Nature of Hedge Funds

In this blog, I’m going to give you a few general notes about the nature of hedge funds and what makes them so different than popularly subscribed to mutual funds. Firstly, a hedge fund is a closed-end fund. Meaning, as an investor, you are unable to invest your money any day you wish. There is a vetting period, part of which requires a minimum net worth to qualify. Then comes the contract offer with a minimum initial subscription amount. Fund managers will only accept what they believe they can actively invest and provide a suitable return on. Remember, every dollar received is a liability for the partnership.

There are share class options, like mutual funds, but there is something else called a “key person” clause. This legal agreement requires the fund to notify all partners in writing if a principal manager becomes unavailable to administer the duties of the fund. A qualified replacement must be hired that will ensure the success and longevity of the fund. If a replacement is not made, then the investors are no longer legally bound and may liquidate and redeem their positions. Next are management fee levels, which can be anywhere from 1 to 3 percent. Manager incentives pay the firm more when the fund performs extremely well, and performance exceeds the top ladder.

Then there are lock-up periods. Lock-ups periods are stretches of time where the fund is illiquid in nature. Meaning, you can’t redeem your position. Lock-ups periods can begin after year one or year two, for example, and thereafter, partners can make the request only once or twice a year. Some are considered soft lockups, and others are hard lock-ups. As the name implies, managers have qualifying criteria in place before investors can touch their assets.

Mutual funds are traded all day, and a person can invest once a day or sell their holdings the next day if they liked. Hedge funds don’t work that way. Any new hedge fund position begins at the start of the month. That’s the date your cash is put to work, and you don’t know how well you did until about 45 days later. Once the performance of the long/short positions is compiled and analyzed, your final monthly return is released.

On a note about strategies, a single limited partnership (LP) can have multiple fund strategies at any time. They have distinct products, markets, or regions unique to that fund. Hedge funds are famous for shorting stocks and they do so with derivatives. Similarly, the value of hedge funds themselves is a result of underlying assets they are invested in. The biggest draw of hedge funds is that successful ones can produce positive returns consistently during bear markets. They can perform well in bull markets too, but they are especially attractive to have during economic lulls. The same cannot be stated for mutual funds and, of course, ETFs and Index funds. Because traders can identify likely company or market weaknesses, they can create profit opportunities from price spreads.

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