A hedge fund is an actively managed investment pool that is managed using a wide range of strategies. These strategies often include buying with borrowed funds and trading obscure assets in an effort to beat average investment returns for its investors.
Requiring a high minimum investment or net worth, means hedge funds are often reserved for the wealthy. Hedge funds are considered a risky alternative investment choice and are thought to be controversial.
But despite these factors, along with high management and transaction fees, the number of available hedge funds continues to grow.
How a hedge fund works
Hedge funds can invest capital anywhere in the market and use a variety of strategies, many thought to be risky. These two factors can make it difficult to generalize what a hedge fund does, but there are some characteristics that apply to most of them.
Most hedge funds have a preference for the public market investments rather than private equity investments. They also have a tendency to use less traditional trading techniques such as short selling or derivatives.
The name hedge fund comes from hedging, a financial term that means limiting the exposure to risk with the desired outcome of making the investment more secure or successful. In order to offset risk, hedge funds deploy various financial instruments or market strategies.
Diversifying the investments that make up the hedge fund is considered to provide less risk as they are not solely dependent on one asset class. Hedge funds make money by charging management fees which are calculated as a percentage of the assets under management and are typically around 2%.
In addition to management fees, hedge funds also charge performance fees. Calculated as a percentage of the profits from investing they are typically around 20%.
In recent years these fees have come under question and fund managers have faced mounting pressure to reduce management fees and step away from the traditional approach. Changes in the fees hedge fund managers charge are now being seen and the changes are thought to have been accelerated by the Covid-19 pandemic.
Historically, hedge funds have faced little regulation from the SEC as it is deemed investors in hedge funds are experienced and affluent enough to understand the risks.
In recent years, hedge funds have been subject to many changes in regulation with the introduction of the Jumpstart Our Business Startups Act (JOBS), a lifting on the ban of hedge fund advertising and the Form D requirement to notify the SEC at least 15 days before advertising to solicit new investors begins.
Couple these regulation changes with the growth in power of hedge funds and breaches of insider trading occurring more frequently, and it is thought that the SEC is now paying closer attention to them.
Types of hedge fund
Hedge funds use a variety of strategies including macro, equity, relative-value, distressed securities and activism. For example, a macro hedge fund invests in stocks, bonds and currencies in the hope that they will profit from changes in macroeconomic variables such as global interest rates or economic policies.
An equity hedge fund can be either global or country-specific and invests in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices. Whereas a relative-value hedge fund takes advantage of price or spread inefficiencies.
Popular hedge fund strategies include:
Long/short equity
Works by exploiting profit opportunities in potential upside and downside expected price moves. This strategy takes long positions in under priced stocks while shorting overpriced stocks.
Merger arbitrage
Involves purchasing and selling stocks of two merging companies to create riskless profits.
Global macro
This strategy bases its holdings on the overall economic and political views of various countries or their macroeconomic principles. Holdings can include long and short positions in equity, fixed income, currency, commodities, and futures markets.
Advantages of hedge funds
The advantages of hedge funds include:
Profits in many markets
Using a variety of investment strategies, including short selling means hedge funds can generate profits in both rising and falling equity and bond markets.
Increases diversification
Offering an array of investments means that hedge funds can increase diversification. Increasing diversification can help investors reduce their exposure to risk and market volatility.
Disadvantages of hedge funds
The disadvantages of hedge funds include:
Standard deviation
Hedge funds use a statistical tool called standard deviation to anticipate the risk in investing in a particular hedge fund. It can provide a good measure of potential variation in gains but cannot indicate the overall big picture of the risk return.
Leverage
Often overlooked when it comes to hedge funds, leverage can be the main factor in investors acquiring large losses. When leverage rises, any downsides in investment returns are magnified. This leads to hedge funds selling assets at a cheaper price and can contribute to hedge funds going bankrupt.
