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Investing in Hedge Funds: Pros and Cons

Just like all other investment instruments, hedge funds have advantages and disadvantages. This article enumerates the pros and cons of hedge funds.

Advantages of Hedge Funds

Contrary to the popular belief that hedge funds are very volatile investment instruments, hedge funds actually have many advantages over traditional investment vehicles like bond and equity investments. The following is a list of some of the advantages of hedge fund investment:

  • Hedge funds can achieve positive gains regardless of market trends, and they can reduce overall portfolio risk. As such, investing in a hedge fund can be a good strategy if you want a more balanced portfolio.
  • Hedge funds make available to investors a wider range of investment strategies as well as market focus. They serve as handy investment tools for sophisticated investors who want to quickly meet their investment objectives.
  • Studies have shown that hedge funds are more effective than traditional investment vehicles when it comes to minimizing risks as well as maximizing returns.
  • Since hedge fund performance is less dependent on the performance of bond and equity markets, hedge funds are a good long term investment option as they do away with the need for timing entry and exit from markets.
  • Since hedge funds employ more sophisticated and diverse investment strategies and have a wider range of markets to invest in, hedge funds offer a lot more diversification than traditional investment options.

Disadvantages of Hedge Funds

The biggest downside to hedge funds investing is the lack of readily available public information about hedge funds. Hedge funds need not register with the SEC. Thus, they are not subject to periodic reporting requirements. This means that ordinary investors who are interested in investing in hedge funds need to do a lot more work when researching a hedge fund than when checking out other registered investment instruments.

The following are some of the other disadvantages of investing in hedge funds:

  • Since hedge funds are not registered, they cannot be freely traded in the exchanges. Thus, hedge funds restrict investors' liquidity. If an investor has an immediate need for cash, he cannot simply sell his hedge fund shares.
  • Since hedge funds are largely unregulated entities, they can invest all or a significant part of their capital in a specific investment instrument, industry or sector. If a hedge fund does this, it can become very vulnerable to market risks.
  • As above-mentioned, hedge funds are not subject to periodic requirements. This implies less transparency and less available information that potential investors can use to assess hedge funds' performance, credibility and potential.
  • Hedge funds' managers are not limited in the amount of money they can borrow. Thus, one wrong decision by the general manager can bring down an entire hedge fund and its investors.
  • Finally, the lack of regulation also means that it's left to investors to assess whether or not hedge fund share prices are fair.

It should be noted, however, that even if hedge funds are largely unregulated, the same fraud protection that is available to investors in regulated or registered securities are also available to hedge funds investors.

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