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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 funds are one sort of institutional investment (Anderson, 2006).
This fund was introduced by Jones in 1949 but was not able to inspire many imitators by 1966. It grabbed attention through an article published in Fortune magazine, which described it as a fund realizing substantially higher returns than some other best performing traditional mutual funds. An increased interest in hedge funds was observed after this and many other hedge funds were also formed in the coming two years
According to Ackermann, McEnally and Ravenscraft, hedge fund is defined as an aggressively or more 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. Fung and Hsieh opine 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. atleast 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 different 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.
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 (Ackerman, McNally and Ravenscraft, 1999). In majority of the hedge funds, objective is to maintain the consistency of returns and preservation of capital rather than maximization of return’s 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) and families. Aim of this investor group is to minimize the overall portfolio volatility and add to returns (Fung and Hsieh, 2000).
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 (Liang, 2000).
Approximately fourteen different investment strategies are used by hedge funds, each of these offers different risk and return exposure. For instance, a macro hedge fund invests in equity & bond markets as well as other investments like currencies with a hope of arbitrage profit making by significant shifts over the securities according to information about global interest rates and economic writing policies, whereas, a distressed-securities hedge fund buys equity or debt of companies, which are about to exit or enter the financial distress (Fung and Hsieh, 2001).
According to Eichengreen and et. al. (1998), retail investors means to the individuals, involved in buying and selling securities for themselves on their own account via traditional as well as online brokerage organization. Some of the retail investors own portfolios amounting to be of millions of dollars, whereas others just own a few securities (Liang, 1999).
Generally, retail investing takes place via 4 different channels i.e. individual investors, retail brokers, managed accounts and investment clubs. Retail brokers act at the direction of the individual investors (Kosowski, Naik and Teo, 2007).
Retail investors as compared to the institutional investors have modest portfolios with a lower degree of acumen and less attention from the professional advisors have given adverse impacts over the retail investment. Collapse of corporate giants in early 2002 such as Enron and World.com plus the burst of the dotcom bubble has revealed the truth to the retail investors that more knowledgeable investment with research based stock recommendations is much important (Asness, Krail and Liew, 2001).
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 (Roth, 1995).
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, thus they have an inbuilt ability to stabilize the portfolio returns during market uncertainty (Baquero, Horst and Verbeek, 2005).
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 (Caldwell, 1995).
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 fulfill, 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 (Brown and et. al.1992).
Higher minimum investment amount requirement is a main disadvantage associated with hedge fund investments. Normal, small retail investors cannot invest in hedge funds due to this reason. But, this limitation has been resolved upto 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 mispricing 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 rumour based investments. Besides all these, many complex management biases are involved in hedge fund investments (Roth, 1995).
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. On the basis of the entire discussion, it can be said that Hedge funds are not meant for the retail investors. For retail investors, option to realize benefits of hedge funds remains to invest in fund of funds.
Ackermann, C., McEnally, R. And Ravenscraft, D., 1999. The performance of hedge funds: risk, return, and incentives. Journal of Finance. 54, pp.833-873.
Anderson, J., 2006. Barring the Hedge Fund Doors to Mere Millionaires. New York Times.
Asness, C., Krail, R. and Liew, J., 2001. Do hedge funds hedge? Journal of Portfolio Management. Pp.6-19.
Baquero G., Horst, J.T. and Verbeek, M., 2005. Survival, look-ahead bias, and the persistence in hedge fund performance. Journal of Financial and Quantitative Analysis. 40, pp.493-517.
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