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7 Things you should know before investing in hedge funds | Hedge Fund Guide

7 Things you should know before investing in hedge funds

importantNavigating the hedge fund landscape is often a daunting task for newcomers to the alternative investment space. There are numerous concepts and terminologies which must be absorbed before you can begin searching through the thousands of potential hedge fund investments which are suited for your particular financial situation. Taking the time to brush up on the role hedge funds play within the broader financial market, and the metrics used to evaluate the performance of hedge funds will help ensure you make optimal investment decisions. Hedge funds are misunderstood by many investors, so its vitally important you do your homework to understand how the industry works.

Have a clear understanding of what you want to invest in.

Before you even begin your quest of finding a suitable hedge fund product – its vitally important to identify what you want to invest in.  Hedge Funds all typically charge a “two and twenty” fee structure -which means you are essentially paying for a particular hedge fund manager’s expertise about a certain market or product. Investors hope such expertise will generate greater returns through improved insight or knowledge of a particular market or asset class.

A good start pointing is usually to identify what type of asset class you are interested in. The alternative asset class space there are literally hundreds of possibilities. Once you have identified the market or asset you are interested in, be it wine, fine art, gold, emerging markets, or any other speciality investment theme- its time to start doing your homework on what hedge funds out there cater to your particular needs.

Ensure you are a qualified investor.

Hedge Funds are typically unregulated investment vehicles and as such, they do not offer the same degree of consumer protections available on conventional mutual funds.  Hedge Funds cannot market themselves to the general public and are typically only offered to high net worth individuals – people with over $1m in liquid assets excluding their primary residences. These rules are in force for a reason – hedge funds are generally the cutting edge of the financial industry, catering towards professional investors and investment banks who have a clear investment objective. Hedge Funds are not in the business of holding your hand as an individual investor. It is entirely your responsibility to conduct due diligence on any particular hedge fund – this leads us nicely into our next point.

Conduct due diligence!

Given the unregulated nature of hedge funds its vitally important that investors conduct thorough due diligence on any investment. There are several examples of very high profile hedge fund frauds in the past few years, Bernie Madoff being the most recent example, shocking the world by operating one of the biggest ponzi schemes in history!

Conduct due diligence again!

We cannot stress this point enough – investors must conduct through due diligence on any potential hedge fund investment.

Know your investment metrics

The main allure of hedge funds is that, when done well, they generate returns independent of the trend in global stock and bond markets, providing diversity to an investor’s portfolio. Hedge Fund investors look at various investment metrics. Statistical information such as sharpe ratios, correlation coefficients, alpha generated as well as data such as biggest draw downs and fund benchmarks all play an important role in evaluating hedge funds.

Screen for Hedge Funds based on your investment objectives

Hedge funds by nature are very non-transparent investment vehicles. Finding out performance data, fund manager information etc can be difficult when so little of this information is in the public domain. In response to this, several database providers exist which provide a vast array of information about hedge funds and their various financial and operating performance metrics. These databases often cost upwards of $1000 and are usually the domain of professional financial analysts and brokers. Screening for suitable hedge funds based on various metrics requires a significant degree of financial knowledge and analytical ability. If you do not have either it is important you find someone to advise you.

Exit strategies

Once you have found a hedge fund suitable to your financial objectives – its is important to understand the exit opportunities available to you as an investor.  Hedge funds are not like traditional stocks and bonds where you can enter and exit at any time – hedge funds are illiquid often closed investment vehicles with limited entry and exit opportunities. Most hedge funds adopt a lock up periods of up to two years in some instances.  In general hedge funds offer limited redemption windows where investors are able to submit requests to redeem any funds invested.

Hedge funds are an ever growing part of the financial landscape and its important for investors to understand how they are used to generate returns outwith the overall trend of the financial markets. Hedge funds often specialize in alternative asset classes which can be highly illiquid in nature and carry a much higher degree of risk than conventional funds. Hedge funds can however, play an important role for sophisticated investors with clear financial objectives.