Day trading and hedge funds are related. They both can generate substantial returns and significant losses for investors, which makes them hazardous investment vehicles. However, are hedge funds day traders?
Hedge funds are not day traders, but they can use a day trading approach to their investments. Hedge funds contain many individual investors, and a fund manager manages them. Managers can day trade with the fund, but they combine other techniques to minimize risks and increase returns.
In this guide, we will take a look at the differences between hedge funds and day trading. We will also address how to choose a suitable hedge fund.
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Table of Contents
What Is a Hedge Fund?
A hedge fund is a pooled fund (a fund that contains many individual investors). It uses an extensive range of strategies to earn the best return for its investors. Hedge funds are regulated with less intensity than most pooled funds, making them a most popular option.
Hedge funds have a particular structure to take advantage of a specific market. As they face fewer regulations, the number of investors allowed in a fund is limited. Nowadays, hedge funds tend to underperform compared to how they were before the financial crisis of 2008.
A critical aspect of a hedge fund is that it is an illiquid form of investment. Most hedge funds stipulate that investors keep their money in the fund for at least a year before withdrawing. On top of that, hedge funds tend to allow withdrawals only once or twice a year.
Fund managers and other essential staff are in charge of managing every strategy and position of the fund. The bigger the fund, the more people it will need, and the more it will cost to run the fund.
What Are the Main Features of a Hedge Fund?
There are many pooled funds in the market. You will find mutual funds, exchange-traded funds, pension funds, and of course, hedge funds. They have many similarities but also differ in crucial elements.
Here is a list of the essential characteristics of a hedge fund:
- Only accredited investors are allowed in a hedge fund. The Securities and Exchange Commission only allows investors with a total net worth of 1 million USD or an annual income that exceeds 200,000 USD. They do this because hedge funds require more capital to invest, leading to possible significant losses. So, the commission only lets investors that can handle the risk.
- Hedge funds can invest in almost anything. Mutual funds, another form of pooled funds, can only invest in stocks or bonds. In contrast, hedge funds can invest in land, real estate, stocks, derivatives, or currencies.
- Hedge funds employ leverage. Hedge funds will frequently use leverage to increase profits. This means that they will use various financial instruments or borrowed money to make a more significant investment and increase the potential return.
- They have a unique fee structure. Hedge funds use a fee structure known as “2-and-20.” This means that hedge funds charge an expense ratio and a performance fee. The expense ratio equals 2% of the assets, and the performance fee is 20% of the return. The 2% that managers receive from the assets is highly controversial, as they receive the fee even when the fund sees no return.
The Risks of Using a Hedge Fund
Hedge funds also present unique risks. As they only allow investors with considerable wealth, they can do pretty much anything if they are upfront about their investment strategies. There are unique risks that are present only in hedge funds.
Here is a list of the unique risks of using a hedge fund:
- Hedge funds are exposed to considerable losses, thanks to their concentrated investments.
- Hedge funds require their investors to lock up their money for years (meaning no withdrawals until further notice).
- As they use leverage for their strategies, a minor loss can turn into a significant one.
How to Pick a Hedge Fund?
Most hedge funds will require you to lock up your money for at least a year, so be careful of which fund you choose. There are a lot of things to consider when choosing a hedge fund.
Here is a list of what to take into consideration when choosing a hedge fund:
- The Fund Absolute Performance Guidelines: Before choosing a hedge fund, you should always look at the annual return rate (the profits a fund made over the previous years). Compare each fund’s returns and strategies to choose the one that accommodates your needs.
- The Fund Relative Performance Guidelines: The next step is to compare each fund’s market. A hedge fund that focuses on global markets using leverage will usually make a better return than a long equity fund. So, make sure you compare each fund’s strategies and markets to make an intelligent decision.
- Fund or firm size: To some, a fund or firm must be big to be trustworthy. To others, a big fund might have difficulties overperforming itself. It is a matter of what you want and what you believe is the right option.
- Track record: Most investors prefer funds with more than 24 or 36 months of existence. However, some managers start new funds after having a high track record. You can find them and decide for yourself.
- Minimum investment: Individual investors will usually choose a fund that requires a lower minimum investment.
The largest hedge funds worldwide are Bridgewater Associates and Renaissance Technologies.
What Is Day Trading?
Day trading means buying and selling positions within one trading day. This can maximize the return of the investments but can also increase the losses.
Day trading is considered a high-risk trading strategy, as 97% of day traders will lose almost all their money. Only 1% of day traders are successful in the trading business.
A profitable day trader requires many hours of in-depth knowledge of the markets and positions to get the best returns. They need dedication, discipline, and other skills to be successful.
The Controversy Between Hedge Funds and Day Traders
There is some controversy between hedge funds and day traders. Many hedge fund managers and traders will use some form of day trading techniques. However, in reality, many hedge funds are losing money, thanks to the increase of day traders worldwide.
What happens is that day traders will buy a stock, making the price go higher, but then they sell the position and take their returns, making the price go lower. This market volatility is useful for day traders but not for hedge funds that focus on long-term positions.
In today’s market, hedge funds are underperforming more and more each year. Some attribute this to the rise of trading platforms and day trading.
Day traders are taking the upper hand when compared to most hedge funds, as some hedge funds can make a return of 20% to 40% on a good year, while the top 1% day traders can make a return of 200% or even 300%.
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Conclusion
Day trading is a trading strategy that allows you to minimize overnight risks by buying and selling positions within a trading day. It is a high-risk strategy, but it can lead to considerable returns.
Hedge funds are pooled funds that use different techniques to increase return for their investors. A hedge fund manager can use day trading techniques, but they will also use other trading techniques that do not qualify as day trading.
Overall, hedge fund managers and day traders share a lot of similarities. However, many argue that day traders are making it more difficult for hedge funds to succeed.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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