What is a hedge fund?

A hedge fund is a financial instrument that allows sophisticated investors to make risky investments. The most basic explanation of a hedge fund is that it’s an investment pool that can be leveraged to profit from market swings in almost any direction. Hedge funds provide investors with insurance against downturns as well as opportunities to profit from upturns.

What are hedge funds?

A hedge fund is an investment vehicle generally for high-net-worth individuals, institutions, and companies. The fund's goal is to provide superior returns (e.g., 20%+ per year), regardless of market conditions. The only way to accomplish that is to make bets on stocks, bonds, currencies, commodities and other investments. In doing so, a hedge fund makes large profits when things go well for it but incurs significant losses when they don't— known as beta risk or volatility risk.

A hedge fund is structured as a limited partnership or limited liability company that pools funds from accredited investors and invests in assets, including securities and derivatives, based on investment strategies. The hedge fund manager typically has extensive investment industry experience and skills including knowledge of advanced financial techniques such as option pricing, hedging and arbitrage. Each fund's strategy is unique and differs from other money management firms. Many hedge funds employ several hundred persons to assist in managing money for clients.

A hedge refers to investments designed to offset potential losses elsewhere in an investor's portfolio, especially those due to changes in currency exchange rates or commodity prices. These potentially-unstable values may be caused by either global events (like market fluctuations) or specific occurrences (such as accidents). Thus, hedge funds tend to employ speciality finance professionals who can identify and take advantage of mispricings in certain market segments which they believe they can hedge.

Although there are many characteristics typical to most hedge funds; these variables may be modified and vary considerably among the established investor base. However, because these types of investments are generally considered quite risky, only experienced professional stock traders should consider making substantial investments within them.

One of the common practices of new market players trading with these organizations is to leverage investing techniques so that more than their initial capital contribution is put at risk. While some critics view hedge funds as overly risky; others insist these investments are excellent additions to their portfolios providing diversification benefits without risking too much capital value. One thing that cannot be disputed about all types of investment vehicles within the financial services world today is that there is great demand for hedge fund products.

Characteristics of hedge funds

• Low liquidity

  Most hedge funds are not traded on stock exchanges and must be purchased in private transactions. The lack of liquidity makes these funds extremely risky for an investor, but can also reap great rewards.

• Low transparency

  Since most hedge funds are not publicly traded, it’s difficult to know what type of investment activities they participate in. There’s no guarantee that their performance data is accurate either. Many hedge fund managers will intentionally make investors think their fund has underperformed or lost money—but still, get paid out substantial fees from investors—making returns appear worse than in reality.

• High fees

  This is a big criticism against hedge funds by both critics and advocates alike. Most investors manage costs as a percentage of assets under management (AUM), or how much you have invested in your fund. For example, if you invest 1 crore into a fund with a 2% annual management fee, you would pay 2 lakhs annually just for service fees.

  While this may seem like a large amount of money upfront, remember that your investing success should cover these costs if your investments increase in value. Of course, there are hedge funds that charge way more than 2%, some even exceeding 30%.

• Extreme leverage

  Because hedge funds operate with less liquid assets, they often use financial instruments called derivatives to create highly leveraged positions. Leverage allows them to generate large profits on relatively small amounts of capital. But, leveraging too much means there’s a greater downside risk for investors when markets go down because losses multiply quickly since minimal capital was used initially.

Considerations on Hedge Funds

A hedge fund aims to maximize profits while minimizing losses by utilizing various investment strategies. These include long-short equity, fixed income arbitrage, merger arbitrage, convertible bond arbitrage and statistical arbitrage. A hedge fund may be characterized as either long/short or market neutral in orientation. Both are absolute return vehicles whose managers can benefit from rising or falling markets. Market neutrality refers to being hedged so that it is not exposed in one direction when other areas are performing poorly.

An overabundance of capital inflow into hedge funds has increased competition for investments in these relatively illiquid assets. This leads to funds seeking opportunities in less liquid assets such as emerging markets, distressed securities, convertible bonds, private equities and real estate.

A hedge fund offers competitive returns with limited risk, although there’s no guarantee you won’t lose money. Because of its relatively small capitalization (i.e., you aren’t investing in billions), it can be more accessible to private investors.