Hedge funds and how they work
/What is a Hedge Fund?
A hedge fund is a privately pooled investment fund that employs a wide range of strategies to earn active returns for its investors, often including leverage, derivatives, short selling, and arbitrage. Unlike mutual funds, hedge funds typically cater to accredited or institutional investors due to their higher risk profiles, regulatory exemptions, and performance-based fee structures. These funds aim to generate positive returns in both rising and falling markets by actively managing portfolios across asset classes. Hedge funds are known for their flexibility and pursuit of absolute returns, but they also carry higher fees, lower transparency, and greater risk compared to traditional investment vehicles.
Hedge funds typically do not accept small investments, with minimum contributions starting as high as $1 million. Hedge fund managers are compensated with a percentage of the total assets in the investment pool, as well as a percentage of all profits generated. For example, a fund manager could take 2% of all capital under management, as well as 20% of all profits earned.
Types of Hedge Funds
The main types of hedge funds are as follows:
Long/short equity hedge funds. These funds buy undervalued stocks (long positions) and sell overvalued stocks (short positions) to profit from price differences. The goal is to generate returns regardless of overall market direction by exploiting stock-specific opportunities. This strategy reduces market risk by balancing long and short exposures, but success depends heavily on accurate stock selection and timing.
Market neutral hedge funds. Market neutral funds seek to eliminate market risk by maintaining balanced long and short positions across sectors or asset classes. They aim to generate consistent returns by focusing purely on the relative performance of securities. These funds typically have low correlation with market movements, making them attractive in volatile environments, though returns may be modest.
Global macro hedge funds. Global macro funds invest based on broad economic and geopolitical trends across global markets, including currencies, commodities, interest rates, and equities. Managers take large directional bets using macroeconomic analysis, often employing leverage and derivatives. These funds can deliver high returns but are also subject to significant volatility and risk.
Event-driven hedge funds. Event-driven funds capitalize on pricing inefficiencies caused by corporate events such as mergers, acquisitions, bankruptcies, or restructurings. Sub-strategies include merger arbitrage, distressed securities, and special situations investing. These funds rely on the manager's ability to analyze complex situations and legal outcomes, which can lead to outsized gains—or losses—based on event resolution.
Relative value hedge funds. Relative value funds aim to exploit price discrepancies between related securities, often through arbitrage strategies. Common approaches include fixed-income arbitrage, convertible arbitrage, and volatility arbitrage. These funds generally focus on stable returns with lower risk, but they can be exposed to liquidity constraints and sudden market shifts that disrupt pricing relationships.
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Hedge Fund Investment Strategies
Hedge fund investment strategies may include the following options:
Leverage investment strategy. There may be a considerable quantity of leverage (that is, investing borrowed funds) to achieve outsized returns on a relatively small capital base. This presents the risk that losses on leveraged funds can be outsized, triggering massive losses for investors.
Short sales investment strategy. Hedge funds may borrow shares and sell them, in the expectation that the price of a security will drop, after which they buy the securities on the open market and return the borrowed securities. This is a very risky strategy, since a share price increase can introduce potentially unlimited losses for investors.
Derivatives investment strategy. Investments are made in any number of derivatives, which can pay off based on a vast number of possible underlying indices or other measures.
Probability of a Loss
Because of the enhanced use of leverage, as well as other speculative strategies, there is a much higher probability of loss in a hedge fund than would be the case in a more traditional investment fund that only invests in the securities of well-established companies. The level of potential loss is accentuated by the common requirement that investments cannot be withdrawn from a hedge fund for a period of at least one year. This requirement is needed because some hedge fund investments cannot be easily liquidated to meet a cash withdrawal demand by an investor. The requirement also allows a hedge fund manager to employ longer-term investment strategies.
Hedge Fund Oversight
Hedge funds avoid oversight by the Securities and Exchange Commission (SEC) by only allowing investments by large institutions and accredited investors (individuals with a large net worth or income). This means that hedge funds do not have to report as much information to their investors or the SEC. This can substantially reduce the cost of financial reporting, which is quite high for publicly-held businesses.
Source of the “Hedge” Name
The term "hedge" in the name "hedge fund" is a misnomer, since it seems to imply that a fund attempts to mitigate its risk. This term comes from the early days of hedge funds, when funds attempted to reduce the risk of securities price declines in a bear market by shorting securities. Nowadays, the pursuit of outsized returns is the primary goal, and that cannot usually be achieved while risk is also being hedged.