Key Takeaways:
- Hedge funds let you invest in professionally managed private funds that use sophisticated techniques to pursue higher returns
- Hedge fund managers can borrow funds to invest and use other trading and risk management techniques not available to mainstream fund managers
What are hedge funds?
Hedge funds are special private funds that use sophisticated trading and risk management techniques to pursue higher returns.
Hedge funds are typically managed by specialist investment managers who have built up impressive track records in their field of investing. They can use investment strategies and trading techniques that are not available to mainstream fund managers, and have more leeway in the way they invest and the instruments they can use.
Hedge fund managers are allowed to invest across a more comprehensive range of listed and unlisted assets. The managers are also allowed to use sophisticated trading and risk management tools, like derivatives and leverage, that are not available to mutual fund managers.
Derivatives are instruments whose value is derived from the value of one or more underlying assets, such as bonds, stock indices, currencies, commodities or interest rates. They can be used by the fund manager to reduce and hedge risk, or to express a view on the future direction of the underlying assets. Leverage allows the fund manager to borrow money to multiply the returns they make. The risk is that negative returns, not just positive ones, are multiplied if something goes wrong.
What are the advantages of investing in hedge funds?
Access to Skilled Hedge Fund Managers – The best hedge funds are helmed by skilled fund managers who have demonstrated track records of producing market-beating returns. By allowing them to take advantage of a broader universe of assets and trading techniques not available to them otherwise, the potential for higher returns is increased.
More Expansive Investment Universe – Hedge fund managers can access a wide range of trading techniques to generate higher returns and improve the fund's risk-return profile. One significant difference between mutual and hedge fund managers is that the latter can sell stocks they think are likely to lose value (a technique known as short-selling). Leverage is another strategy often used by hedge funds to multiply their returns on an investment. They borrow money to make a larger investment in an opportunity than the funds they already have at hand.
Greater Flexibility – Hedge fund managers have a lot more flexibility to invest where they see opportunities than mutual fund managers, such as across different asset classes or geographical markets, and that offers the potential of higher returns. However, it also means that the risks could be higher, and thus investors need to ensure they are investing with a fund manager with a track record of delivering on the hedge fund's investment aims.
Less Correlated To Public Market Volatility – While not all hedge funds do this, hedge fund managers may deliberately seek to either eliminate market risk or generate returns that are unrelated to the movements in the public financial markets. As a result, they are attractive additions to a diversified investment portfolio because their returns are less correlated to those from public markets.
What are the disadvantages?
Fees – Fees charged by hedge funds are quite commonly higher than those charged by mutual funds. Investors should educate themselves about these fees and take them into account before deciding to invest in any specific fund.
Transparency – Many hedge fund managers are loathe to share details of their investment strategy because they don't want to risk having their competitive advantage eroded by copycat managers. Thus investors in hedge funds may have to accept that they have little control or oversight over how the money is invested.
Risk – Though hedge fund managers have more tools at their disposal to manage risks, they can still potentially expose investors to risks. Some unique risks of investing in hedge funds include potential outsized losses from a concentrated investment strategy, or the use of leverage magnifying an investment loss. Investors should be aware of such risks before deciding to invest in any hedge fund
Lock-ups – Traditionally, hedge funds have lock-up periods whereby investors are not allowed to withdraw capital for several months or longer. Though not as restrictive as some of the other private asset classes, such lock-ups could create issues for investors needing to withdraw funds to meet unforeseen liquidity needs. However, ADDX offers users access to the ADDX Exchange, where they can buy and sell hedge funds listed on the exchange without lock-up restrictions.
Who can invest in hedge funds?
In Singapore, entry-level investments into hedge funds can run into millions of dollars, making them inaccessible to all but institutional investors and the very wealthy. ADDX, however, democratizes hedge fund investing by making it available to investors for as little as S$10,000 to invest in primary offerings and as little as S$100 to trade.
To qualify as an ADDX investor, investors need to meet one or more of the following conditions:
- Yearly income of at least S$300,000 or
- Net financial assets of at least S$1,000,000 or
- Net total assets of at least S$2,000,000
What types of hedge funds are there?
Long-Short Equity – These funds take so-called long positions on stocks they believe will rise and short positions on those they expect to decline. To build a long position, the fund managers usually buy the stocks. In contrast, to build a short position, the fund managers either use short-selling (borrowing stocks from a broker and selling them with the aim of buying back and returning the stocks after the price has declined) or derivative instruments such as put options (contracts that give the owner the right, but not the obligation, to sell the underlying stock at a set price).
Market-Neutral – These funds aim to generate positive returns no matter what the financial markets are doing by hedging out the market risk. To do so, the fund manager takes both long and short positions in stocks or stock indices, but together, the aim is to achieve a neutral market exposure.
Merger Arbitrage – These funds buy and sell stocks of two companies who have announced a merger, based on the fund managers' analysis of the share price valuations of the two companies and the merged entity if the deal goes ahead. Returns are generated if the fund manager's expectations of the merger outcome and share price valuations are met. For example, a basic merger arbitrage strategy involves buying shares in the company being acquired at a discount to the takeover price, with the goal of selling them at a higher price when the merger goes through.
Macro – The fund manager invests in assets including stocks, bonds, commodities and currencies based on predictions of large-scale macroeconomic events, for instance broad market swings caused by political or economic events.
The bottom line
The universe of hedge funds is vast and, even within a particular strategy, the way the hedge fund managers invest can be unique. While investing in a successful hedge fund can offer high returns relative to mutual funds, there are also risks that investors needs to be conscious of when deciding whether and how much to invest in a particular fund. Though hedge funds have historically been limited to institutional investors and the extremely wealthy, ADDX allows investors to buy into them for as little as S$10,000 (to participate in primary offerings) or even S$100 (to trade).
ADDX is your entry to private market investing. It is a proprietary platform that lets you invest from USD 10,000 in unicorns, pre-IPO companies, hedge funds, and other opportunities that traditionally require millions or more to enter. ADDX is regulated by the Monetary Authority of Singapore (MAS) and is open to all non-US accredited and institutional investors.
