With the numerous advantages, the hedge funds provide, it has some disadvantages as well because low regulation and aggressive strategies by the management to grow and generate higher return. The main disadvantages are
Higher Minimum Investment Amount Requirement: Hedge funds investment normally requires a very high minimum amount. That’s why only the high net worth individuals, pension funds, endowment funds, insurance funds, corporate funds can utilize this investment route. Normal small retail investors can’t invest in hedge funds. Though Fund of Funds has been formed for the small retail investors to make them enable to invest in hedge funds.
Higher Risk: Hedge funds mostly take higher risk to generate higher returns which increases the risk of losing money. One wrong huge investment decision can lead to huge losses for the entire hedge funds.
Lower Liquidity: Hedge funds have lower liquidity compared to other funds in the market. The investors can’t buy or sell instantly whenever they want.
Mispricing: The price of the hedge funds units is decided by the management itself which can lead to mispricing of the hedge fund net asset value (NAV). Because of this mispricing the buyers can end up paying more than actual or the sellers can end up receiving less than the actual amount.
More Risk to Improve performance: As the management fees are performance based, sometimes the managers end up taking much higher risk than the projected one to increase the return and performance. This can lead to huge losses because of unnecessarily high risk taking by the managers. Couple of such decisions can completely close the hedge fund and the investors can end up losing their all investments.
Short Selling and Margin Calls: Hedge funds have huge exposures in the short selling and margin calls which carries very high risk of losing money. These exposures can lead to loss for the entire hedge funds.
Rumor based Investment Risk: Hedge funds invest based on some event news of rumors which normally do not have any base. Investing based on these news can make them end up having huge losses and complete losing the entire investment amount.
Low Regulation: All the hedge funds are very much unregulated which increases the possibility of unfair trade practices and publishing of wrong information about the performance. Galleon Group hedge fund owned by Raj Rajaratnam is an example of such unfair trade practices (trade on insider information) because of low regulation. Because of these the investors become the worst affected.
Management Selection Bias: As the management publishes the performance report every time without any review and scrutiny, the management normally selects the best performing hedge funds and ignore the worst performed hedge funds to make the performance report more attractive. The worst affected hedge funds are withdrawn from the market without anyone noticing it except the investors who lose the invested money. The selection of best performing funds are done to attract more investors or customers and to increase the asset under management which is the most important parameter of a hedge fund.
High Management Fees: Hedge funds normally charge very high management and performance fees if the performance is good, which reduces the effective return to the investors significantly.
Lower Risk Management: Hedge funds normally have very low risk management process in place which makes them more vulnerable during any financial crisis or liquidity crisis situation.
In spite of the disadvantages the hedge funds are gaining popularity every day because of its numerous advantages. As per the latest “Financial Times” data, the combined Hedge fund asset value stands at around USD 2.9 trillion.