Ten Good Reasons to Invest in a Hedge Fund

Helping You Reduce Risk

In their purest forms, hedge funds are about reducing risk. A hedge fund is structured to reduce the risk of the portfolio without sacrificing return. Financial research has shown that investment return is closely related to the risk that an investor takes. In most cases, a hedge fund investor has other investments outside of the fund that carry market risk. The different risk-and-return profile of the hedge fund can offset the risk in the other investments, making the investor, as a whole, better off.

Helping You Weather Market Conditions

Political turmoil, natural disasters, and economic upheaval, for example, all are reflected in the daily machinations of stocks, bonds, currencies, and commodities. Hedge funds are set up to work through this upheaval for two reasons: (1) They have access to a wide array of risk-management techniques that can help limit the effects of market downturns, and (2) They have less oversight and more freedom in their operations, which allows them to move quickly to profit from the wild swings in markets. A hedge fund manager simply makes a trade when the time is right.

Increasing Your Total Diversification

Diversifying your portfolio is an easy way of hedging. A hedge fund increases the amount of diversification in a portfolio because it has a different risk-and-return profile than other investments you may have. A fund also has more freedom to invest in other types of assets. A good hedge fund manager stays plugged into the market, maintaining access to currency swaps, commodity pools, private offerings, and other types of investments that may be hard to own otherwise. A hedge fund manager can generally use investments and investment techniques that would be impossible for individuals to try.

Increasing Your Absolute Return

If you remove market risk, which is the goal of many hedge funds, you still need some return, which is why hedge fund managers look for investments that can bring them alpha. In their search, they may find offbeat investments that can generate a greater return than what they have available from other types of investments. Hedge funds also increase potential return by using leverage. Because a fund can borrow money in ways that other types of investments can’t, it can look for an asset with a relatively low return and relatively little risk that can become an asset that offers a much higher return.

Increasing Returns for Tax-Exempt Investors

Hedge fund managers often invest without concern for the tax implications of its investment positions. That’s perfectly fine for major hedge fund investors, because they don’t pay taxes. For them, the aggressive and offbeat investment techniques that some hedge funds use are a perfect fit, because they don’t have to worry about the friendly revenue collector taking the profits away. If you’re working for a large tax-exempt investor, it makes sense for you to investigate hedge funds as a way to increase your portfolio’s overall rate of return.

Helping Smooth Out Returns

A fund may not go up as much as the stock market during a year when the market is unusually strong, but the fund shouldn’t perform as badly as the market during years when the market isn’t so hot. This baseline may make returns more predictable. An investment in fixed-income securities, like U.S. government bonds, generates a predictable return, albeit a relatively low return. Many hedge funds can offer increased predictability at higher rates of return.

Giving You Access to Broad Asset Categories

Hedge funds have a broader charter. The fund manager doesn’t need approval to try a new investment strategy. She doesn’t have to report to fund investors daily, weekly, or even monthly, so she doesn’t have to worry about how an investment will look on some report card. Private equity deals, complicated currency hedges, and strange commodity plays all have time to work, free of the messy oversight of people who aren’t intimate with the market’s machinations.

Exploiting Market Inefficiencies Quickly

Hedge funds have the ability to move quickly in changing markets. If a fund manager sees an investment opportunity but doesn’t have the necessary cash on hand to make a transaction, he can borrow money from a bank, a brokerage firm, or even a loan shark to make the purchase. Hedge funds are also free to sell short. The ability to sell short increases the opportunities to make money, even in a down market. Another opportunity for hedge funds is merger and acquisition financing. The private-partnership structure limits the number of people who have to approve a capital commitment. A hedge fund can move quickly to make money on even a small difference between the market price of a company’s bonds and the price that an acquirer is willing to pay.

Fund Managers Tend to Be the Savviest Investors on the Street

Hedge fund managers tend to be really smart, are passionate about investing, and care about making money, period. Making you money is their drive, meaning they don’t show interest in sales and marketing, management, and the niceties of business etiquette. Many of the brightest people on Wall Street run hedge funds. When you invest in a hedge fund, you’re more likely to have a sharp manager than if you choose another vehicle for your money. Of course, brainpower is no guarantee of great results. But smarts are a good start!

Incentives for Hedge Fund Managers Are Aligned with Your Needs

Investing in a hedge fund is a great way to ensure that your interests are taken as seriously as the fund manager’s. Although they take a hefty cut of the fund’s profits, they receive that money only if the fund sees profits. If the fund has a losing year, a fund manager can’t collect a performance fee until the fund gets back to the level it enjoyed before the losses occurred, a level called the high water mark. A mutual fund manager, by contrast, takes home a nice salary even if the fund’s performance is poor. In addition to adhering to the pay-for-performance policy, hedge fund managers often manage money for themselves and their families.