The final part of our “investment basics” series will cover the wild world of hedge funds. Hedge funds get a lot of press for their high fees, big-ego portfolio managers and seemingly complex investment strategies. But are they truly the great investment vehicles their managers would have you believe, or are they “all hat and no cattle?”

First off, what is a hedge fund? In the investment world, the verb “to hedge” means to implement a strategy that reduces your risk or exposure to a particular type of investment. As we discussed in the last blog entry, farmers and bread-makers can hedge their exposure to the price of wheat by entering into futures contracts that guarantee both parties an exchange price. Similarly, investors can use options contracts to hedge exposure to stocks, currencies, or virtually any other investment vehicle out there. Hedge funds originally earned their name because they primarily focused on these types of hedging transactions.

Nowadays, the term describes pooled investment vehicles reserved for high-net-worth investors. Hedge funds often do hedge their investments, but it’s no longer a requirement to use the moniker. Some hedge funds will invest only in private equity, or company stock that does not trade on public exchanges. Some funds will pursue specific “macro” investment strategies using global economic data to make investment decisions. “Activist” funds will purchase large stakes in companies with the goal of streamlining their operations and unlocking shareholder value. In many ways, the average hedge fund looks quite a bit like the average mutual fund.

One big difference between the two, however, is fee. Mutual funds have annual expenses between 0.5% and 1.25% depending on the type of fund and share class. Traditional hedge funds charge “2 and 20,” meaning a 2% annual fee on assets, PLUS 20% of any profits generated by the fund. In the past, hedge funds have been able to achieve higher-than-average annual returns for their investors, thus justifying the high cost. Since the financial crisis, however, hedge funds have had significant difficulty beating their benchmarks and that fee has started to look mighty steep. In response, many funds have lowered their fee to “1 and 10” or something similar.

As for egos and personalities, you’ll be hard-pressed to find a more colorful cast of characters in the investment industry. Depending on who you ask, the villainous Gordon Gekko in Oliver Stone’s film Wall Street is based on a combination of Carl Icahn, Michael Milken, and Ivan Boesky, all names you’ve likely heard at one point or another, and all well-known for their brand of ruthless (sometimes not-so-legal) investment strategy. Other major names in the hedge fund field include Bill Ackman, David Einhorn, and Ray Dalio, the latter of whom leads the largest hedge fund in the world. 

Should you invest in a hedge fund? The honest answer is “probably not.” There is likely a cheaper, more orthodox method for achieving your investment goals. Hedge funds are typically also illiquid, offering limited redemption windows throughout the year. That being said, they are fun things to watch and their managers are often interesting individuals to follow. 

The above article is for informational and educational purposes only. Neither the information presented nor any opinion expressed constitutes a recommendation or endorsement by Gore Capital Management nor Cantella & Co., Inc. of a specific investment or the purchase or sale of any securities. 

Submitted by Ben Sadtler