Hedge funds are only suitable for some investors. When hedge fund managers mismanage their clients’ investments or defraud clients, investors stand to lose significant sums of money.
Hedge funds, or private investment funds, use pooled money from many investors to finance specific strategies. The goal of hedge funds is to earn active returns for investors, using leverage and derivatives with the hope of generating high returns. Many investors allocate money to hedge funds as a good portfolio diversifier, as they typically have low correlation with traditional portfolio investments, such as stocks and bonds.
How Do Hedge Funds Work?
Hedge funds take advantage of market opportunities using different investment strategies. Financial advisers often classify hedge funds according to their investment styles. Each style has its own risk attributes and return opportunities. Hedge funds are flexible, with immense diversity among styles.
This diversity can benefit investors by providing a range of choices. Most often, investors set up hedge funds as private investment limited partnerships. In this scenario, two or more partners unite to conduct business, and each partner is liable for risks only to the amount of money personally invested.
Hedge funds face minimal regulations and operate differently than most other investment methods. Investors essentially pour capital into the hedge fund, and then the hedge fund manager invests the capital however he or she chooses. Generally, the hedge fund manager receives a percentage of all the returns on these investments, which logically should incentivize hedge fund managers to make responsible investments. Unfortunately, due to a general low level of oversight on most hedge fund practices, hedge fund fraud is becoming increasingly common.
Since the goal of most hedge funds is to maximize returns on investment, they may have high risks. Hedge fund managers may make speculative investments, operating outside of Securities and Exchange Commission (SEC) regulations. Hedge funds are private investments and thus do not have to register with the SEC. They do not have to abide by SEC regulations and may pose more of a risk to investors. However, the returns can be higher than safer investments. Hedge funds therefore cater mostly to sophisticated investors.
Types of Hedge Fund Strategies
In the United States, most hedge funds require investors to earn a minimum income annually and have a net worth of at least one million. Investors must have significant investment knowledge to join a hedge fund. There are many different strategies hedge fund managers might take to maximize returns. Examples include:
Equity market neutral. Managers attempt to identify under- and over-valued equity securities while combining short and long positions to neutralize a portfolio’s exposure to market risk. Holding short and long equity positions can balance risk with returns.
Convertible arbitrage. Managers take advantage of mispricings in corporate convertible bonds, preferred stocks, and warrants. Managers can buy or sell these securities and hedge the associated risks. This strategy can generate returns if the price of the underlying assets increases or the issuer’s credit quality improves.
Fixed-income arbitrage. This strategy identifies under- and over-valued fixed-income securities with the purpose of capitalizing on chances in the term structure or credit quality of issuers. Like equity market neutral funds, fixed-income portfolios combine short and long positions to neutralize against market movements.
These are just three of the dozens of different strategies hedge fund managers may use to maximize returns. If you’re considering investing in a hedge fund, you must be an accredited investor and understand how they work. Research hedge fund managers to ensure they are qualified to handle your money wisely.
Most hedge funds are legitimate private businesses that appeal to wealthy investors with a high tolerance for risk, but fraudulent hedge funds hurt the economy and can financially ruin some investors. Identifying hedge fund fraud isn’t easy; it requires the help of a skilled team of attorneys. Hedge funds are notoriously riskier than other investments as well, making it difficult to prove that losses resulted from fraud and not natural market forces.
However, an experienced attorney can help wronged investors develop a strategy for accusing a firm or manager of hedge fund fraud. At Miller Stern lawyers, LLC., we are committed to protecting investors from fraud.