What is a hedge fund?

What are hedge funds? A hedge fund meaning comprises a private pool of funds that involves different investment strategies to gain profits. It is a collective endeavor of investors who aspire to earn high profits. There is no well-defined set of regulations to process hedge funds. All the terms and conditions are defined by the partners collaborating to acquire profits through hedge fund strategies. 

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How a hedge fund works

Hedge funds take amounts of money combined from different qualifying investors in order to seek generous returns. This can be done through various strategies, usually those with increased risk – including taking concentrated positions, using leverage to invest, and others.

These funds are investments that happen when a fund manager invests a part of his or her assets in the other direction of the focus of the fund, making a hedged bet. As such, this can neutralize any potential losses in the main holdings.

Hedge funds that focus on travel or another cyclical sector may decide to invest some of their assets in opposite sectors. One example would be energy, which is part of a non-cyclical sector. The goal here is to use the returns coming from the opposite sector to negate losses in the focus sector.

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Hedge fund investors are often called “accredited investors”. Generally, these investors must have a minimum asset or income level. But when it comes to typical investors, this category usually includes institutional investors, which could be insurance companies, pension funds, and others.

Example of a hedge fund

There are many hedge funds on the market, but the most outstanding ones as of today include:

·  AQR Capital Management, with Clifford Asness as a founder. Based in Greenwich, Conn., it uses mutual funds to implement its strategies. In order to create good financial models, it uses quantitative analysis. It had $164 billion in assets on March 31, 2020.

·  Elliott Management Corporation has its main holdings in the energy sector. It has been around for 55 years, and it counts more than $50 billion in assets.

·  BlackRock Advisors was established back in 1994, and it has over $2.25 trillion under management.

Types of hedge funds

There are different kinds of hedge funds, each with its own goal:

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·  Relative value hedge funds

These hedge funds want to use temporarily related security prices and take advantage of them. Whenever there are any inefficiencies in spreads or prices, the fund will exploit them.

·  Global macro hedge funds

Global macro hedge funds take advantage of the fluctuations of the market caused by economic or political events. They are actively managed.

·  Activist hedge funds

With activist hedge funds, one would be able to invest in different businesses, and then try to increase the stock price. This may demand an asset reorganization, price cuts, or board of director changes.

·  Equity hedge funds

These hedge funds may either be specific to a particular country or can be global. An equity hedge fund will hedge against equity market downturns and invest in profitable stocks by decreasing stock indices or stocks with an overestimated value.

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How do hedge funds make money?

The very first hedge fund was created and launched back in 1949 by Alfred Winslow Jones, an Australian investor. He did it through A.W. Jones & Co., which was his company. He was able to lower long-term risk in stock investing by short selling after he obtained $100,000 and made a new type of fund.

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Jones decided to turn the fund into a limited partnership later in 1952, and then introduced an incentive fee of 20%, thus compensating his managing partner. As a result, he turned into the very first money manager who was able to mix leverage use, short selling, and a performance-based compensation system.

Nowadays, hedge funds have a “2 and 20” standard fee system – a performance fee of 20%, and a management fee of 2%.

Usually, the performance fee is 20% of profits. In case an investment goes from $1 million to $1.2 million within one year, the fund is entitled to $40,000.

Meanwhile, the management always depends on every investor’s share net asset value. As such, a $1 million investment gets a management fee of $20,000 in order to offer the fund manager compensation and cover the hedge’s operations.

How do hedge funds compare to other investments?

Hedge funds are unique when compared to other types of investments. Although a hedge fund is a pool of money just like exchange-traded funds and mutual funds, they are their own thing and have their own properties.

Their goal is to take high risks and obtain the best possible returns while doing so. Most of the time, they are controlled by professional managers. These people purchase and sell specific investments, aiming to surpass market returns or another index or sector of the markets.

Also, unlike other investments, hedge funds offer you more freedom to make investments into derivatives and options as they are not as strictly regulated.

Why do people invest in hedge funds?

People invest in hedge funds for different reasons. Usually, someone with a lot of wealth may notice that a particular hedge fund’s manager has a great reputation. Therefore, they will want to diversify into this fund. Other times, they might be interested in the strategies of the hedge fund or the assets in which it’s invested.

Common hedge fund strategies 

What do hedge funds do? They are financial partnerships that utilize pooled funds for the purpose of earning a positive return for the hedge fund investors. There are different types of strategies utilized in the process – some more aggressive, others more conservative. A hedge fund may use derivatives and leverage in order to increase the returns, or avoid high-risk instruments completely for a sure-fire result.

Long/short equity strategy

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This is one of the oldest hedge fund strategies. In this strategy, the fund manager buys those stocks which are expected to perform well in the future and shorts the stocks which are expected to be overvalued. Doing so profits the fund manager regardless of the fluctuations in the overall market. This shorting and buying of stocks brings good returns to the investor. 

Market neutral strategy

In this strategy, a fund manager buys the stocks that are expected to perform well in the market and shorts the stocks which are expected to underperform. Doing so offsets the profit and loss of both stocks and net market exposure becomes zero. So, the price movement of stocks determines the final outcome of investment rather than market fluctuations. This strategy is less risky but offers lower returns to the fund manager. 

Merger arbitrage strategy

In this strategy, the fund manager takes advantage of the price differences in the stocks before and after mergers. This strategy involves buying and selling of stocks through successfully completed mergers. The fund manager buys the shares in the target acquisition before the deal at a discounted rate and sells the shares at a higher price once the deal is done. 

Benefits of hedge funds 

Don’t take a hasty decision to call hedge funds a less beneficial investment option simply because it is risky and comprises illiquid capital. There are a wide range of benefits of having a hedge account. These benefits include:

Good financial portfolio 

Your financial portfolio will surely improve if you are using hedge funds. These funds are regarded as risky, but they turn out to be quite profitable assets. Hedge funds have aggressive investment strategies. Hedge funds can bring you positive returns in rising as well as falling equity and bond markets. These funds will reduce the overall portfolio risk. 

Less vulnerable to volatility 

Market fluctuations are one of the major concerns for investors. This problem increases if you are not aware of all the ins and outs of market trends. But hedge funds are never dependent on market fluctuations. Their dependence is on money-making assets, thus making them less vulnerable to volatility. This minimal correlation of hedge funds with the market fluctuations makes them a desirable investment alternative.

Diversification of investment methods 

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Hedge funds offer investors with a wide range of investment strategies, each one coming with its own set of advantages. Hedge fund managers can choose long/short equity, merger arbitrage, event-driven global macro strategies, and quantitative strategies. Possibilities of generating good returns are endless if you know the hedge funds definition and learn which hedge fund type suits your needs the best. Hopefully, this article was instrumental in familiarizing you with what is hedge fund and the various ways to bring in returns through using them. It’s one of the many ways to invest, and it may just be the right one for you. Do remember the risks of hedge funds and the fact that they are less liquid than mutual funds, requiring investors to keep money in the fund for a number of years.

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