hedge funds

Hedge Funds 101: Your Guide To Risk And Reward

Hedge funds: Tycoons love them, regulators loath them, but what exactly do they do?

What do hedge funds do?

According to Investopedia, hedge funds, by definition are:

“An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns.”

In essence, what hedge funds do is pool investors’ assets in an attempt to generate money while simultaneously managing risk–all through investing in securities (a financial instrument like a stock or bond).

hedge funds

While hedge funds are similar to mutual funds in many ways, they differ in both regulation (hedge funds are significantly less regulated) and who can participate–only accredited investors with a minimum of between $500,000 to $1 million.

Specifically hedge funds are meant to do two things:

  • Generate significant returns to investors
  • Eliminate the greatest amount of risk possible

What are the advantages?

Unlike hedge funds’ counterpart, mutual funds, which also pools investors assets for reinvestment, they are significantly less regulated. This means hedge fund managers are able to invest in a much wider array of securities.[contextly_auto_sidebar id=”lq5bL3wYGZmWUfKeohi2sh5RCoZp83F9″]

Though hedge funds invest in some traditional securities (stocks, bonds, commodities, real estate) they also use more complex strategies like long-short investments which may entail selling stocks with borrowed money and then buying back at a later date for less.

There are a few aspects which make hedge funds advantageous for investors:

  • The lack of regulation makes them more flexible and therefore allows them to use more lucrative strategies like derivative trading and short-selling.
  • By diversifying portfolios with derivatives and short sales (which are often uncorrelated with stock indexes) hedge funds are able to reduce investors risk by breaking reliance on just one or two market factors.
  • Hedge fund managers are paid as per their return performance, unlike mutual funds which have a constant fee

What are the risks?

For many of the same reasons hedge funds might be advantageous, they also come with inherent risks.

A few reasons why hedge funds may pose risk to investors include:

  • Lack of regulation in hedge funds makes them more susceptible to fraud (as seen in the case of Bernie Madoff)
  • Instruments like derivatives are volatile since they are affected by a number of complex and opaque market factors.
  • Though hedge fund managers are compensated per their returns, they do not compensate for losses they might incur on a portfolio. Additionally, they take a 2 percent management fee regardless of returns.

The takeaway

Hedge funds have grown in popularity since the recession in 2008. According to The Wall Street Journal, current size estimates have hovered at around $3 trillion.

This trend will likely continue as long as stock markets are still perceived to be volatile.

For investors with enough money, hedge funds have become the investment vehicle of choice.

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