What’s a Hedge Fund?

mark tuminello hedge fundsIt may come as a surprise to finance professionals, but many people don’t truly know what a hedge fund is.  The following is a very broad and simple look at hedge funds and how they work.

First, a hedge fund is a privately owned company.  This is different from a mutual fund, which is a public corporation.  The point of a hedge fund is to invest money and make enough money that they significantly outperform the market.  When you invest in a hedge fund, they reinvest your money into other financial instruments.  Because hedge funds are private, they are not subject to regulation from the Securities and Exchange Commission (SEC) like a mutual fund is.  This makes them more risky.  On the flip side, there can be higher returns.

Lack of financial regulation is just one factor that makes investing in hedge funds so potentially lucrative.  Another factor is the way they pay their managers.  Hedge fund managers are compensated with a percentage of the returns they earn.  If you’ve invested in mutual funds and had to pay fees despite poor performance, you’ll understand why this idea is so attractive.  Hedge fund managers have real motivation to make money for their clients.

The types of financial instruments used by hedge funds also sets them apart, such as derivatives like collateralized debt obligations, futures contracts, and options.  Using these tools, hedge fund managers can profit even when the stock market is going down.  Products like these use only a little money (also known as leverage) to control quantities of stocks and commodities.  These devices can offer high returns, but are completely speculative.  It’s all about correctly predicting whether the stock market will rise or fall over the life of the investment – hedge funds pay out by a particular place in time.

While hedge fund managers are paid a percentage of earnings, they don’t share risk in the same way.  If the fund loses money, they simply receive no compensation.  In this way, managers of hedge funds are risk tolerant.  The risk is completely on the investor.  Investors also become part owners of the LLC, which means they could lose their investment if the hedge fund goes bankrupt.  Also, options have to be delivered within a certain amount of time.  Hedge fund managers try to time the market, which some say is practically impossible.  Even if managers are correct about the longterm results, an unexpected economic event could cause them to lose the investment.

New hedge fund regulations were enacted in 2010, with the Dodd-Frank Wall Street Reform Act now regulating the industry.  Hedge funds above $150 million now register with the SEC.  There are many new regulations in effect that are designed to protect investors, banks, and the national economy.

from Mark Tuminello http://ift.tt/1jxXnM1 – latest post by Mark Tuminello

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