A hedge fund is a pooled investment that uses sophisticated trading techniques to make money for wealthy investors. According to Securities and Exchange Commission rules, hedge fund investors must be “accredited” -- they must meet certain wealth or income tests. LCH Investments NV reports that the top ten hedge funds through 2011 by net gains since inception are, in descending order, Bridgewater PureAlpha, Quantum Endowment, Paulson & Co., Baupost Group, Brevan Howard, Appaloosa Management, Caxton Associates, Moore Capital, Farallon Capital and SAC Capital.
Through the use of exotic financial instruments and aggressive trading strategies, hedge funds attempt to provide higher returns with less risk, as compared to other investment vehicles such as mutual funds and index funds. Investors pay a steep price: hedge fund managers normally take 20 percent of profits and 2 percent of assets under management. Hedge funds may limit the size and timing of investor withdrawals. Hedge funds oversee over $2.1 trillion in investments, according to The Economist.
Benefits of Hedge Funds
A successful hedge fund provides steady returns in any market environment. An investor increases portfolio diversification by including hedge funds, as these funds execute many trading strategies with returns that are not closely correlated to returns from the stock and bond markets. Foreign investors can benefit from tax advantages provided by offshore hedge funds operating in tax-free havens such as Bermuda and the Cayman Islands. Hedge funds can give investors access to private investments not available to the general public.
Reality or Illusion?
Simon Lack, a veteran JPMorgan investment banker, writes in “The Hedge Fund Mirage” that throughout their history, the average hedge fund has underperformed Treasury bills, which are risk-free. Lack points out that the hedge fund universe has undergone explosive growth since 2003, but that hedge funds had better performances when the industry was smaller. He blames marketing for hyping the benefits of hedge funds relative to the costs. Hedge fund managers have prospered, receiving 84 percent of all profits since 1998, according to Lack.
Performance in 2012
The S&P; 500 stock index rose 18 percent in 2012. In the same year, hedge funds rose 3 percent, according to the HFRX hedge fund index. The year 2012 marked the tenth straight year hedge funds lagged behind the S&P; 500, with the exception of 2008 in which both measures fell sharply. The Economist reports that, over the period of 2003 to 2012, a portfolio composed of 60 percent stocks and 40 percent in government bonds returned a total of 90 percent for the period. During the same time, the total after-fee returns from hedge funds were 17 percent.
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