What is a Hedge Fund?
A hedge fund is an aggressively managed investment fund that is maintained by a professional management firm. Hedge funds are typically a portfolio of investments that makes use of advanced and complex investment strategies like short and long positions, leveraged positions, arbitrage, and derivative positions in domestic and international markets with the aim of generating higher returns. Hedge funds invest in a broad set of markets and employ an extensive variety of investment styles and financial instruments. The term hedge funds employs the varying hedging techniques conventionally used by hedge fund investors. This definition may seem confusing to understand; hence, traditionally, hedge funds are classified as any sort of investment company or private partnership that makes use of the below mentioned strategies and instruments:
- Long or short positions across varying asset classes
- Derivatives, such as options and swaps
- Financial leverage
Hedge funds are legally set up as private partnerships that are open to only a few investors and require a hefty initial minimum investment. Typically, investments in hedge funds are largely illiquid because it stipulates the money to be held in the fund for a minimum of one year.
Some common characteristics of hedge funds are:
- Hedge funds are usually formed as an unregulated investment pool and are domiciled offshore.
- Their performance is measured in absolute terms, which means that it is unaffected by market direction, and any benchmark.
- Hedge funds charge a performance fee. A performance fee is a payment made to a fund manager when they generate high positive returns for the investor. This fee is usually calculated as a fraction of investment profits.
- Hedge funds have fairly restrictive subscription and redemption policies and can even impose lock-up periods (a time duration within which hedge fund investors are disallowed from selling or redeeming shares) and gate provisions (this is a limit placed on hedge funds restricting them the amount of withdrawals from the fund for the duration of the redemption period).
- Hedge funds employ a combination of financial instruments to minimize risk, increase returns, and decrease the correlation concerning the bond and equity markets. Hence, many hedge funds are fairly flexible in their investment strategy options. Fund managers can use short selling, leverages and derivatives.
- Hedge funds greatly vary in terms of investment returns, volatility and risk. Most hedge fund strategies lean towards hedging against downturns in the market being traded.
- Hedge fund managers tend to invest their own capital along with that of their clients.
Typically, hedge funds are unregulated as they cater solely to sophisticated investors. The United States has made it mandatory for the hedge fund investors to be accredited. This implies that the investors must earn a minimum fixed amount of money each year and have a net worth exceeding $1 million and rudimentary knowledge about investment. Hedging is actually the practice of reducing risk; however, the name is now largely ceremonial as their aim is to maximize returns. The first traditional hedge funds were used to hedge against the downside risk of a bear market by shorting the market, however now many intricate techniques are used via hedge funds.
The different types of hedge funds are usually categorized as either fixed income or equity-focused. Subcategories of hedge funds are divided according to their investment techniques. Some common types of hedge funds include:
- Long-short funds: This is a common investment strategy used for hedge funds that entails taking a long position in stocks that are anticipated to increase in value and simultaneously taking a short position in stocks that are predicted to decrease in value.
- Market-neutral funds: This is an extension of the long-short hedge fund as it entails a combination of different investment strategies that the hedge funds have expertise in. These funds focus on making concentrated bets hinging upon observed price asymmetry whilst minimizing the general market exposure.
- Event-driven funds: This strategy entails taking advantage of pricing inefficiencies that can occur before or after a corporate event, such as bankruptcy, mergers and acquisitions.
- Macro funds: This strategy focuses on financial instruments that have a broad scope and operate based on systematic risk. Thus, fund managers trade within the context of broad global macro strategies (currency, interest rate, and stock index strategies).
- Absolute-return funds: Also known as non-directional funds, as the name suggests, this fund guarantees a consistent return regardless of the market direction. These are also known as alpha funds.
- Directional funds6: These are funds that do not hedge. Fund managers do account for some market exposure and they try to aim for the higher-than-expected return for the amount of risk undertaken. These are also called beta funds.