For investors tempted by opportunities - what is a hedge fund?
When the financial crisis hit the markets two years back, the initial wave of bad news came in hard at the investment banks. And with many big names holed beneath the water line, big bank casualties were only avoided by unparalleled rescue efforts - from the US federal authorities. But the failings in the investment banking sector, and the consequent heavy burden of regulation now being laid upon its banks, have led to a rise in the profile of the hedge funds. With trading risks, and opportunities, looking to be squashed for the big banks, by the forthcoming Volcker rules, it may well be that hedge funds are the investment vehicle of choice - for high-risk appetite investors. Let's start with the fundamentals - what is a hedge fund?
The critical difference between a hedge fund, and other types of investment funds, such as mutual funds and exchange traded funds, lies in the degree of regulation. In the US, mutual funds are held by public investment companies, which fall under the tight regulatory orbit of the Securities and Exchange Commission (SEC). In contrast, the hedge fund industry has been built around specific exemptions from SEC regulation; in effect they are separate private pools of funds, for those investors with the wherewithal to take greater risks.
This is made possible by ensuring hedge funds are subscribed to only by wealthy individuals, who must meet certain income criteria. Known as 'accredited investors', they must have either a minimum net worth of $1m - or a secure annual income of $200,000. It is that latter criteria which opens up hedge funds to participation by a surprising number of middle-income US citizens. But equally, limited companies with $5m or more in invested assets, can also place monies with hedge funds- and institutional investors make up a big slice of the capital under hedge fund management.
The hedge fund is usually registered with an offshore tax haven, to maximize tax efficiency for its trading operations. But their day-to-day running will be in one of the mainstream financial centers, such as New York or London. The hedge fund manager is the point man for the fund. He or she is in charge of deciding on, and directing, the strategy for the funds placed at their disposal. This strategy is outlined for investors, and can cover a wide number of different investment approaches, and operations staff. However the buck stops with the fund manager - and so hedge funds rely heavily on their trustworthiness and reputation to draw in wealthy clients.
So what is a hedge fund able to do, that can differentiate them from other types of fund? Well, given the lack of regulatory constraints, there are, in fact, few investment strategies and techniques that funds aren't involved in. They are able to place their assets across a wide spectrum of markets, including stock, commodity, bonds, private companies and real estate. They are big players in the exchange markets - and can also adopt short selling, which involves selling assets that are not owned. By judicious involvement in various derivative instruments they can also make use of highly leveraged plays.
These sorts of activities, to a greater or lesser extent, have been available for corporate investors with investment banks - but Volcker looks likely to change all of that. The new regulations seem likely to prompt an exodus into the hedge funds, and many are foreseeing a bumper year for new hedge fund startups. So "what is a hedge fund?" can be answered in one word: opportunity. If you have the wealth, hedge funds may be the last frontier where opportunity is still unbridled.