Hedge funds are investment funds. Unlike 'normal' investment funds, however, hedge funds use more and riskier strategies to achieve returns. Ordinary investment funds invest based on a comparative index, the benchmark. The aim of these fund managers is to achieve a return that is better than that of the benchmark. They can therefore only achieve a return in a rising market. This is also known as taking a long position. Ordinary investment funds are therefore also known as long-only funds.
Hedge funds have a broader investment policy that gives fund managers more freedom to seek returns, with the emphasis on achieving an absolute positive return rather than outperforming an index. They can, for example, also go short. In a short sale, an investor sells an investment product that they do not own at that time. Alternatively, they can use derivatives (derivative products such as options, futures, swaps and forwards) to protect capital. Hedge funds also often exploit leverage (see below), which allows the fund to borrow funds to finance investments that it believes are interesting. In short, hedge funds ensure greater diversification of your investment portfolio and can therefore usually have a positive effect on the risk-return ratio.
Hedge funds fall within the category of complex investment products. It's therefore important that you are well informed before investing in a hedge fund.
There are a number of things that are the same for hedge funds as for 'normal' investment funds, such as having a KIID and a prospectus. They can also be open-ended or closed-ended.
The price of a hedge fund is more sensitive to market movements than the price of an ordinary investment fund. This sensitivity is reflected in the beta. A hedge fund's beta shows how the price of that hedge fund moves compared to a benchmark. Let's take an example where the benchmark's beta is 1. If the hedge fund's beta is higher than 1, the hedge fund does better in rising markets. But the reverse is also true: it does extremely badly in falling markets. The higher the hedge fund's beta, the more sensitive the hedge fund is to market movements.
Many hedge funds aim to achieve absolute returns, regardless of market conditions. Most long-only funds focus on relative return, and want to beat their benchmark. An absolute-return fund wants to limit large losses. To achieve this, it uses derivatives to provide a certain level of protection for the underlying investments. As a result, the fund manager accepts that they cannot fully exploit a rising market.
Hedge funds have the option of short-selling. Ordinary investment funds do not have this option – they invest long-only. By going short, a hedge fund can also achieve returns in falling markets.
How does short-selling work? If the fund manager of a hedge fund does not expect a particular share to perform well, they may decide to go short on that share. They then borrow shares for a fixed period and sell them again immediately. They therefore sell shares that they do not actually own (short). If, during the period they are short, the price of the share falls, the fund manager can buy the shares at a lower price than they sold them for. This enables them to return the borrowed shares, and make a profit. However, if what they expected to happen does not materialise and the price of the share rises, they make a loss. They must then buy the shares at a higher price than they previously sold them for. The fund manager does not have to take out actual short positions; they can also simulate them using derivatives (options and futures).
The ability to apply different strategies means that the costs of a hedge fund will often exceed the costs of an ordinary investment fund. Management fees are usually a fixed percentage of the hedge fund's assets under management. In addition, a hedge fund's fund manager can charge a performance-related fee, allowing the manager to share in the success alongside the investors. They will then do their utmost to achieve the highest possible return. In exchange for this effort, the investor hands over part of the return. Performance-related returns on hedge funds are usually between 5% and 20% of the positive return on an annual basis.
Hedge funds offer a number of advantages compared to ordinary investment funds:
In addition to the general investment risks, investing in hedge funds entails the following risks:
Hedge funds can use leveraged products (options and futures) and short-selling. They can also borrow money to increase an investment in a certain position (leverage). This so-called 'leverage effect' allows them to respond to small price differences between investment products. The risks taken by some hedge funds may therefore be greater than those of ordinary investment funds.
Hedge funds often are less liquid; they cannot always be traded on a daily basis. The fund manager may even close the hedge fund in certain situations. You will then not be able to sell your investment in the hedge fund.
The costs of hedge funds are not always clear due to the use of a performance-related fee, often with varying conditions. The management fees are also often higher than the management fees for ordinary investment funds.
Investments in hedge funds can be complex and unclear, as the portfolio is not based on a benchmark. As a private investor, it is difficult to work out what hedge funds invest in.
You may lose (part of) your investment.
Make sure you know as much as possible about a hedge fund before investing in it.
Your portfolio manager guides you through every choice you make.
You would like to decide on your own in what you invest.
