Compared to individual portfolios, such funds woo investors by offering several advantages namely: professional asset/money management, liquidity and more diversification than most individuals can create or afford in a personal portfolio. The brokerage’s motivation in recommending energy investments can be explained by the high commission that could be earned. Hedge funds charge a fee for assets under management and incentive fees based on a certain percentage of the profits earned. With good stock picking, the brokerage would be able to earn profits in both up and down markets.
A regional broker would want to offer hedge funds because they are only lightly regulated and thus the fund managers can use more advanced investment strategies such as a leveraged and derivatives positions. It is stated in their selling memorandum that their mission is to exploit investment opportunities in publicly traded companies in the energy sector. Hence, the fund seeks to generate above average returns relative to both S&P Energy composite and the broader market through a variety of investment
instruments. Also, the fund’s use of various strategies will be designed to minimize risk while maximizing potential return, again increasing the commission that could be paid to the hedge fund managers. This potentially high level of compensation helps the brokerage retain talented brokers and specialists, raising the reputation of the firm. Furthermore, investing in energy funds serves as a diversification tool. This is because from historical records, energy prices have had a high correlation with inflation.
In times of rising inflation, energy funds have been found to perform better than the market. Thus, they are able to act as a source of risk diversification. This explains the presence of a market for such energy funds. 1 In addition, energy funds have been a very popular fund with investors. The high dependence on oil in all parts of the world has made energy stocks a hedge for emerging market portfolios. With a demand for such energy stocks, a regional brokerage will want to cash in on this opportunity and offer energy funds.
In order to cater to a larger crowd of investors, the brokerage firm will offer energy hedge funds to sophisticated investors and energy mutual fund to general public who will like to invest in energy fund, but are unable to do so given their smaller amount of capital. Investing in energy funds is often complicated and risky, given the volatility of such commodities. Brokerage firms have a fiduciary responsibility to research on such funds before recommending them to their clients. They have to ascertain if the investments are suitable for the clients based on their age, investment experience and tolerance for risk.
In view of this, investors prefer a firm that can provide them with personalized services suited to their needs and risk tolerances. To be able to get these services, most of these investors go to regional brokerage firms. Such regional brokerages can deliver the attention to their clients due to their small size. Thus, with such demand in energy funds, regional brokerage firms would be able to make a profit out of offering such instruments. It will allow them to better position themselves in the market. 2.
Why did S&S start a hedge fund in addition to its energy portfolio The Energy portfolio is essentially a long equity fund for investors to buy stocks. It is stated that in their selling memorandum that the Energy Portfolio will seek to earn above average returns by investing in smaller and medium-size companies that are growing earnings and cash flow in a dramatic way. Therefore, it can only stand to gain when the market goes up. On the other hand, the introduction of the hedge fund will provide benefits to both its investors and the fund manager in the following ways: 2
For the investors, the hedge fund acts as a better investment for reaping returns in both bull and bear markets by having both long and short positions. Also, hedge funds are lightly regulated as compared to mutual funds and thus the fund managers can pursue more advanced and a wider range of strategies including leverages, derivatives, short sales, options and futures contracts. The flexibility in managing the hedge funds allows fund managers to exploit opportunities within the energy sector. The potentially higher returns attract investors with higher risk tolerance.
Hedge funds cater to sophisticated investors who earn a minimum amount of money annually and have a certain amount of net worth, along with investment knowledge. It helps to cater to the needs of the sophisticated investors and target a substantially different market from the mutual funds. This is in line with S&S’s corporate strategy of providing the best possible service to its retail customers and continuing to grow the asset management business. As for the fund managers, a hedge fund provides a radically different incentive package than the typical mutual fund.
The fees paid by investors are higher as compared to that for mutual funds, including additional fees that mutual funds do not charge. There are no restrictions on the fees a hedge fund manager can charge, as compared to mutual fund fees which are regulated and transparent. The energy hedge fund charges a 1% management fee, which is for the same service that the management fee covers in mutual funds. This fee alone may form a substantial part of the fund manager’s profit, thus making the management of the hedge fund attractive to the fund manager.