Hedge Funds as Investment Instruments - Essay Example

? Hedge Funds Introduction Hedge Funds are a particular kind for investment instruments in the form of collective investment in which the investors may invest capital in a speculatively manner in order to get more return than what the markets would otherwise offer. Hedge fund offers diversified investment opportunity to the investors. The hedge fund managers collect the money from the public and invest in diversified constituent of a hedge fund. The investors have the flexibility to withdraw their money at any point of time (Lo 40). Most of the hedge funds are devised in such a manner that they are able to generate return for the investors with the rate of return that is generally more than the market return and even in times when the market is not performing well due to recession or some other reason. However, a retail investor cannot invest in the hedge fund the same way as he would have done it for stocks or mutual funds. The operations of these funds fall beyond the control of any government regulation and hence it is mainly at the fund manager’s discretion that the investment portfolio would be designed, what strategies would be employed and which stocks are to be included. The main motive behind devising such a fund was to secure the funds from the market risk and to earn more return. Hedge Fund Management and Skill The management of this kind of investment product requires a lot of skill. The fund managers need to have an insight about the market and the various risk management strategies that can help the managers to cover the fund against probable losses and gain profits out of those risky situations. The managers and the investors of these kinds of funds need to be aware of the types of investment risks that they may come across. Since higher the risk taken higher is the possibility of return, the hedge funds often attempt at taking risks that may not be beneficial for the investors. The capabilities and expertise of management of the hedge funds cannot be determined from their past performances because there are a lot of fluctuations in the way the hedge funds tend to perform. If an investor tries to invest in a fund looking at the past performance he might face a lot of challenges because the fund may not perform as before. Hedge Funds and Luck Often the investors of a hedge fund are confused between luck and skill. The common people think that a particular fund performed well because of the efficiency of the manager. But it is not always the case. It might happen because of good luck as well. Most of the hedge funds do not encounter any kind of restrictions and hence their portfolios are not very diversified. For any risk averse individual it is highly risky to invest because the direction in which the market moves may not favour that particular fund. These kinds of funds often result in a mixed performance which may not be favourable for the investors in the long run. Hence, though the skill level of the managers is extremely important for prediction of the market and for choosing the correct investment avenue, the investors cannot rely on the intuition of the fund managers or their past performance solely. There is a luck factor and there should be a certain level of control of expectations on part of the investors because the markets may change its colour due to any kind of unprecedented event and hence may expose them to a risky situation. Hedge Funds and Insider Trading The agency theory is often applicable in case of hedge funds where the fund managers act as the agents of the investors. In most cases there exists an information asymmetry between the investors and the managers and the latter take this advantage for deriving undue profit from the market. Since Hedge Funds, are privately owned, they do not fall under the jurisdiction of any rigid regulatory framework. Thus the disclosure requirements of this fund are also less. Thus there may be problems of insider trading in case of hedge funds. The phenomenon of insider trading takes place when a fund manager makes use of any price sensitive information that may change the stock prices, to earn profits. There are a number of instances where fund managers have taken the advantage of insider price sensitive information to earn profits from the present market scenario. R. Rajaratnam was a hedge fund manager who was accused of being involved in such insider trading practices when he used the confidential information about the purchases made by Berkshire Hathaway to gain profits (Pulliam 2011). The person was arrested and sentenced with imprisonment. Wealth managers like John Paulson again became famous during the subprime mortgage crisis in the US in 2007. The strategies that this person took during that time earned huge profits on the collapse of the housing bubble (Vardi 2012). Such kind of profits may be considered as just luck or sheer speculation because the economy at that time declined drastically and most of the hedge funds suffered losses. Recommendations The hedge funds may not be a sound instrument for the common public to invest in. There is a lot of fluctuation and volatility in the performance of the funds and the fund managers may derive undue benefit out of this. Thus there should be more stringent regulatory framework regarding how these funds should be operated and there should not be any kind of asymmetric information between the investors and the managers. Thus proper investor awareness has to be ensured. There is the necessity for every fund management company to be transparent about their investment options and have to inform it to the investors. Risk Management has to be undertaken keeping the investors in mind. These funds may also face liquidity risk and thus methods should be adopted for diversification of these kinds of risks. Hence any kind of funds portfolio should be designed so that the risk is effectively diversified. The managers should not rely on speculation singularly. Works Cited Lo, W., Andrew. Hedge Funds: An Analytic Perspective. New Jersey: Princeton University Press, 2010. Print. Pulliam, Susan and Chad Bray. Trader Draws Record Sentence. 13 October, 2011. Web. 03 September, 2013. Vardi, Nathan. Billionaire John Paulson's Hedge Fund: Too Big To Manage.12 December, 2012. Web. 03 September, 2013. Read More