Hedge funds are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies. Fund managers use advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns. For the most part, hedge funds are unregulated because they cater to sophisticated investors.
The majority of investors in the fund must be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. They are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year. Fund managers have a ridiculously high fee structure for taking big risks. A typical hedge fund has a two and twenty compensation package for performance. A flat 2% fee on total assets under management plus 20% on any profits earned by the fund. (Can you imagine getting a $200,000 bonus for increasing the value of a portfolio by million dollars)?
As a small investor, you should be aware that hedge funds have control of large pools of money. They can have a positive or negative effect on a stock and even an entire sector of the stock market. Here is an example: Carl Icahn made a huge investment in “Apple” shares. Carl put pressure on Tim Cook to spend some of its cash hoard to buy back shares boosting the share price. Very positive for the small investor who owned Apple shares
Carl Icahn had a very pubic battle with Bill Ackman, another hedge fund manager, over Herbalife. Bill was shorting the stock saying that it was a Ponzi scheme and Carl had the opposite view and was buying the stock
Can you imagine making nearly a billion dollar bet that a stock is over valued? The battle between just two hedge fund managers can have catastrophic effects on your investments. The chart below illustrates a two-year battle on just one stock.
I believe that you should be aware that hedge funds are making both positive and negative bets causing extreme volatility. They can change directions very quickly making your winning position into a losing position in the blink of an eye. Another example: GoPro Inc. had a disappointing earnings report yesterday. According to the business media, 64% of the outstanding shares have been sold short. Hedge funds are betting that the stock is going to continue to fall in price
There is no doubt in my mind that hedge funds are betting heavy in the oil sector. The opportunity to make huge profits resulting in big bonuses is far too tempting to play it safe.
“Twenty years ago, one bond-trading hedge fund grew from launch to over $100 billion in assets in less than three years. It saw yearly returns of over 40 percent. But by 1998, that firm was primed to expose America’s largest banks to more than $1 trillion in default risks. The demise of the firm, Long-Term Capital Management (LTCM), was swift and sudden. In less than one year, LTCM had lost $4.4 billion of its $4.7 billion in capital. “ The entire story is recounted in Roger Lowenstein’s book, ‘When Genius Failed‘,