What is a Hedge Fund

A hedge fund is a private investment fund that manages third-party securities to cover them against possible and eventual risks, as well as to increase the value of these securities. In simpler words: a hedge fund is an investment company, the union between the fund manager and the investors in the hedge fund. The purpose of any hedge fund is to achieve maximum returns for investors and to minimize potential risks.

The name “hedge fund” refers to the fact that the objective of these funds is to make money regardless of whether the market goes up or down. Which is possible because managers can protect themselves by trading long or short with stocks.

Key features of the hedge fund

Hedge funds have a number of features that are essential. They are as follows:

  1. Hedge funds are only open to qualified investors

    This means that hedge fund investors have to meet a number of net worth requirements to invest in them. Thus, the net worth of qualified investors must be more than one million dollars, not including their primary residence.

  1. Greater investment latitude

    The world of hedge fund investing is limited only by its mandate, so a hedge fund can invest in anything you can think of, from land to real estate and currency to shares and derivative financial products. However, mutual funds may only invest in stocks and bonds.

  2. Investment funds often use leverage

    This means that investment funds are going to use borrowed money with some assistance to amplify the returns on this. However, this technique must be used with caution. Because as we have already seen with the financial crisis that shook the world in 2008, leverage can lead to the end of hedge funds.

  3. Fees and structure of the same

    Instead of charging an expense ratio only. The hedge funds will bear the proportion of the expenses, as well as a performance commission. The common commission structure is as follows: an asset management commission of 2% and, on the other hand, a commission for generated profits of 20%.

  4. Freedom to operate

    Investment funds have great freedom to operate, so their operations will only be limited by their own regulations. This allows investment funds, among many other things, to massively use derivative options, in addition to allowing them to take short positions by lending securities, which consists of the sale of an asset not owned by the investor.

  5. Advantage of market inefficiencies

    Hedge fund try to take advantage of market inefficiencies, in a way that they aim to make money regardless of where the market is.

How does a hedge fund work?

Hedge funds are structured as company, it has already been pointed out by the one who manages the investment portfolio and by a series of investors. How does a hedge fund work? Attentive, the working is as follows:

  1. Several investors get together and agree to pool money with which they will create a hedge fund.
  2. These investors are assigned shares or a package of shares in exchange for a certain return, so that these shares will be sold later by the investors. After selling them, investors will buy back the shares when their value has dropped, and then sell them again to earn the difference.
  3. Once the invested money has backed down, the initial investment is returned to the investors who form the hedge fund.
  4. After these operations, the bank or manager that carried out the working, will charge a commission, which have been agreed earlier.

Are hedge funds for everyone?

Hedge funds are clearly going to offer some valuable benefits. Including investment strategies that will generate positive returns. Or reducing overall portfolio risk for hedge funds with a balanced portfolio. However, these trades are not without risk, so the investment strategy may expose hedge funds to huge losses. It is possible that the use of leverage can turn a loss into something really significant. And finally , hedge funds often require investors to lock in the money invested for long periods of time.

Advantages of a hedge fund

In general terms, a hedge fund brings a triple advantage to the investor :

  • They are expected to offer a higher return, even if it is simply a consequence of taking higher risk.
  • Returns are less correlated with the general trend of the market. So, it can be useful, as the name suggests, to offer investment coverage in downturns.
  • They allow a better use of opportunities, through the breadth of the range of strategies that can be carried out. They are extremely flexible investment funds.

Disadvantages of a hedge fund

On the contrary, the disadvantages of hedge funds are inherent in their own characteristics :

  • They have less liquidity than traditional funds.
  • The commissions are higher.
  • Less transparency and therefore less control.
  • Higher risk.
  • Greater access restrictions.
  • Greater sophistication and complexity. Sometimes they are not suitable for individual investors.

Strategies of a hedge fund

In the information brochure of a hedge fund you can see its qualitative data and the type of strategy that it follows. The strategies that a hedge fund can follow are diversified. Some of the most common strategies are the following:

1. Global Macro Strategy

In a global macro strategy, managers place bets based on key global macroeconomic trends. Such as interest rates, currencies, demographic shifts, and moves in economic cycles. Fund managers use a discretionary and systematic approach in the major financial and non-financial markets. By trading currencies, futures, option contracts and traditional equities and bonds. Bridgewater is the best-known example of a global macro fund.

2. Directional hedge fund strategies

In the directional approach, managers bet on the market’s directional moves (long or short) because they expect the trend to continue or reverse for a period of time. A manager analyzes market movements, trends, or anomalies, which can then be applied to investing in vehicles such as long or short equity hedge funds and emerging market funds.

3. Event-driven hedge fund strategies

Event-driven strategies are used in situations in which inherent opportunities and risks are associated with an event. Fund managers find investment opportunities in corporate transactions such as acquisitions, consolidation, recapitalization, liquidation and bankruptcy. These form the basis of investments in securities, risk arbitrage and special situations distressed by the events of the transaction.

4. Relative Price Mediation Strategies

Relative value arbitrage hedge fund strategies take advantage of relative price discrepancies between different securities whose prices managers expect to increase or change over time. Sub-strategies in the category include fixed income arbitration, equity market neutral position, variable arbitrage and volatility arbitration, among others.

5. Long / short strategies

In long / short hedge fund strategies, managers are known as “pair trades” to place bets on two securities in the same industry. For example, if they expect Coke to outperform Pepsi, they will run longer Coke and shorter Pepsi. Despite the overall market trends, they will remain fine as long as Coke outperforms Pepsi on a relative basis.

6. Capital Structure Strategies

Some hedge funds take advantage of the misunderstanding of securities to capitalize the structure of a single company. For example, if they believe that debt is high, they reduce debt and lengthen equity, thus creating a hedge and betting on the final spread correction between securities.

Conclusion

In short, we can see how a hedge fund escapes from the traditional investment consisting of buying assets, building a portfolio, adjusting it, reorganizing it, taking care of it and pampering it. Thus, a hedge fund can be useful in some circumstances. However, the characteristics of this type of investment fund make them risky and speculative options.

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