Hedge Funds: History, Advantages, Disadvantages, And Recommendations In The UK Economy

What is Hedge Fund

Write the a view about hedge fund on the history, advantages and disadvantages. Also include recommendation. Must be based on UK economy.

At the time of conducting the financial operations of the businesses, the financial managers of the companies are required to take into consideration many aspects of finance and accounts. One such aspect is Hedging. Hedging is regarded as a crucial investment position and the main intention of hedging is the offsetting of the potential losses or gains of the businesses can be arised as a result of different investment activities and decisions of the companies (Tauser and ?ajka 2014). It needs to be mentioned that the Hedge Fund is an important aspects of the process of hedging. Hedge fund is considered as an offshore investment fund that is formed as a private limited partnership and it involves in the speculation to use borrowing and credit capital. Hence, it is necessary for the business organizations as well as individuals to consider the aspects of hedge fund in the investment activities (Davies, Kat and Lu 2016). The main aim of this report is to analyze and evaluate various aspects of hedge funds.   

The above discussion provides a short overview about hedge fund. The follow discussion provides an in-depth overview about hedge fund.

Hedge fund is regarded as an alternative investment with the use of pooled funds that use different types of investment strategies in order to earn healthy return for the investors. The investment managers have the option to manage the hedge funds in aggressive manner in order to use investment derivatives and it can also be leveraged in both international as well as domestic market of United Kingdom in order to gain higher return from the investments. In this context, it is crucial to mention that only the accredited investors can use the hedge funds due to the fact that the requirement for investment related regulations is less for them. In addition, the presence of less regulation can be seen in the hedge funds as compared to other investment vehicles like mutual funds (Cao et al. 2013). The following discussion shows certain characteristics of the hedge funds:

• One major characteristic of hedge fund is that the qualified investors can only be able to use the hedge fund. For this reason, the Securities and Exchange Commission of United Kingdom can be considered as deemed qualified to bear the risks related to hedge funds.
• Another major characteristics of hedge fund is that it offers wider investment opportunities that the other funds (Aragon, Hertzel and Shi 2013).
• In the hedge fund, the investors have the option to use borrowed money in order to increase the return.

In this context, it needs to be mentioned that it is not an easy job to provide description about how hedge funds work due to the fact that all the hedge funds use different investment strategies. It is the responsibility of the investors to work out the risks related to the hedge funds and it largely depends in the intended strategies of hedge funds. However, the presence of some common facts can be seen in the operation process of hedge funds (Lan, Wang and Yang 2013).

Process to Work of Hedge Fund

In the operation process of hedge funds, the hedge fund managers have the option for the use of complex financial tools like the derivatives. In this case, they can use different types of derivatives like swaps, options and warrants (Davies, Kat and Lu 2016). The involvement of different types of terms can be seen with the derivatives; like ‘gearing’ and ‘short selling’. In case of hedge funds, gearing is regarded as the process to make large investments with the help of small deposits with the aim to magnify the profits and losses from the investments. On the other hand, short-selling is regarded as the process to sell something that the inventors do not own yet due to the possibility of decrease in the pries so that the investors can buy back them at cheaper price (Cao et al. 2013). In the working process of hedge funds, the investors have to largely rely on the skill and knowledge of the fund managers in order to make good investment decisions. The hedge funds do not provide the guarantee to provide good return when the stocks go up even the hedge funds have specialization in specific bonds. One crucial aspect is that the hedge fund managers have the right to charge specific fees based on their performance along with the annual fees on the bonds (Bebchuk, Brav and Jiang 2015). The working process of hedge funds can be explained with the following example:

In an hypothetical situation, Mr. Alex set up a business in UK named Global Investment Limited, LLC. As per the operating agreement, Alex will receive 25% of any profit over 3% per year and he also has the opting to invest in anything like mutual funds, bonds, stocks and others. In this situation, an investor invests £100 million into the hedge fund of Alex by writing a check and Alex puts it into the brokerage account by deploying it as per the guidelines. Alex has the option to use the money to buy a restaurant or to start a new business. Thus, the main purpose for Alex is to put the cash of the investors at the highest rate possible in order get healthy return from them. Now, for the sake of argument, Alex made an unbelievable investment in the year that doubles the asset of the company from £100 million to £200 million. Now, based on the agreement of the company, the first 3% belongs to the inventor with any amount more than that being split 25% to Alex and 75% to the investors. In this situation, there would be reduction in £100 gain by £3 million in the presence of the hurdle rate. The remaining of £97 million is split 25% to Alex and 75% to the investor. Thus, as per the net result, Alex receives £24.25 million as compensation. The investor receives £3 milling as hurdle and £72.75 million from the split (Bebchuk, Brav and Jiang 2015).       

Advantages of Hedge Fund

The above discussion shows the main working process of hedge funds. Now, it needs to be mentioned that there are some major advantage of hedge funds and they are discussed below:

Aggressive Investment Strategies: The use of aggressive investment strategies used by the hedge fund managers in order to gain higher return is considered as a major advantage of hedge funds. For example, the name of some of the major investment strategies can be mentioned like leverage, derivatives and others and these can be use un both the UK marker and the international market. The right of the investors to borrow and trade money on top of their gained capital can be considered as an aggressive strategy as it can enhance the scope to gain higher return and it also employs effective risk management tool in the process (Bollen 2013).   

Large Amount of Gains: Another major advantage of hedge funds is that the investors get the chance to obtain huge large amount of money by using the hedge funds in the investment portfolio. The main aim of the hedge funds is the acquisition of high return in spite of the presence of market fluctuations in the provided period. The strategy of ‘global macro’ approach can be presented as an example as this strategy helps in the forecasting of the investment opportunities in the future economic events of UK (Getmansky, Lee and Lo 2015).

Advice of the Experts: In the process of hedge funds, the investors get expert advice from the hedge fund managers and it is considered as one of the major advantages of hedge funds. In this process, the investors are required to pay handsome amount to the managers for their expert opinions as the managers are extremely experienced and knowledgeable in the areas of financial investments. This aspect increases the chance to gain higher return (Bollen 2013).  

Apart from the advantages, the presence of some of the major disadvantages can also be seen. They are discussed below:

Large Fees for Investment: The investors have to incur large amount of fees to the fund managers in order to make investments in the hedge funds. Fox example, the investors have to pay both the performance fees along with the management fees. This is highly criticized disadvantage of hedge funds (Stowell 2017).

Standard Deviation: The use of the statistical tool that is standard deviation is considered as another main disadvantage of hedge funds and it is used for the anticipation of the involved risks in the hedge funds. However, the failure of standard deviation can be seen in depicting the whole risk scenario related to the hedge funds (Lim 2015).

Disadvantages of Hedge Fund

Downside Capture: Hedge fund managers use downside capture, a risk management measure, for assessing the level of correlation of the hedge funds at the time of the decline of the market. However, the underperformance of this aspect can be seen in case the fund managers use it in case of widely different types of investment.

Drawdown: It is considered as a major statistic for the estimation of the overall rate of return on an investment as compared to the most recent highest rate of return. However, this aspect fails to provide the correct statistics in case the hedge funds do not perform constantly (He and Kou 2018).

It is required for the hedge fund managers to maintain some aspects in order to make correct hedge fund investments. These recommendations are provided below:

• It is needed for the hedge fund managers to set realistic investment goals as well as important schedule as they have to face disastrous consequences in case they rush to start a new hedge fund. For this reason, the recommendation for them is to make effective investment strategies for the selection of best hedge fund strategy (Soydemir, Smolarski and Shin 2014).
• As pet another recommendation, the hedge fund managers are needed to be cautious enough at the time of the consideration of the liquid alternative investments. For this reason, the requirement for them is the making of well informed decisions related to the registered products as well as investment services (Chen and Jung 2016).
• In order to make correct decision related to the hedge funds, the hedge fund managers are recommended to use the cloud based solutions rather than traditional on-premise solutions. At the same time, it is also the recommendation that the hedge fund managers need to put more focus on the development of disaster recovery plans (Soydemir, Smolarski and Shin 2014).
• It is recommended to the hedge fund managers to take into consideration all the operations risks related to the development of the hedge funds as the valuation of operational risks is considered as a crucial step for the development of correct investment decisions.
• For the investors, the recommendation is to do all the necessary research about the hedge fund industry for gaining in-depth knowledge about them and to get clear picture about the risk involved in the investment in hedge funds (Chen and Jung 2016).    

Conclusion

From the above discussion, it can be seen that there are many dimensions of hedge fund that both the investors as well as the hedge fund managers are needed to take into consideration. From the above discussion, it can be observed that there are some specific characteristics of hedge fund that the fund managers and investors are needed to take into consideration. The above discussion indicates towards the fact that the hedge funds work in a specific manner where both the investors as well as the hedge fund companies receives certain amount of money and it is beneficial for both of them. From the above discussion, it can be also seen that the hedge fund both have the advantages as well as disadvantages. Some of the major advantages are the presence of aggressive strategies, expert opinion, wider return and others. At the same time, there are many disadvantages of hedge fund like huge fees, standard deviation, downside capture, drawdown and others. For this reason, the above discussion provides some recommendations for both the hedge fund managers and investors for effective hedge fund investment.

References

Aragon, G.O., Hertzel, M. and Shi, Z., 2013. Why do hedge funds avoid disclosure? Evidence from confidential 13F filings. Journal of Financial and Quantitative Analysis, 48(5), pp.1499-1518.

Bebchuk, L.A., Brav, A. and Jiang, W., 2015. The long-term effects of hedge fund activism (No. w21227). National Bureau of Economic Research.

Bollen, N.P., 2013. Zero-R 2 hedge funds and market neutrality. Journal of Financial and Quantitative analysis, 48(2), pp.519-547.

Cao, C., Chen, Y., Liang, B. and Lo, A.W., 2013. Can hedge funds time market liquidity?. Journal of Financial Economics, 109(2), pp.493-516.

Cao, C., Chen, Y., Liang, B. and Lo, A.W., 2013. Can hedge funds time market liquidity?. Journal of Financial Economics, 109(2), pp.493-516.

Chen, J. and Jung, M.J., 2016. Activist hedge funds and firm disclosure. Review of Financial Economics, 29, pp.52-63.   

Davies, R.J., Kat, H.M. and Lu, S., 2016. Fund of hedge funds portfolio selection: A multiple-objective approach. In Derivatives and Hedge Funds (pp. 45-71). Palgrave Macmillan, London.

Davies, R.J., Kat, H.M. and Lu, S., 2016. Fund of hedge funds portfolio selection: A multiple-objective approach. In Derivatives and Hedge Funds (pp. 45-71). Palgrave Macmillan, London.

Getmansky, M., Lee, P.A. and Lo, A.W., 2015. Hedge funds: A dynamic industry in transition. Annual Review of Financial Economics, 7, pp.483-577.

He, X.D. and Kou, S., 2018. Profit sharing in hedge funds. Mathematical Finance, 28(1), pp.50-81.

Lan, Y., Wang, N. and Yang, J., 2013. The economics of hedge funds. Journal of Financial Economics, 110(2), pp.300-323.

Lim, J., 2015. The role of activist hedge funds in financially distressed firms. Journal of Financial and Quantitative Analysis, 50(6), pp.1321-1351.

Soydemir, G., Smolarski, J. and Shin, S., 2014. Hedge funds, fund attributes and risk adjusted returns. Journal of Economics and Finance, 38(1), pp.133-149.

Stowell, D.P., 2017. Investment banks, hedge funds, and private equity. Academic Press.

TAUŠER, J. and ?AJKA, R., 2014. Hedging techniques in commodity risk management. Agricultural Economics/Zemedelska Ekonomika, 60(4).