What is a Hedge Fund?
A hedge fund is an investment vehicle that pools capital from accredited investors and employs various strategies to achieve high returns, often utilizing leverage and derivatives. Hedge funds are typically less regulated than mutual funds and can take more aggressive investment positions.
Definition of a Hedge Fund
Hedge funds are privately managed investment funds that seek to generate high returns for their investors through a range of strategies, including long and short positions, leverage, arbitrage, and derivatives trading.
Discover the wide range of funds available on UMushroom to help you grow your investment portfolio.
How Do Hedge Funds Work?
To fully understand how hedge funds work and what they try and achieve it is recommended to read through the Lexicon articles about ETFs and Funds (once more). ETFs were introduced as being efficient mechanisms to get passive exposure to the global markets at a low cost. Funds, or more precisely, Mutual Funds, also provide exposure to the global markets but they try and perform better than the markets through intelligent, active investing. Furthermore, in the piece on funds the concept of alpha and beta were introduced. Beta was defined as that part of the investment returns which are directly correlated with the global markets. ETFs deliver, on the whole, only beta. Funds deliver both beta and alpha where alpha is that part of the investment returns over and above the performance of the global markets. (And therefore it was noted that funds on the whole are more expensive than ETFs because delivering alpha takes skill).
Hedge funds deliver only alpha. At least that is the theory. A hedge fund manager believes he or she has a very specific experise in certain well defined money making opportunities. But since the overal direction of the global markets may not be part of that expertise the manager may choose to hedge (neutralize, disarm, etc) all exposure to those markets resulting in the holy grail of investing: regardless of the state of the global markets (whether they're going up, down or simply trending sideways) the hedge fund manager always makes money. What is not to like?
The main aspect to like therefore are the promised/implied positive investment returns, regardless of the state of the global markets. But investor beware! The holy grail comes at a cost. The obvious cost is the real cost of the manager who will often speak about '2 and 20' where the 2 refers to the 2% fixed annual fee and the 20 refers to the 20% of upside performance which the manager keeps for him or herself. Granted, since the 2008 financial crisis (when many hedge funds appeared not to be as hedged as hoped and lost a lot of money) these funds have become somewhat cheaper. The more hidden cost though is that it is not unusual for hedge fund managers to perhaps not be as good as promised leading to substantial invesment losses, if not total loss of all invested capital.
As a result, the average regulator does not believe the general public should have easy access to these funds and effectively does not allow 'retail investors' to invest in hedge funds. Implementation of this 'ban' has been realized through requiring very high initial investments into a hedge fund. Usually, an investor would need to have at least $1,000,000 available to invest in a hedge fund, the idea being that if an investor has that kind of money available to invest in a hedge fund then that same investor would probably not end up in an existential crisis if all of that cash was lost. Another person with that much money available comprising all of his or her life savings would not be well served by losing it all and therefore is effectively barred from investing in a hedge fund.
The question of what a hedge fund manager actually does is very simply answered: they can do anything which they believe will make them money. An excellent primer on the subject is actually the movie 'The Big Short' which revolves around a number of hedge fund managers and other smart investors who have a strong conviction that certain parts of the market (in particular real estate) are completely out of touch with reality. They proceed to put on huge 'shorts' (bets on a declining market) which initially results in them being the laughing stock of Wall Street. But they were right and went on to what might be called 'a killing'.
So these managers were shorting the housing market (and had they been incorrect in their view then all capital would have been wiped out). Other strategies include: equity long/short whereby the manager knows how to pick winners (and buys them) and losers (and sells them short, shortselling meaning selling something you don't own, strangely enough), the result being a 'market neutral strategy' generating pure alpha. Quant hedge funds are hedge funds driven primarily by computers programmed by an individual with ideas on how to make money by having a computer react very quickly to temporary 'market dislocations'. And the list goes on. But regardless, investing in hedge funds should and must not be done blindly which is the exact opposite of what might be said about investing in an S&P500 ETF managed by a leading ETF provider: such an investment is unlikely to be a disappointment over the long term.
On UMushroom, hedge funds are not well represented because of the considerations mentioned above: they are risky and opague.
Why Are Hedge Funds Important?
Hedge funds play an important role in making the markets more efficient. Our capitalist system relies on healthy companies staying in business and badly run/failing companies going out of business. The stock markets drive this process by allowing capital to flow to the healthy companies and away from the failing companies. But these markets can only do so much in that not buying the shares in failing companies does not necessarily drive the company out of business in the short term. To speed things up hedge funds may often step in and actively 'sell short' the shares of failing companies. This has the effect that there is large downside price pressure on those shares (making it very hard for the failing company to raise additional capital) and the negative publicity will further downgrade the failing company's future prospects.
This is one of many examples whereby hedge funds improve the efficiency of the global markets, sometimes making a lot of money in the process, though far from always! But they all try and make a lot of money, the fact that there are quite a few who don't should also serve as a warning that investing money successfully is not easy: in fact, let UMushroom lead the way!
In summary about why hedge funds play a significant role in the financial markets:
- Market Efficiency: Hedge funds often engage in active trading and arbitrage, contributing to market efficiency.
- Diverse Strategies: They provide investors access to alternative investment strategies that can enhance portfolio diversification.
- Potential for High Returns: Hedge funds aim for higher returns than traditional investments, attracting sophisticated investors.
Common Misconceptions About Hedge Funds
- "Hedge Funds Are Only for the Wealthy": Effectively this is true but institutional investors (asset managers) may invest pooled money in hedge funds meaning savings such as pension funds may have some investments in hedge funds too.
- "Hedge Funds Always Use High Risk": While some hedge funds employ aggressive strategies, others may focus on risk management and preservation of capital.
Conclusion
Hedge funds offer sophisticated investment opportunities that can enhance portfolio performance and diversification. Understanding how hedge funds operate is critical however to ensure investors make informed decisions about their investment strategies.
FAQs About Hedge Funds
Q: Who can invest in hedge funds?
A: Hedge funds are typically open to accredited investors, which include high-net-worth individuals and institutional investors.
Q: What are the risks associated with hedge funds?
A: Risks include market risk, liquidity risk, and the potential for significant losses due to leverage and aggressive strategies.
Q: How do I evaluate a hedge fund?
A: Consider the fund's performance history, investment strategy, fees, and the experience of the fund manager.
Related Terms
- Private Equity: Investment funds that provide capital to private companies or engage in buyouts of public companies.
- Mutual Fund: An investment vehicle that pools funds from many investors to purchase a diversified portfolio of assets.
- Alternative Investment: Investments that fall outside traditional asset classes, such as stocks and bonds.
