest the money in the fund. Mutual funds are regulated financial products which are offered to the public, so buying a fund is a simple as making a call to your broker.
Hedge funds are structured in the same basic manner as mutual funds, in that they are made up of pooled funds from investors. However, hedge funds are generally run much more aggressively than mutual funds in order to maximize profit for the investors. As well, hedge fund managers have a wider variety of financial products to choose from compared to mutual funds.
At this stage, you may like the sound of hedge fund trading and are interested in learning how to start a hedge fund. Unfortunately, unlike mutual funds, hedge funds are available solely to private clients. Under US securities law, the majority of the investors of a hedge fund must have a net worth of 1 million USD and must have an extensive understanding of the risks of trading and investing in the financial markets. Hedge funds usually require that an investor has a minimum net worth of 100,000 USD. Those investors who meet the net worth requirements are known as “accredited investors”. Individuals who do not qualify can still purchase “repetition” funds, which try to mimic hedge funds strategies of the most successful hedge funds.
It is important to keep in mind that hedge funds are used in a variety of financial markets. These include equity, fixed income, commodities and foreign exchange. For traders who are interested in trading forex and are high net-worth individuals, hedge funds provide a unique opportunity to trade and profit in a manner that is not available to most investors.
Hedge funds obtain their high returns by taking risks; this means that fund managers will look for investing opportunities in almost any market. Some carry a greater risk than others; therefore, it is essential that the investor in a particular fund is aware of the hedge fund strategies which are being utilized and that she is comfortable with the degree of risk.
No two hedge funds are exactly alike, and hedge fund investors can choose from many funds, which will utilize one or more trading strategies. It goes without saying that before investing in a hedge fund, you must due your due diligence and ensure that the fund is reputable and has an established track record. A trader or investor should always feel comfortable with the degree of risk involved in the purchase of a financial instrument; if you are losing sleep over your portfolio, it’s a safe guess that your portfolio needs to be reviewed and changes made in order to better suit your tolerance for risk.
Hedge Fund Strategies
There are many hedge fund trading strategies employed by hedge fund managers. Let’s take a look at some of the most popular hedge fund strategies. For the investor interested in hedge fund forex trading strategies, the methods discussed below can be successfully used by a hedge fund in order to make profits from forex trading.
1. Long/Short Equity
In this type of trading, investors go and short on two competing companies which are in the same industry. This is an example of hedge fund strategies that have a relatively low risk. For example, if the fund manager feels that Toyota shares look cheap compared to Ford, the fund might purchase 100,000 USD of Toyota shares, while shorting an equal amount worth of Ford shares. This leaves a net market exposure of zero, which means that the risk is relatively low. If Toyota shares outperform Ford, the fund will make a profit. Of course, if Ford outperformed Toyota, then the fund will have lost money on this trade.
2. Market Neutral
Similar to the long/short equity strategy, market-neutral funds will often make use of taking matching long and short positions in different stocks, with the aim of increasing return based on good stock selections. However, long/equity looks to take advantage of underpriced stocks, while the market-neutral method looks to profit from yields which are above the average market return while minimizing risk through matching positions.
Arbitrage involves exploiting price differences between similar financial instruments, by simultaneously buying and selling those instruments and making a profit. Essentially, arbitrage takes advantage of inefficiencies in the market. If arbitrage is executed in a responsible manner, the fund can produce consistent returns with low risk. However, since price inefficiencies between similar instruments is usually very small, arbitrage funds will often rely on leverage to obtain high returns. The use of leverage can achieve high returns, but at the same time involves significant risk, because price differences can suddenly shift in direction.
4. Global Macro
A fund manager that is using a global macro strategy will make investment decisions which are based on the political and economic outlook of various countries. This involves an analysis of a country’s economy and attempting to predict if the economy is on the rise or decline. Forex traders often use the global macro strategy to forecast movements in the currency markets. Thus, an investor with experience in forex trading who wishes to engage in hedge fund forex trading may feel comfortable investing in a global macro fund.
A fund manager may decide to use a wide range of hedge fund strategies. Multi-strategy funds will take advantage of a variety of investment strategies in order to achieve profits. There is no particular investment strategy or objective, besides providing the investor with a positive return. These funds generally put a high emphasis on capital preservation and therefore engage in purchases that are relatively low-risk.
How to Invest in a Hedge Fund
We mentioned earlier that in order to join a hedge fund, you need to be an accredited investor, which means that you have a minimum level of assets. If you have passed this first requirement, there still plenty of research you will need to do in order to choose a fund that is right for you.
- Prospectus – Review the fund’s prospectus and other related materials. You should understand the hedge fund strategies employed by this particular fund and the level of risk. The fund may promise attractive rates of return, but remember that a higher potential return comes with a higher risk for the investor.
- Fees – Hedge funds generally charge of 1-2% of the fund’s assets. In addition, fund managers are often given a “performance fee”, which could be up to 20% of the fund’s profits. Higher fees mean a smaller return for the investor, so an investor will want to know all the fees involved prior to signing up with the fund.
- Valuation – Since hedge funds can invest in a wide range of financial instruments, some investments may be difficult to sell and therefore difficult to value. It is important to understand the valuation process of the assets in the fund so that you can assess the value of your portfolio.
- Share redemption – Hedge funds often have specific time periods during the year in which an investor is allowed to redeem (cash) her shares. As well, the fund may have a “lock-up period” of a year or more, in which you cannot redeem your shares. It is important for a trader to be aware of the restrictions on redeeming his shares in the fund.
- Fund manager – You should ensure that you know who is managing the fund and that they are qualified to do so. Fund managers will have different levels of risk and trading strategies; make sure that you are comfortable with how the manager is running the hedge fund.
We hope that this blog has provided you with useful insights about hedge funds. We invite you to learn more about hedge fund trading at Platinum Trading Academy. Looking to become involved in hedge fund trading? Learn more about our unique Forex Elite Trading Programme.
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