Hedge Funds.Characteristics Example For Free - Free Essay Example

Institutional investment is defined as financially advanced investment forms that endow in substantial volumes. These are in the form of portfolios normally including large numbers of investments. Because of such advanced characteristics, the institutional investments are frequently done, involving private security placements; so as to escape from the securities regulations. Hedge fund is one sort of institutional investment This fund was introduced by Jones in 1949. He set up hedges through investment in securities chosen from the set of undervalued ones and funding such long term positions a part through short positions in some overvalued securities, Thus through these hedges, a market neutral position is created. Also, these funds were designed in such a way that incentive fee compensation was paid as a percentage of the profits attained from the clients assets. Besides, he invested his own capital in that fund to ensure an investment partnership. There is no specific definition about hedge funds but according to some authors, defines hedge fund as an appropriately assertively managed portfolio of investments using advanced strategies for investment including leveraged, long, short position and derivative trade in domestic as well as international markets to generate higher returns. explains that hedge funds are set up or established in the form of private investment partnerships which are available for a restricted set of investors requiring quite large initial investment. Hedge funds investments are illiquid in nature (mostly) because the money invested by any investor is not assured to be there for a long term i.e. at least for one year. Unlike mutual funds, hedge funds in majority of states are unregulated, since they cater or involve sophisticated investors. Hedge funds can be regarded as mutual funds designed for the super rich individuals. Such hedge funds are similar to mutual funds in the sense that in both funds, investments are to be pooled and further professionally managed. Still, significant difference is there in terms of flexibility of investment strategies. Hedge funds hold their origin in a popular risk management term i.e. hedging. Hedging is actually the practice of risk reduction, but on contrary, the aim behind most of the hedge funds is maximize the return on investment. Nowadays, dozens of differ ent investment strategies are used by hedge funds, thus they are just not meant for hedging risk, but with a speculative investment attitude of hedge fund managers, such funds involves more risk than the overall market. CHARACTERISTICS OF HEDGE FUNDS A variety of financial instruments are utilized in Hedge funds to condense the risk, improve returns and minimize the degree of correlation of the fund with the equity and bond markets. Majority of the hedge funds are flexible as far as the investment options are considered. These can employ leverage, short selling, derivatives like puts or calls, futures, etc. In terms of investment returns, instability and risk, Hedge funds are enormous. Most of the hedge fund strategies are aligned towards the goal of hedging against downturns in the markets being traded, but not all of them. Non market correlated returns can be generated through some of the hedge fund strategies In majority of the hedge funds, objective is to maintain the consistency of returns and preservation of capital rather than maximization of returns magnitude which is the best way to attract sufficiently large capital inflows along with retention of investors. Hedge funds are managed with the help of some experienced as well as disciplined and diligent investment professionals. Main investor group for hedge funds is the Pension funds, endowment funds, some private banks, insurance companies and HNIs (high net worth individuals). Aim of this investor group is to minimize the overall portfolio volatility and add to returns Managers for Hedge funds are usually specialized in particular sectors and trade only within the area of expertise. Managers remuneration in hedge funds is heavily weighted with the performance incentives to attract the best talent in this business, but this can also result in undue risks. Hedge funds largely involve the funds of the managers also, giving it a look of investment partnership form and assuring the investors for personal interest of the managers RETAIL INVESTORS According to retail investors means individuals, involved in buying and selling securities for themselves on their own account via traditional as well as online brokerage organization. Individual investors have reasons to make investment. This investment can be short or long-term goals such as providing for their ward good education, saving to acquire land, houses or setting up their own establishment in the near future. Retail investors invest a portion of their pay check in the workforce, in order to shoot the accumulated funds to provide a retirement earnings or to give part of their assets to their wards. individuals are investing for growth and to make sure all their investment are not in vain therefore they intend to invest in companies that makes a lot of profits and to bring good returns. ADVANTAGES OF INVESTING IN HEDGE FUNDS Through traditional asset allocation, use of equities, bonds, real estate and private equity investment can be optimized in a portfolio which result in return maximization and portfolio risk minimization. The same objective is pursued by hedge funds, as a result of which hedge funds have become a natural candidate for investment consideration. Hedge funds are commonly believed to have superior returns then retail or other investment alternatives. A professional management of fund minimize the risk associated with non research based investment decisions Returns of the Hedge funds have a very low correlation with the returns of the traditional asset classes such as debt, bond, equity etc. This lower correlation gives an advantage of the diversifying effect on a portfolio. Thus, asset classes with diverse correlations are not going to react in the similar way to the market conditions. As majority of the well-managed hedge funds do not act in alignment with the market movements, thu s they have an inbuilt ability to stabilize the portfolio returns during market uncertainty Hedge funds have a relatively low volatility. Institutional investments, by allocating more to alternative investments have reduced the overall portfolio volatility. Volatility is a measure of fluctuation. By less volatility, one can refer to more stability or minimized extremes associated with the portfolio. Hedge funds have the potential to realize sufficient returns for aggressive investors. One of the strongest reasons behind hedge fund investment is the nature it has to offer steadying hand over time for well-diversified portfolios In addition to the traditional hedge funds, many relatively new specialized hedge funds are popular. These are referred as hedge fund-like mutual funds. Such funds are basically mutual funds, which are engaged in hedging techniques up to some extent. Such funds offer certain advantages over the traditional ones including greater liquidity, lower fees, lo wer leverage and better transparency. Also, fund of funds are popular among the retail investors. Fund of funds is a hedge fund which invests in other hedge funds. DISADVANTAGES OF INVESTING IN HEDGE FUNDS Primarily, Hedge funds are speculative investment vehicles that employ a strategy of aggressive investment to magnify the returns. Such funds usually comprises of high end clients. This is because of the strict criteria posed on investors to fulfil, so as to partake in hedge funds. These funds are not regulated ones which is a serious limitation in account of the retail investor. This lessens the security factors of the funds. Main disadvantages are discussed in the below section Higher minimum investment amount requirement is a main disadvantage associated with hedge fund investments. Retail investors cannot invest in hedge funds due to this reason. But, this limitation has been resolved up to some extent by introduction of fund of funds. Also the Hedge funds involve great risk to generate higher returns. Hedge funds are comparatively less liquid. Investors are not able to buy or sell them whenever they wish. Also many a times, Hedge funds are mispriced. Because of this misp ricing risk, retail investors find it a less attractive investment alternative. As management fees are performance based, so there is a chance that managers could start taking much higher risk. This may be unfair for the retail investors. Hedge funds involve speculation based investments and rumor based investments. Besides all these, many complex management biases are involved in hedge fund investments RETURN AND RISK OF HEDGE FUNDS Hedge funds have become popular asset class among the HNI investors, since the early 1990s. The amount invested globally has rose from around $50 billion in 1990 to around $1 trillion by the end of 2004. As substantial leverage is used in these funds, a far more important role is played in the global securities markets by hedge funds. Hedge funds are bundled with some management biases. Correcting for such biases, hedge funds have lower returns than the supposed level. Furthermore, the funds have lower correlations with the market equity indices and thus are excellent diversifiers. Such funds are very risky. The cross sectional volatility and individual hedge fund returns, both are greater comparatively to the traditional asset classes. Considering the Hedge funds to be similar in risk terms to the other types of investments is a mistake. Risk in other asset classes is measured by quantitative metrics, but in case of hedge funds, risk is measured in qualitative terms making it u nique to evaluate and analyze. The most common measure of risk used for both hedge and mutual fund analysis is the standard deviation. Here, it is the level of instability in returns. Standard deviation gives a good indication of the variability of annual returns and makes it easy to compare to other funds when combined with annual return data. For instance, to compare 2 funds with similar annualized returns, fund with relatively lower standard deviation should be more attractive Particularly for hedge funds, StDev is not considered sufficient to capture total risk depiction of returns as for majority of the hedge funds, returns are not normally distributed. But, the standard deviation assumes a normal bell-shaped distribution where similar probability is assigned to different return prospects above and below the mean. Hedge funds involve several interesting characteristics which influence the performance. These include strong managerial incentives, sophisticated investors, fl exible investment strategies, substantial managerial investment and limited government oversight. Researchers have observed that hedge funds have consistently outperformed. Hedge funds are more volatile and their returns have been widely discussed in the literature. According to researchers Brooks and Kat, the published hedge fund indices are normally distributed exhibiting relatively low skewness. Return is measured and evaluated with the use of descriptive statistics mean and median. The risk is measured by the second and fourth moment. From investor perspective, this combined characteristic is important having derived with sufficiently weak assumptions with respect to investors utility functions that investors prefer first and third moments i.e. mean and skewness higher and second and fourth moments i.e. standard deviation and kurtosis lower. Higher value of skewness implies asymmetrical distribution of returns with the mean return sufficiently higher than median. Also, for hedge fund survival probability, profit analysis is designed. Here, a funds probability of survival is measured. A funds time to survival or more specifically the duration of a fund is examined in this method. Duration of a hedge fund is the time until a fund gets failure CONCLUSION In terms of investment returns, instability and risk, Hedge funds are enormous. Most of the hedge fund strategies are aligned towards the goal of hedging against downturns in the markets being traded, but not all of them. Hedge funds are managed with the help of some experienced as well as disciplined and diligent investment professionals. Main investor group for hedge funds is the Pension funds, endowment funds, some private banks, insurance companies and HNIs (high net worth individuals) and families. Aim of this investor group is to minimize the overall portfolio volatility and add to returns. Hedge funds largely involve the funds of the managers also giving it a look of investment partnership form and assuring the investors for personal interest of the managers. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive (absolute) returns under all market conditions. Although the returns from hedge funds are significantly high, still these are not able to attract the retail investors. Retail investors profiles are not matched with the investment motives behind the hedge funds. Hedge funds can be regarded as mutual funds designed for the super rich individuals. Such funds are similar to mutual funds in the sense that in both funds, investments are to be pooled and further professionally managed. Still significant difference is there in terms of flexibility of investment strategies. For retail investors, who are interested in realizing the higher returns from hedge funds as well as invest in lower proportion have the option of fund of funds.