What is: Hedge Funds…
Hello again everybody! This week’s post is going to be fun, but to be brutally honest, it will only be useful for 1 out of every 5 readers, probably less. But for those of you who are curious, or think that you are destined for the top 18.5% of America, this is for you. Inspired by a conversation I had with a friend a while ago, I’ve decided to do a “What is?” segment every now and then, and you are currently reading the very first edition. Truly history in the making.
So “what is” a Hedge Fund?
This can mean two different things, the first is obviously “A pile of money you have saved to purchase some bushes”, but that’s not the definition we explore today. The second definition is definitely more complicated. I think that to best explain what a hedge fund is, we should start with Mutual Funds, and before that, Stock.
Stock: Stock is essentially participation in a company. If you purchase a company’s stock, you are literally an owner of that company, and even have certain powers that come with that! Owners of stock (shareholders) are usually able to “vote their shares”, which means they get a say in who sits on the board of directors for the company. Also, if the company does well, the shareholders are entitled to a percentage of the profits (stock price increases). Obviously, this coin has two sides, and if the company performs poorly the shareholders will experience losses (stock price decreases).
Mutual Fund: The thing about buying stocks is that you really have to believe in the company you are investing in. If that company goes bankrupt, the shares you own may become worthless, and all the money you invested goes up in smoke. Mutual funds try to reduce that risk through diversification. A mutual fund is kind of like a cake. The mutual fund company buys a lot of different ingredients (stocks) and combines them into one cake (portfolio). It then sells thousands of slices of that cake (shares) to everyone at the party (investors). If you have a slice of that cake, it means that you own a very small part of a lot of different companies. The benefit of this is that if one company goes bankrupt, the losses are spread out over many investors, and hopefully gains from companies that performed well will offset this loss. However, you do have to pay the mutual fund company a fee for baking that cake (managing the portfolio), and you lose the ability to vote the shares, the mutual fund company gets to do that.
Hedge Funds: A hedge fund is like a mutual fund for the cool kids. If you want to invest in one, you have to be an accredited investor. This means that you have at least a $1 million net worth (not including your house) or you have earned $200,000 for the last two years (or $300,000 with a spouse). After everybody pools their money together, they agree to not take it out for a period of time (called a lock-up period), and they hand the reigns over to a fund manager. That guy has a stressful job, because it’s up to him to choose the investments, and he’s expected to make the money grow whether the economy goes up or down. To do that he will most likely use strategies that are way riskier than the “buy and hold” strategy of the mutual fund companies, such as “leveraging”, and “short selling” (I’ll dive into these another day). If everything goes according to plan, the fund manager makes wise decisions, the risky investments increase in value, and everybody walks away with a large profit.
Hedge funds are for people who like to take risks with large amounts of money. And yeah, they can be both massively profitably and a little sketchy! Hedge funds aren’t subject to as many regulations as other investment vehicles, and if they have less than $150 million in assets they don’t even need to register with the SEC (Securities and Exchange Commission)! The hedge fund is a high-risk, high reward, highly sophisticated investment vehicle, and definitely not a vehicle that everyone should be “driving”.
Earlier I said that this is really only important for 18.5% of Americans, that’s because 18.5% is the percentage of Americans that are allowed to invest in hedge funds (accredited investors). I have to say that percentage is much higher than I thought it would be. Keep in mind that just because you are an accredited investor, doesn’t mean that you should invest in hedge funds. Just because I can buy a live tiger doesn’t mean I should.
Now you know.
Here’s this week’s quote:
“Progress happens too slowly to notice, but setbacks happen too quickly to ignore.”
Want a “What is” article on something else? Have a good quote? Questions?
brett@centennialsec.com or use the “Contact” tab above
