The hedge fund world was one of the most enigmatic sections of the finance universe up until recently. Initially, it started as a consortium of the world’s best money managers who stepped out of the shadow of the banks, investment houses and funds they worked for to manage their own pool of capital and provide ultra-wealthy investors an avenue to make significant returns above the market performance. However, as other managers started recognizing the lucrative nature of these funds (top managers can earn upwards of $1 billion a year), more and more funds started piling into the industry, driving up competition. The competition is only intensified further by the fact that these hedge funds only have a finite set of customers they can cater to. Because of their inherent risk, hedge fund regulations require funds to only sell their services to investors who have a net worth above a minimum threshold and have the risk appetite to absorb losses.
The typical hedge fund investor is not your average private investor that is the bread and butter of most mutual funds around the world. The main investors in the hedge fund industries are institutional investors i.e. money managers hired by and representing an institution that has a pool of capital that it is looking to generate a return for. Some examples of institutional investors are pension fund managers, labour unions, government institutions, insurance companies, certain types of corporations and even sovereign wealth funds. Some of these institutional investors manage upwards of $100 billion in capital and they can all be characterized as having a much higher risk tolerance than an individual private investor. Of all the capital floating around in the hedge fund industry, 65% is estimated to be institutional assets.
However, it is not an absolute requirement to be an institutional investor to park money in a hedge fund. Private investors with $1 million in net worth can also be investors. This minimum threshold is a cushion that allows them to survive any major downturns that the hedge fund portfolio incurs due to the large amount of risk it takes relative to the market. The threshold is also important as the timeframe in a hedge fund generally does not allow redemptions before a certain time period. The convention is 6 months, however certain funds even have no redemption periods of 3 years. This means that if the investor wanted to take his/her money out of the account, they would not be able to do so for 3 years after making their initial investment – a feature that makes it an absolute must for them to have other liquid assets they can deploy when needed.
Moreover, the hedge fund fees are steep. Most managers follow a 2 and 20 structure i.e. 2% management fee and 20% performance fee. Let’s take the example of an investor who invests $10 million in Hedge Fund A. At the end of the year, the fund’s skilled managers deliver a 20% return growing the $10 million to $12 million. The investor will then have to pay 2% of $10 million + 20% of $2 million. This equals out to $600,000. While it may be worth it for investors as large as this one, the average private investor would not be able to gain the same magnifying effect on returns with a smaller capital base. Once again, the minimum threshold comes in handy to filter out the investors who would only truly benefit from the asymmetrical fee structure. The last requirement is to be a sophisticated investor i.e. one who knows how leverage, derivatives and other instruments commonly used by hedge funds work. This also helps as hedge funds are not obligated to report what they are invested in. The lack of transparency means that investors have to be good judges of character and also understand all risks associated with such investments prior to execution.
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