Mutual funds are hedge funds

Hedge funds simply explained: a sensitive investment?

Their reputation is bad, but hedge funds are speculating on the financial markets with ever larger sums of money. Why do investors choose this risky investment? And can I also get involved as a private investor?

Hedge funds - for many laypeople, they are the epitome of the evil speculator. Only looking for your own benefit, without scruples and completely non-transparent. The former SPD chairman Franz M√ľntefering insulted them in 2005 as "grasshoppers" that attack companies like insects on a cornfield.

What is it about this bad reputation? How exactly do hedge funds work? And as a private investor can you also benefit from the investment funds of the super-rich? Our overview provides the answers.

What are hedge funds?

Hedge funds are among the alternative investment funds. In contrast to stocks and bonds, they are not traded on the stock exchange and - unlike conventional investment funds - are not accessible to everyone, very risky and hardly regulated. They can also do so-called short sales, i.e. bet on falling prices (more on this in the info box below). In order to be able to do this to the greatest possible extent, hedge funds may even be allowed in addition to equity Borrowed capital take up. That further increases the risk.

Originally, hedge funds were created for institutional investors, such as life insurance companies, pension funds and foundations, but wealthy private individuals can also invest in them. As a rule, wealthy means that if you want to get involved, you often have to invest at least 500,000 euros.

Hedge funds areactive investments. A fund manager takes care of the administration. Its aim is to achieve the greatest possible return, known as the return. To do this, he develops an investment strategy and selects the appropriate securities.

there are Single manager hedge funds with just one fund manager and Multi-manager hedge funds. In the case of the latter, it is assumed that the risk of making losses is lower because the return depends not only on the expertise and strategy of one person, but on several.

Big influence:
At the end of 2018, hedge funds managed a volume of around 3.1 trillion US dollars. You can therefore exert a considerable influence on states, companies and the entire economic system. The number of hedge funds has declined since the financial crisis of 2018, but the volume managed has increased. The USA is the largest hedge fund market.

How do hedge funds work?

As with traditional active investment funds, hedge fund managers equip their funds with what they consider to be the most promising securities. To do this, they analyze the prices of stocks and bonds, for example, and use financial mathematical methods to assess their Investment strategies to build. Then they put together the portfolio to match, i.e. the entirety of the assets in which you want to invest. The investors then buy fund shares.

For hedge funds there is no asset class restriction. So you can invest in stocks and bonds as well as in commodities, precious metals and currencies. More precisely: You can speculate on it. Because a special feature of hedge funds is that they - unlike traditional investment funds - so-called Short sales be allowed to operate, i.e. bet on falling or rising prices.

Example of a short sale:
The hedge fund manager assumes that a particular stock could soon decline in price. To bet on a falling price, he doesn't buy the stock, but borrows it from another investor for a period of time. As an example, let us assume that the hedge fund manager receives 100,000 shares in this way, which are worth EUR 100 each at the time of loan. Although they do not belong to him, the hedge fund manager now sells the shares directly on the stock exchange - and receives 10 million euros. In order for the manager to make a profit, the bet must now pay off: by the time he has agreed with the investor to return the borrowed shares, the share must actually fall in value. Let us assume that is the case: the share loses value and is only worth 90 euros shortly before the end of the loan period. The hedge fund manager then buys the 100,000 shares on the stock exchange for only 9 million euros and gives them back to the investor - so he takes a profit of 1 million euros from the sale. He then only has to deduct the interest that he has to pay the investor for lending the shares per day. The hedge fund therefore earns the difference between the sales proceeds and the repurchase price minus the interest as a profit.

The fund manager usually receives a Fee of up to 20 percent of the income. The investor also pays a administration fee of usually between 2 and 5 percent per year as well as where applicable Custody fees. If a hedge fund loses, the fund manager can simply close it and open a new fund. All he needs are new investors who believe in his strategy.

Another unique thing about hedge funds is that they too Borrowed capitalso Loans, allowed to record. The idea behind this is that they will generate higher profits because they are from the so-called Leverage effect benefit, too Leverage called. This works when the interest a hedge fund has to pay on the debt is lower than the interest on the equity. In relation to the equity capital employed, the return can increase many times over - but the hedge fund also accepts a higher risk.

The largest hedge funds (as of June 30, 2019):

  • Bridgewater Associates (USA): $ 132.050 billion
  • Renaissance Technologies (USA): $ 68,000 billion
  • Man Group (GBR): $ 62,000 billion

Why do hedge funds have a bad rap?

This is mainly due to the combination of theirs great scope for investment and the huge sums of moneywho manage them. So it is possible for them to act morally questionable, while at the same time they can exert considerable influence on the entire economic system.

Especially the Short sales Many people see it critically because they believe there is an oversupply of certain securities, which in truth does not even exist. In a crisis, selling short can lead to the price decline accelerating - and the hedge fund also earns from it because it later buys the stocks that have been sold short at the then lower prices.

Additionally Many hedge funds speculate on credit. If all goes well, a hedge fund will multiply its profit - but if the bet is lost, the hedge fund is threatened with complete failure because it has little equity. Critics complain that such a collapse is a great risk for the stability of the entire financial market.

How do hedge funds differ from traditional investment funds?

There are clear differences between classic active investment funds and hedge funds. We have summarized the most important in the table.

What investment strategies do hedge funds pursue?

The investment strategies of hedge funds are diverse and depend on the fund manager. Popular investment strategies include:

  • Long Short Equity: Here the fund manager buys stocks that he expects to rise and sells stocks that he expects to fall. Most hedge fund managers, however, rely on falling prices.
  • Arbitrage deals: Fund managers take advantage of price and exchange rate differences between currencies and securities at different trading venues.
  • Event-Driven: The fund manager speculates on sudden changes in the trend in sales of a company, on mergers, but also bankruptcies - both of companies and states.
  • Global macro: Here the manager looks at the historical and expected future price development of various asset classes and makes his selection for the fund on this basis.

What are the opportunities and risks?

Hedge funds promise enormous profits. But at the same time it is Risk of Losing Money, so huge. So Total losses are not uncommon. Whether a hedge fund is successful depends on the investment strategy and, to a not inconsiderable extent, simply on the luck of the fund manager. In addition, there is often a lack of transparency.

Do hedge funds make sense?

For normal private investors, hedge funds are not of interest simply because of the high entry barriers and costs. But even if you can easily shake half a million euros off your sleeve, you should consider carefully whether you want to accept the high risk.

In any case, as a private investor, you are prohibited from investing in hedge funds in EU countries. You can, however, take a detour via Fund of funds walk.

These are funds that hold shares in several hedge funds. The risk of suffering losses should be lower because many different investment strategies are in one basket, so to speak. If one doesn't come up, another might make up for the loss. Short sales for funds of funds are also only possible to a limited extent.

Indeed:You have to pay higher fees for funds of funds. Because you not only pay the manager of the fund of funds, but also all the individual managers of the hedge funds it contains.

Another way to invest in hedge funds indirectly is through the via Shares of the fund companies. In this case, you participate in the companies that set up and manage hedge funds, which also means a plus in transparency.

EU regulation of hedge funds:
The EU has been regulating hedge funds more closely since 2011. Managers of these funds now need approval. To get this, you have to hold a minimum amount of capital, which has to be higher, the riskier the fund is. In addition, hedge fund managers are under constant supervision. In Germany, this is done by the Federal Financial Supervisory Authority (Bafin). For example, the Bafin looks at how heavily a hedge fund is indebted, which investment strategy it is pursuing or how often it makes short sales.

Where did the name hedge fund come from?

The term can be traced back to short sales. The English verb "to hedge" means "to hedge" in German. And that is exactly what short sales are actually intended for.

If a fund manager buys gold for his fund, for example, he can hedge against a possible price fall by also short selling gold. If the investment in gold loses value, speculation on this falling price compensates for the loss.