We continue series of posts based on the book “The Pragmatic Hedge Fund Manager” that will be published in the near future. Our first post was Part 1 on The History of Hedge Fund Industry. The second part was introducing Hedge fund trends and strategy recommendation for small and mid-sized Hedge funds for investors’ attraction while below we present the third part on Glossary of Funds, Hedge Funds and Alternative Investment.
Before we can start discussing anything else, we have to define what terms such as hedge funds and the alternative investment industry mean. Without knowing what they mean, it is impossible to move forward and develop a good understanding of the concepts and many details that are related to each of them. Thus, this section of the book will focus on introducing you to these terms and phrases in the simplest way possible. By the end of the segment, you will be able to pinpoint what each of them entails in general and will find it easier to make sense of the rest of the chapters.
So let’s begin by taking a look at the most basic of these which is ‘funds’. The word fund is typically used by many of us in our daily lives and we already have a somewhat relatively sound understanding of what it means. However, for our purposes here, it is necessary to view it strictly through the lens of the finance world.
A fund can generally be understood as an investment mechanism. It allows an individual to make an investment (which is usually a sum of money) as part of a larger group of people who want to do the same. They all pitch in to create what is then known as a fund. There are several reasons why people use this kind of a set up. This allows people to gather a quantity, which can potentially get them higher returns and helps them to enjoy what are known as economies of scale. It also enables them to hire a fund manager, a person with some training and expertise in the area. The fund manager then implements strategies and make decisions in order to steer the fund towards economic success.
This is why funds have become increasingly popular with time because it opens up avenues for people, which they alone would not be capable of getting access to. Today there are several different kinds of funds that exist, each of which has its own unique set of qualities and benefits.
Alternative Investment Industry
Let’s proceed to define the alternative investment industry. Alternative investments are all those investments that do not fall under the category of bonds, cash or stocks for instance real estate and precious metals such as gold and platinum. The alternative investment strategy includes all such actions, which have to do with these other kinds of valuables. One of the main characteristics of such investments is that they are kept under relatively much more secrecy and little information tends to be available regarding them, which is sometimes even true in the case of potential investors who may want to know more.
The industry also goes through less scrutiny by the government and as such has greater flexibility in the way it works and manifests itself. Secondly, not everyone can take part in this industry, as it is rather exclusive. The nature of the industry necessitates that a person must be able to meet the bare minimum cutoff for investment otherwise, they cannot enter into it. As this cutoff tends to be very high, it means that the general public will not be able to participate in it.
Hedge funds are also classified as being a subset of the alternative investment industry. They too are managed and run by a fund manager who has been hired specifically to ensure that the hedge fund performs well. He is also supposed to keep the investors up to date with all the latest trends in the market and discuss the subsequent strategies with them.
A hedge fund is a special high-end fund that employs a financial strategy known as ‘hedging’ to bring forth benefits. The practice itself is quite complicated but from the nonprofessional’s perspective, it can be seen as the trading of commodities such as stocks, options, swaps and several others by following a special pattern. In short, two such commodities are traded simultaneously so that in case there is any loss that occurs from trading one, then this can be compensated by the gains from trading the other.
The primary principle, which hedge funds operate upon, is that of reducing the overall risk that is involved. Once the risk has been shed, there is a better chance that the returns will be positive. Hedge funds have existed for a long time now but it was really during the 1980’s that people saw them as a force to be reckoned with. Ever since then, the industry has multiplied many times and more and more people have been drawn towards it. However, the fundamental characteristics of hedge funds have remained intact and only the super wealthy are able to take part in it.
However, the one thing we would like to add at this point is that modern hedge funds do not necessarily always make us of the hedging strategy. Many hedge funds and fund managers are now looking towards several other methodologies, which are relatively new on the horizon. Thus using the term hedge funds no longer specifically means that the process being used is hedging, as this would now be an incorrect assumption.
With a basic level understanding of these terms, it is now more feasible to move ahead and continue developing our knowledge of hedge funds and how they work.