Hedge Funds Are Risky for a Reason
by Shane Flait, ©2011 

Hedge funds pool investors' money to invest those funds in financial instruments to make a significant positive return in all kinds of markets. This isn’t easy, but hedge fund managers use a wide set of investment practices that may increase the risk of investment loss.

Unlike mutual funds,  hedge funds are lightly regulated.  They’re not required to register with the SEC; they typically issue securities in “private offerings” - also not registered with the SEC; and they aren’t required to make period reports under the Securities Exchange Act of 1934. Nevertheless they’re subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary duties as other investment advisers.

Reaching while hedging for profits

Hedge fund managers seek to capture more return while at the same time hedging out many unwanted investment risk. In fact, for many so-called market-neutral hedge funds, the target is to eliminate their portfolio's sensitivity to the market's ups and downs. They do this by their ‘hedging’ techniques such as short-selling securities as much as they buy long. Their efforts may mitigate some risks but can add others.

Additionally, hedge fund managers may ‘go long’ on securities they believe will appreciate, they’ll also ‘short-sell’ other securities they expect to fall in value. More than this, they may use financial derivatives and leverage in their strategy as well. Some will invest in non-traditional or illiquid assets, such as loans or private equity. While others may invest in distressed assets or employ arbitrage techniques that attempt to capitalize on merger opportunities or perceived incorrect valuations among closely related securities.

You can see that employing such a wide array of investment strategies makes hedge fund returns strongly dependent on a manager's investment skills. Such strategies will tax them much more than those managing most traditional portfolios as mutual fund managers 

The table shows how hedge funds, traditional funds and index funds compare in terms of their goals, strategies and risks versus their target market performance.

	Typical hedge fund	Traditionally managed fund	Index fund
Goal	Positive return in up and down markets	Premium over market return	Market return
Strategy	Reduce/eliminate risk of declining market, fully exploit manager's ability to generate return through flexible investing techniques	Benefit from rising market, manager uses expertise in security selection to generate return	Replicate the market
Risks	Poor investment section and investment techniques; underperforming a rising market	Market decline; poor investment selection	Market decline

You can see that the typical hedge fund and index funds are on opposite poles when relying on market performance while traditionally managed portfolios are somewhere in the middle. So, the returns of hedge funds are driven primarily by their managers’ strategies than by simply following the broad market direction. That’s why skill is so important for drumming up profits and risks can by greater. 

If you’re interested in hedge fund investing, be sure to read the prospectuses to understand the level of risk involved in the fund's investment strategies and ensure that they are suitable to your personal investing goals, time horizons, and risk tolerance. As with any investment, the higher the potential returns, the higher the risks you must assume.

 

---