Why are hedge funds NOT suitable for retail (unsophisticated) investors? You res
ID: 1172099 • Letter: W
Question
Why are hedge funds NOT suitable for retail (unsophisticated) investors? You response must draw upon the two most important considerations. Your response may be framed around an average retail investor, in his mid-40s, who desires to create a nest-egg for his post-retirement needs, is unable to (or restricted to) invest in a hedge fund. 1. Explain the risks faced by the investor when investing in a managed investment scheme, such as liquidity (ability to move in and out of the investments) and transparency (ability to identify and value investments) Explain the constraints faced by the investor, such as capital (minimum capital necessary to invest) and sophistication (ability to understand or devise complex investment strategies) Show how mutual fund overcomes these risks and constraints, while Hedge funds do not. 2. 3.Explanation / Answer
Hedge funds involves complex transactions & the manager significantly changes the strategy time to time and thus, is usually not advisable for retail investors with retirement goals. Major risk and constraint faced by investors for investing in hedge fund are as under:
1) Risks:
a) Liquidity: Since hedge funds usually have lock up provisions, as such, they have liquidity risk , that is,investors cannot draw out their money within lock up time period.
b) Transperency: Since hedge funds manager have their own unique & complex derivative strategies, they don't disclose this to the investors for the risk of getting the idea public. However, this brings in transpareny risk for the retail investors who are not able to identity and value their investments.
2) Constraints:
a) Capital: As hedge funds involves more speculative transaction, uses more complex derivative and thus large transactions, capital investment need in hedge fund is generally high as against mutual fund, where investment with minimal investment can be done. This is thus, major constraint for a retail investor.
b) Sophistication: Hedge funds involves complex transactions, use of derivatives, short selling. Further, the manager significantly changes the investment strategy time to time and thus, is usually not advisable for retail investors, and is a constraint.
3. Following is the reason why mutual fund are able to overcome these risks and constraints:
1) Liquidity: Unlike hedge funds, mutual funds are open ended as well as close ended and includes plans with option to enter and exit anytime under open ended schemes and thus, overcome liquidity challenge faced by hedge fund.
2) Transparency: Unlike hedge funds, mutual funds are transparent and share investment details with investor. Investor know from time to time, where their money is invested and get periodical reports with details of investment in assets.
3) Capital: Unlike hedge funds which required large capital investment, mutual fund invesment can be done with minimal capital and have SIP options as well. They investment strategy are simple and less aggresive than hedge fund.
4) Sophistication: Mutual fund investment are as per plans opted by investors and are static in nature, which means, if particular plan is choosen , investment will be based on that. This makes it simpler. However, in case of hedge fund, the manager significantly changes the investment strategy & plans time to time to get higher return and uses complex strategy which is difficult to understand for retail investor.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.