They have a bad reputation, but hedge funds are still speculating on the financial markets with ever-increasing sums of money. Can I also get involved as a private investor?
The most important things at a glance
Hedge funds – for many laypeople they are the epitome of evil speculators. Only concerned with their own advantage, without scruples and completely non-transparent. In 2005, former SPD chairman Franz Müntefering called them “locusts” who attack companies like insects over a cornfield.
What’s with 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. Unlike stocks and bonds, they are not traded on a stock exchange and – unlike traditional mutual funds – are not accessible to everyone, are very risky and hardly regulated.
They can also make so-called short sales, i.e. rely 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 are even allowed to borrow outside capital in addition to equity. This further increases the risk.
Hedge funds were originally created for institutional investors, such as life insurance companies, pension funds and endowments, but wealthy individuals can also invest in them. As a rule, being wealthy means that anyone who wants to get started often has to invest at least 500,000 euros.
Hedge funds are active investments. A fund manager takes care of the administration. His goal is to achieve the greatest possible return, called return. To do this, he develops an investment strategy and selects the appropriate securities.
There are single manager hedge funds with only one fund manager and multi-manager hedge funds. With the latter, it is believed that the risk of making losses decreases because the return depends not just on the expertise and strategy of one person, but on several.
Big Impact:
At the end of 2021, hedge funds managed a volume of around 4.8 trillion US dollars. They can therefore have a significant influence on states, companies and the entire economic system. Although the number of hedge funds has declined since the financial crisis of 2008, the managed volume has increased. The US is the largest hedge fund market.
How do hedge funds work?
As with classic active investment funds, hedge fund managers equip their funds with what they consider to be the most promising securities. For example, they analyze the prices of stocks and bonds and use financial mathematical methods to form their investment strategies. They then put together the appropriate portfolio, i.e. the entirety of the assets in which to invest. The investors then buy shares in the fund.
There are no asset class restrictions for hedge funds. You can therefore make investments 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 – unlike classic investment funds – they are allowed to carry out so-called short sales, i.e. they can rely on falling or rising prices.
Example of a short sale:
The hedge fund manager believes that a certain stock could soon fall in price. In order to bet on a falling price, he does not buy the stock, but borrows it from another investor for a certain period of time. For example, let’s assume that the hedge fund manager gets 100,000 shares that are worth 100 euros each at the time of the loan. Although he does not own them, the hedge fund manager now sells the shares directly on the stock exchange – and thus receives 10 million euros. In order for the manager to make a profit, the bet must now work out: the share must actually fall in value by the time that he has agreed with the investor for the return of the borrowed shares. Let’s assume that’s the case: The share loses value and is only worth 90 euros shortly before the end of the loan. The hedge fund manager then buys the 100,000 shares on the stock exchange for only 9 million euros and returns them to the investor – making a profit of 1 million euros from the sale. All he then has to do is deduct the interest that he has to pay to the investors each day for lending the shares. The difference between the proceeds from the sale and the repurchase price minus the interest is thus pocketed by the hedge fund as profit.
The fund manager usually receives a fee of up to 20 percent of the return. The investor also pays an administration fee of usually between 2 and 5 percent per year and, if applicable, custody fees. If a hedge fund makes a loss, the fund manager can simply close it and open a new fund. All he needs are new investors who believe in his strategy.
Another special feature of hedge funds is that they can also borrow capital, i.e. loans. The idea behind this is that they generate higher profits because they benefit from the so-called leverage effect, also known as leverage. This works when the interest that a hedge fund has to pay for the debt is lower than the interest on the equity. In relation to the equity invested, the return can increase many times over – but the hedge fund also accepts a higher risk.
The largest hedge funds (as of September 2022):
- Bridgewater Associates (USA): 126,4 Mrd. US-Dollar
- Man Group (GBR): 73,5 Mrd. US-Dollar
- Renaissance Technologies (USA): 57 Mrd. US-Dollar
Why do hedge funds have a bad reputation?
This is largely due to the combination of their wide investment latitude and the vast amounts of money they manage. This makes it possible for them to act in a morally questionable manner, while at the same time having a significant influence on the entire economic system.
Many people are particularly critical of short sales because they pretend that there is an oversupply of certain securities that in reality does not exist. In crises, short selling can therefore lead to the rate falling faster – and the hedge fund also makes money from it because it later buys the shorted shares at the then lower prices.
