Participating in hedge funds as an alternative investment vehicle became increasingly popular after the 2008 financial crisis. A hedge fund is an investment fund that obtains capital from investors and invests in a variety of assets, focusing on diversification and risk management. Hedge funds seek to realize large capital gains without increasing the risk of losing an investment. They have been known to generate higher returns than other investments. A key element of hedge funds that public corporations’ investments lack is hedging. Hedging means reducing risk, while maintain or increasing returns on investment. Though in theory, investing in hedge funds can be beneficial for individual investors, current law prevents most individual investors from participating in hedge funds. Accordingly, mutual funds are likely the best alternative for individual investors to access the high return benefits of hedge funds while preserving the legal and regulatory requirements that public corporations offer.
Advantages and Disadvantages of Hedge Funds
This post will discuss four major advantages of hedge funds: (1) limited liability and flow-through taxation structure, (2) ability to reduce losses, (3) capital preservation, and (4) diversification. Most hedge funds in the United States are structured as a limited partnership with a separate limited liability company (“LLC”) that serves as its general partner. Here, investors will contribute capital in the form of limited partnership interests. This structure is beneficial for two reasons. First, there is no double taxation, as in a C corporation structure. Instead, there is a flow-through taxation, where there is no entity level taxation – only individual investors are taxed. Second, a limited partner cannot lose more than he or she invested in the partnership. The only time a partner would lose his or her investment in the partnership is when the limited partnership entity is unable to pay its debts as they become due.
A second major benefit of hedge funds is the ability of hedge funds to limit losses in terms of capital losses, as opposed to regular fund managers, whose goal is to limit risk in terms of short-term corporate profits. Third, hedge funds preserve capital because hedge fund managers use a range of investment techniques and invest in a wide array of assets to generate a higher return than what is expected of normal investments. In many cases, hedge funds generate a consistent level of return, regardless of market fluctuations. Fourth, hedge funds diversify investments, allowing investors to generate income regardless of whether the market is thriving or losing.
However, there are three main disadvantages to hedge funds that ultimately prohibit individual investors from participating: (1) the SEC’s requirement that investors be accredited, (2) decreased investor activism, and (3) higher agency costs because hedge fund managers have less fiduciary duties than a corporation’s board of directors. First, the SEC requires that hedge fund investors be accredited, which is the largest factor preventing individual investors from participating in hedge funds. While hedge funds avoid most regulations under the Securities and Exchange Act of 1933, the SEC’s accreditation requirement provides that an investor must have a net worth of at least $1 million, and must have a sophisticated understanding of personal finance and investing. Thus, hedge fund general partners and managers usually require that an investor put forth anywhere from $100,000 to $1 million to initially participate.
Second, hedge fund activism is not equivalent to shareholder activism in public corporations. Because hedge fund investors must be accredited, most hedge fund investors are institutional investors. This factor, combined with less transparency required by the SEC offsets most benefits that shareholder activism would otherwise have. Third, hedge funds managers do not have the same fiduciary duties to their investors as the board of directors in public corporations. Agency costs reflect the negative effects of managers pursuing self-interest agendas at the expense of shareholder interests. Thus, agency costs are more likely to occur where managers have less accountability to care for the interests of investors.
These downsides are unfortunate for individual investors, because hedge funds also have valuable benefits. Contrary to most public investments, hedge funds can produce a return on capital with a lower level of general risk than other equity investments. However, mutual funds provide the advantages of hedge funds while minimizing the disadvantages of decreased transparency and high cost.
Mutual Funds As an Alternative to Hedge Funds for Individual Investors
A mutual fund is a pool of stocks, bonds, and other investments owned by the fund’s investors. Mutual funds: (1) are governed by the legal and regulatory requirements of the SEC, (2) allow individual investors to actively participate in their investments, and (3) provide hedge fund like qualities of reducing risk in investments. All mutual funds are required by law to have a board of directors. The SEC monitors a fund’s compliance with the Investment Company Act of 1940. The Investment Company Act of 1940 (“1940 Act”)—the primary federal law governing mutual funds and directors—imposes specific responsibilities on independent directors and relies on these directors to monitor potential conflicts of interest within the fund. Moreover, the fund’s advisers have a fiduciary duty to represent the interests of shareholders.
Moreover, the SEC requires that the holdings of mutual funds be publicly available. Here, investors can reduce the risk of loss by diversifying their investments in a portfolio held by a mutual fund. Thus, investors can “hedge”—gain income both when the market thrives and loses, without incurring the high fees of hedge funds. Second, mutual funds allow for more investor participation than hedge funds, because mutual fund managers are more available to consult with individual investors about their portfolios, thus reducing agency costs and preserving the shareholder primacy model. Third, investors can engage in capital preservation as an investment strategy. This allows an investor to protect the capital they already have, instead of having to focus solely on short term return on investments. Accordingly, investors looking to stay within the law’s protection and increase profits should consider investing in mutual funds as an alternative to hedge funds.
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