Market Basics: Hedge Funds

Intro to hedge funds

While reading journals or financial-related papers, you have probably come in contact with the term ‘hedge fund.’ Consequently, chances are you have asked yourself what a hedge fund is and what some of the key characteristics of this type of fund are. If you do not know yet, or simply feel like refreshing your memory, grasp the concept in this 4-5 minutes read.

What is a hedge fund?

A hedge fund is a pooled investment vehicle. This means that a multitude of private or institutional investors put their invested capital together. By doing so, they have a larger pool of capital to invest with and can generate larger returns.

What are some of the key characteristics of a hedge fund?

A typical trait of a hedge fund is that the managers are willing to face high risk levels in order to maximize profits. Most of them do not follow a long-only (read previous articles) strategy but many are also ready to short stocks.

A second characteristic of hedge funds is the fact that they are illiquid. Dependent on the strategy of the hedge fund, investors can be locked in for multiple years in the case of long-term strategies. Alternatively, investors can be granted access to their money at all times. This is often the case if hedge funds trust their investors to be reliant and not to remove their money in the scenario of poor stock performance.

Another characteristic which follows from the risky strategies taken on by hedge funds is the fact that managers of hedge funds are frequently inventivized through bonuses. A common example of this is the 2 and 20 arrangement. This entails that managers are compensated with an annual fee worth 2% of the assets under their control and a 20% bonus of the annual profits. Hence, managers are inclined to follow short-term gains, rather than adopt a long-term focus.

So what does hedging then refer to?

In common investor terminology, hedging means buying stocks with different correlations to the market to leverage out a portfolio and avoid over-reliance on the performance of a single investment. Having said this, hedging for a hedge fund refers to protecting the capital against a dropping market in a more general sense.

How are hedge funds used in practice?

Pension funds and money market funds usually use less complex investment strategies than hedge funds, as their clients are more risk-averse and would not be content with the level of risk involved with most hedge funds.

What typical investments are included in hedge funds?

The typical investments hedge funds tend to invest in are derivatives, creating leverage and not being shy when it comes to emerging markets. Although this probably seems like a rather general explanation, there is not much information available on the exact investments of hedge funds. In fact, they tend to be extremely secretive regarding their investments, out of fear that other hedge funds will invest in the same stocks as them and drive down their profits.

How can I invest in hedge funds?

Unfortunately, if an individual wishes to invest in a hedge fund, several conditions have to be met: The investor has to benefit from a certain level of regular incomes, have a net worth of at least USD one million and prove to have a certain level of knowledge in investments. Those restrictions are set in place, as hedge funds are currently not under strict supervision of financial authorities. Although this may change in the future, this is one of the reason why they can take risks of the aforementioned magnitude.

We hope you enjoyed reading and feel free to leave your thoughts in the comments below!