The global hedge fund industry is estimated to be worth around $ 1.9 trillion. They intend to hold a portfolio that will increase in value regardless of what the market does. To achieve this they invest in a wider range of assets types than usual investment funds and private investors. They tend to invest in equities, commodities, contracts and bonds, but can invest in anything legal, which sets them apart from most other investment funds.
Hedge funds are only available to Accredited Investors or 'qualified purchasers', and this generally involves assets of at least $ 1 million. This before rules out the vast majority of investors and so the purpose of this article is to give a brief introduction and explain how they work as well as see if there is anything that smaller investors can learn from them.
The first hedge fund was set up by Alfred Jones in 1949. His aim was to develop a portfolio that was 'market neutral', meaning that if the market went up or down his portfolio would be unaffected and this would allow his returns to be based solely on his stock picking ability, as opposed to market conditions. To do this he held long and short positions, so that any market changes would result in a loss on one position, but an equal gain on another. This means hedge fund performance is significantly driven by the fund manager's skill, as opposed to market conditions.
Compared to hedge funds now Jones' strategy was very basic. However they all follow more or less the same principle. Different hedge funds employ different strategies, some apply a 'global macro' approach, which aims to benefit from change in the world economy, others employ event driven strategies, and some try to profit from the varying prices between assets classes.
Risk management is key to all hedge funds and some even employ people to constantly assess the risk of the positions they are taking but otherwise play no part in the actual investments made.
Managers' pay is calculated on a performance basis, as well as an annual management fee. This has led to managers making bankers bonuses look small. In 2009 David Tepper of Appaloosa Management took home £ 2.5 million.
Warren Buffett argues that hedge funds are not good value for money, as the fees take away too much of the earnings, if there are any, and take money away even if the hedge fund's value Declines. Buffett has even entered into a bet with Protégé Partners LLC that over ten years the S & P 500 will outperform a selection of their five favorite funds. Each side has bet $ 320 000, which has been used to buy a bond, which at maturity, after the 10 years, will be worth $ 1 million and will be donated to the winner's charity of choice.
So investing in hedge funds is out of the question for most private investors, but can they learn anything from them? Their strategy clearly indicate the advantages of short selling and diversification of your portfolio. However doing it on the same level as hedge funds is expensive and difficult for private investors. On the other hand it is now reasonably easy to use spread betting to short shares as long as the investor feels comfortable using spread betting services.