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What is a hedge fund?

Find out what a hedge fund is and how these firms invest.

Hedge funds are difficult for most to understand. [©Shutterstock, 2010]
©Shutterstock, 2010
Hedge funds are difficult for most to understand.

Many investors often wonder, What is a hedge fund? The question is well deserved because hedge funds are one of the most glamorous and mysterious investment vehicles operating in today's market. As a class of investments, hedge funds have historically performed very well, generating high enough returns to beat market indexes and outperform safer, more traditional investments vehicles, such as mutual funds. According to the New York Times, some have even continued to generate billions of dollars in profit after the financial markets collapsed in 2008.

Hedge Fund Basics

Hedge funds are defined by a few important characteristics:

  • They often use complex investment strategies, e.g., short selling and derivative positions, to generate high returns
  • They are controlled by a single manager
  • They are open to only a small number of investors
  • They require a large initial investment (sometimes as much as $1 million)

Because they are not open to the general public, most hedge funds do not have to register with the Securities and Exchange Commission a government organization that protects investors by regulating the securities markets (stocks, bonds and mutual funds). This exposes investors to a relatively high level of risk, but it allows hedge fund managers to pursue aggressive, sometimes unconventional investment strategies.

Another notable aspect of a hedge fund is its fees. In general, hedge fund investors must pay both a management and a performance fee. According to the SEC, these fees usually hover around 2 percent of the funds assets and 20 percent of its profits, respectively. A high performance fee can be a drawback, but it can also encourage a manager to seek out greater returns.

A Quick Note on Short Selling

The classic strategy hedge funds use to minimize risk and prevent losses is short selling. As explained by Investorwords.com, instead of buying a security and hoping its value will rise (called going long), investors who go short borrow a security and sell it with the expectation that, after its value drops sometime in the future, they will be able to buy it back at a cheaper price. The technique is a bit advanced for the average investor, but it forms the foundation of most hedge fund management strategies.

Hedge Fund Strategies

Although there are a large number of strategies hedge fund managers use to generate profits, they can generally all be grouped into three broad categories: arbitrage or relative value strategies, even-driven strategies and tactical or directional strategies.

According to Investopedia, arbitrage works by exploiting price differences (also known as inefficiencies) in the same market or security. For example, if a company's stock is priced at $20 now, but is priced at $25 in a future contract, the investor can make a guaranteed profit of $5 by buying the first and selling the second. Pure arbitrage carries no risk, but hedge fund managers often look for price inefficiencies in securities that may move up and down independently, e.g., a convertible bond and a stock share from the same company, meaning the investors could lose money. However, arbitrageurs (hedge funds following an arbitrage strategy) usually produce reliable returns with only moderate risk.

Event-driven and tactical strategies are more complicated, but they share the same basic principle as arbitrage strategies—in order to make money, the fund manager uses short selling, derivative positions and other advanced investments to exploit price inefficiencies in the market.

Hedge Funds versus Mutual Funds

Mutual funds and hedge funds mainly have two things in common: they are both run by a single manager who controls the investor's money and they both invest in publicly traded securities. Because they seek relative returns—returns that beat an index or other benchmark—mutual funds are typically low-risk and reliable. Hedge funds, however, go for absolute returns, meaning they try to meet their goals regardless of how other investments perform.

The Future of Hedge Funds

After the financial collapse of 2008, investors and legislators alike called into question the future of hedge funds, a class of investments that had been growing strong for nearly 60 years. According to Investment Dealers' Digest, the main change likely to occur is to fee structures, which should shift from 2-and-20 to 1-and-10, i.e., a 1 percent management and a 10 percent performance fee. However, because of the enormous size of the hedge fund industry and its influence on the financial markets, fund managers may be required to disclose more information to government agencies in the future.

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