What is a Hedge Fund?
A hedge fund is considered an alternative private investment vehicle. It is available to accredited investors with a net worth of more than $1 million excluding the worth of their primary residence and qualified purchasers with more than $5 million in investments. Hedge funds are designed to protect portfolios from market uncertainties and are intended to be able to generate positive returns in both up and down markets.
Benefits of Investing in a Hedge Fund
Hedge funds offer three key benefits: diversification, downside protection and a focus on absolute return. Hedge Funds invest in a wide range of area, which makes the worth of the hedge fund less dependent on a particular asset class, such as the stock market. These funds are also designed to be less volatile than a typical long-only portfolio, and seek to make a return in all kinds of markets.
How Hedge Funds Work
A typical goal of a hedge fund is to increase the investors’ money at the highest rate possible while adjusting for risk. A hedge fund requires an initial investment to be made toward the fund. This initial investment is then invested in anything of value, such as bonds, stocks, collectibles, real estate, startups, mutual funds or gold.
After a year, the fund’s revenue is calculated by subtracting the initial investment from the total net worth of the fund. Based on the operating agreement of the fund, the profit is then divided up between the investors and the managers. Most managers have to pay what’s known as a hurdle rate up front to investors before making any money themselves. A typical rate is about 4 percent of the profits. After the hurdle rate is taken out, a large portion, such as 75 percent of the remaining profits, would be returned to the investors and a smaller portion, such as 25 percent, would be given to the managers.
Shadow Accounting
Shadow accounting is used by traders, hedge fund managers, fund-of-fund managers, pensions, endowment funds and corporations. Shadow accounting offers investors additional protection for their funds and is critical for detailing investment earnings. Shadow accounting also helps managers to keep accurate records of the trades executed and valued, have an accurate calculation of the reported results and gives them the ability to evaluate the reported results of underlying managers in a fund of hedge funds.
84 percent of hedge fund managers use shadow accounting for the administrator who provides the Net Asset Value for the fund. 65 percent of managers say the primary reason to use shadow accounting is to provide a back-up that mitigates the risk of error in the fund’s finances. 76 percent of investors say it is important for hedge fund managers to maintain shadow accounting.
Variables Tracked in Shadow Accounting
The most common variables tracked include the following:
- Calculation of NAV
- Investment Valuation no-OTC
- Trade Processing
- Investment Valuation OTC
- Trade Reconciliation
- Cash Reconciliation
- P&L Production and Allocation
- Cash/Collateral Management
- Risk Reporting
- Partner/Shareholder Activity
- Investor Reporting
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