Hedge Fund Definition
Hedge funds are privately pooled investment funds that use leverage and other non-traditional risky investment techniques to profit.
Hedge funds are distinguished from mutual funds and ETFs through their availability to the public. Unlike mutual funds and ETFs, which are available to the public, hedge funds are only offered to qualified investors.
What does ‘hedge fund’ mean?
Hedging means to reduce market risk. Therefore, traditionally, funds that shorted stock to hedge market risk were called hedge funds. In other words, in order to “hedge” risk, a portion of the hedge fund was devoted to a hedged bet against its core holdings.
- Hedging: protecting something against financial loss
- Shorting (short-selling): a trading method, where the person shorting the stock believes that they will buy back a profit when the value of the asset falls
In the present day, however, most mutual funds no longer have much to do with hedging risk.
Leverage and risky assets
One of the key features of a hedge fund is their ability of use leverage and risky assets as investment strategies. This is because, compared to mutual funds, hedge funds are less regulated by the Security and Exchange Commission. As a result, hedge fund managers are allowed to adopt riskier strategies that cannot be used in other types of funds.
What is leverage?
Leverage is defined as using debt to invest in financial assets so as to multiply returns. That is, hedge fund managers will often use borrowed money to buy more assets in order to amplify their returns (or losses) from an investment. While potentially profitable, leverage is considered extremely risky since it has the potential to wipe out the entire fund.
Aside from the use of leverage, hedge fund managers also invest in high risk financial assets, like options and futures.
Four major strategies:
There are four major investment strategies hedge fund managers use: (1) global macro, (2) directional, (3) event-driven, and (4) arbitrage. A manager can adopt one or multiple strategies in order to achieve risk management and diversification.
(1) Global macro strategies: identify investment opportunities and risk based on macroeconomic events.
(2) Directional strategies: identify investment opportunities and risk based on market movement, trends, and inconsistencies. An example would be emerging market funds being able to identify investment opportunities based on the growing market trends of developing countries.
(3) Event-driven strategies: identify investment opportunities and risk based on events such as the merger, acquisition, or bankruptcy of corporation.
(4) Arbitrage strategies: also known as relative value arbitrage, this strategy profits from the discrepancies in the price between assets.
Who can invest in hedge fund?
Unfortunately, not everyone is allowed to invest in a hedge fund. Under the Securities and Exchange Commission (SEC) regulations, only investors that have a net worth more than $1 million or an annual income of more than $200,000 are qualified to invest in hedge funds.
Furthermore, some hedge funds set their minimum qualifications even higher to reduce potential risk.
Examples of Hedge Funds
Some of the most famous hedge funds include:
- Long-Term Capital Management
- Appaloosa Management
- Quantum Group of Funds
- Bridgewater Associates
- Point72 Asset Management
How do hedge funds charge?
Hedge funds typically charge 2% of the assets under management and 20 % of the total profit yielded from its investment. Just remember 2 and 20!
Pros and Cons of Investing in Hedge Funds
Hedge funds are able to generate the highest possible returns through taking the highest risk.
- Pro 1: High return
- Con 1: High risk
Hedge funds are less regulated by the SEC compared to mutual funds and ETFs, making them able to invest in more types of asset classes than mutual funds or ETFs.
- Pro 2: Flexibility
- Pro 3: Access to more assets
The “2 and 20 structure” of a hedge fund’s fees are significantly higher than other investment options.
- High cost
