Hedge funds are investment tools that are out of reach for the average investor
A hedge fund is a limited partnership of private investors whose money is managed by professional fund managers who use a wide range of strategies, including leveraging or trading of non-traditional assets, to earn above-average investment returns.
Hedge fund investment is often considered a risky alternative investment choice and usually requires a high minimum investment or net worth, often targeting wealthy clients.
Understanding the Hedge Fund
The term "hedge fund" defines this investment instrument as the manager of the fund often creating a hedged bet by investing a portion of assets in the opposite direction of the fund's focus to offset any losses in its core holdings.
A hedge fund that focuses on a cyclical sector such as travel, may invest a portion of its assets in a non-cyclical sector such as energy, aiming to use the returns of the non-cyclical stocks to offset any losses in cyclical stocks.
Hedge funds use riskier strategies, leverage assets, and invest in derivatives such as options and futures. The appeal of many hedge funds lies in the reputation of their managers in the closed world of hedge fund investing.
An investor in a hedge fund is commonly regarded as an accredited investor, which requires a minimum level of income or assets. Typical investors include institutional investors, such as pension funds, insurance companies, and wealthy individuals.
Investments in hedge funds are considered illiquid as they often require investors to keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.
Types of Hedge Funds
Hedge funds target select investments and pools of securities primed for gains. Four common types of hedge funds include:
Global macro hedge funds are actively managed funds that attempt to profit from broad market swings caused by political or economic events.
An equity hedge fund may be global or specific to one country, investing in lucrative stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices.
A relative value hedge fund seeks to exploit temporary differences in the prices of related securities, taking advantage of price or spread inefficiencies.
An activist hedge fund aims to invest in businesses and take actions that boost the stock price which may include demands that companies cut costs, restructure assets or change the board of directors.
Common Hedge Fund Strategies
Hedge fund strategies cover a broad range of risk tolerance and investment philosophies using a large selection of investments, including debt and equity securities, commodities, currencies, derivatives, and real estate.
Common hedge fund strategies are classified according to the investment style of the fund's manager and include equity, fixed-income, and event-driven goals. A long/short hedge fund strategy is an extension of pairs trading, in which investors go long and short on two competing companies in the same industry based on their relative valuations. A fixed-income hedge fund strategy gives investors solid returns, with minimal monthly volatility and aims for capital preservation taking both long and short positions in fixed-income securities. An event-driven hedge fund strategy takes advantage of temporary stock mispricing, spawned by corporate events like restructurings, mergers and acquisitions, bankruptcy, or takeovers.
How Do Hedge Funds Make Money?
Australian investor Alfred Winslow Jones is credited with launching the first hedge fund in 1949 through his company, A.W. Jones & Co. Raising $100,000, he designed a fund that aimed to minimize the risk in long-term stock investing by short-selling, now referred to as the long/short equities model.
In 1952, Jones converted his fund to a limited partnership, added a 20% incentive fee as compensation for the managing partner, and became the first money manager to combine short selling, the use of leverage, and a compensation system based on performance.
Hedge Fund vs. Mutual Fund
Hedge funds differ from mutual funds and hedge funds are not as strictly regulated by the Securities and Exchange Commission (SEC) as mutual funds are. Mutual funds are a practical cost-efficient way to build a diversified portfolio of stocks, bonds, or short-term investments and are available to the general public and average investor. Hedge funds can only accept money from accredited investors which includes individuals with an annual income that exceeds $200,000 or a net worth exceeding $1 million, excluding their primary residence. These investors are considered suitable to handle the potential risks that hedge funds are permitted to take.
The current market for Hedge fund looks....to be continued!
By Sunny Wadhwani
December 4th, 2022
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