Hedge Funds – The Drawbacks of Investing

It is almost impossible to define what a hedge fund is due to its secretive and rather enigmatic nature. However, by textbook definition, ‘hedge fund’ can be described as a private investment portfolio, usually structured as a limited partnership, open to accredited investors, charging an incentive based fee, and managed by a general partner with every financial tool imaginable at his disposal.

It is only in recent years that hedge funds have become a significant part of the UK economy. Twenty years ago, they were almost unheard of, quietly operating in the background as a marginal part of the market. Due to their early success, many expanded and new funds have entered the market in recent years, with some being listed on exchanges such as the FTSE 100. However, as commodity prices fluctuate and the economy hits a double, perhaps triple dip recession, many are going into administration, which has created an uneasy and unsettling atmosphere for both investors and fund managers. This article will outline some of the drawbacks and potential risks involved with investing in hedge funds.

According to research carried out by Hedge Fund Research (HFR), the last quarter of 2011 took a big hit on hedge fund businesses with losses across almost every strategy. This included Equity Hedge strategies and Emerging Market funds, which fell by huge values. The disappointing figures published by funds, has and will continue to deter potential investors and thus, reducing consumer expenditure in the sector. This in itself will have a knock-on effect on the stability of a hedge fund, causing some to potentially enter administration.

Despite the added privacy of a hedge fund, many investors are exploited and treated unfairly as a result of a lack of transparency between investors. The ‘light regulation’ of funds has led to an increase in risk of fraud, style drifts and faulty operations. Additionally, an unregulated oversight of those in managerial positions may lead to infrequent return reports and therefore, resulting in imperfect market information and causing market failure. However, the extent to which the events above are occurring has been reduced by the recent introduction of new regulations set by the EU, which requires hedge fund managers to provide more information to investors and other stakeholders. Such government intervention has helped increase investor and consumer confidence.

There are several requirements when investing. For example, a reasonable investment must be provided in order to make the venture worthwhile for both the investor and fund. This alone will deter many who consider using hedge funds as a large investment will carry more risk than a smaller one. There are also other requirements, which include having a high individual income. These necessities therefore rule out much of the potential market and can cause problems for those wishing to invest but do not fill the criteria set out by the fund.

The amount of risk involved is quite possibly the biggest drawback as many investments can lead to huge losses. The amount of risk associated with an investment depends on the amount invested and the economic climate. However, this could be reduced through the investment in more than one fund, adding diversification and variation to one’s portfolio which ultimately could reduce risk exposures. Overall, there will be a risk attached to any investment. Therefore, investors should take care by considering the potential risk involved.

Another drawback of investing in a hedge fund is the presence of both a management and performance fee. A management fee is usually calculated as a percentage of the funds net asset value, which typically ranges from 1% to 5% per annum. A performance fee is typically 20% of the profits made on the fund each year. Another fee that some hedge funds charge is a redemption fee for early withdrawals. These fees can take a substantive cut out of potential profits for the investor and thus, should be considered before investing.

In conclusion, there are many drawbacks to investing in hedge funds and careful planning is required before interacting with a fund. This should include the consideration of the points made above.

Contributed by Alexander Wright

3 thoughts on “Hedge Funds – The Drawbacks of Investing

Leave a Reply

Your email address will not be published. Required fields are marked *