What Are Hedge Funds? – Meaning & Types
You are ready to invest your money and reap the profits that you have never experienced before. Then comes along the hedge funds which entices you, with famous hedge funds like Renaissance Technologies, AQR Capital Investments and Bridgewater Associates making headlines. But wait, do you know everything about hedge funds?
If you want to know about this mysterious entity, read on to find out.
Table of Contents
What Are Hedge Funds?
At the rudimentary level, hedge funds are just another way to invest, but the main difference between normal investments and hedge funds lies in the way they operate.
Hedge funds are pooled funds usually formed by pooling the investment. They are usually formed on the pretext of having some strategy which has been not discovered yet and therefore would reap enormous benefits for the people who invest in it in the future.
For example: Let’s have a hypothetical situation where there is a live match going on, and there is a delay of a few seconds between different mode of the telecast. Now let’s say you live in a town with no TV and people live on radio telecast. Suddenly you buy a TV secretly and have early access to the telecast. Now you would place bets because of those split seconds delay you made money.
Since hedge funds have such a secret strategy, they are often set up as a private investment where partnerships are only offered to accredited investors. Since there is a standard set for who could invest or not you should read on about accredited investor and whether you make the cut or not.
Who Is An Accredited Investor?
Accredited investor are investors who are given special authority or sanction if they meet certain recognised standards.
In the case of hedge funds individuals with an annual income that exceeds a certain limit, for example, $200,000 for the past two years or a net worth exceeding $1 million excluding their primary residence qualify for investing and this is because Securities and Exchange Commission deems such investor to handle the losses incurred well enough. The cap, however, differs from country to country.
Now you have your basics cleared up the next logical thing to ask is how do the hedge funds operate. Although this may differ from hedge funds to hedge funds, there are some characteristics common to hedge funds.
You will be well equipped to identify hedge funds if you read the next section.
Characteristics Of Hedge Funds
We have already covered type of investor hedge funds are looking for. We shall now discover some of the common characteristics of hedge funds.
Now unregulated doesn’t necessarily point to illegal. Unregulated in case of hedge funds is basically where hedge funds operate from.
Suppose they operate from a country where the information to be made public is in the hand of the company then this type of regulations benefit hedge funds.
Area of Investment
Unlike mutual funds which are allowed to invest in stocks and bonds, hedge funds can invest in anything—land, real estate, stocks, derivatives, and currencies.
Since hedge funds promise high returns for the investor, hedge funds are illiquid as they keep the investment of their investor for a certain period and this is known as the lock-up period.
This is done to ensure that individuals do not cash out easily after gaining a substantial amount.
Hedge fund and hedge fund managers usually follow ‘Two and Twenty’ structure which means that 2 per cent of the total assets goes into the pocket of the manager as part of the management fee along with the 20 per cent on the profits. This 2 per cent brings a shadow of a doubt when it comes to actual fruition because managers could claim on a 10 million dollar investment a hefty sum of 200 thousand dollars without lifting a finger.
Although there have been some measures introduced to mitigate this kind of anomaly.
Leverage is the act of borrowing money. Leverage is different from margins because margin refers to the use of borrowed money in various other financial institutions.
Hedge funds make use of leverage to maximise their gains by leveraging the broker’s money to reap significant returns that are larger than the interest.
This strategy is used to maximise profits, but this may also lead to maximising losses as if the returns are not high enough then along with interest, money borrowed has to be paid back, and therefore it would result in losing all of the current worth of the fund.
One of the recent examples where leverage backfired is the financial crisis of 2008.
Types of Hedge Funds
Hedge funds usually differ from each other based on the strategy they employ to invest in the market. Based on such strategies hedge funds could be classified broadly into the following types.
Long/Short strategy is an investment in a specific market segment by actively taking both long and short positions.
Hedge funds usually employ this strategy to maximise the returns, but they also run a risk of running into huge losses due to the short positions they take which is essentially selling off frequently by betting on a favourable outcome. This strategy is also commonly known as 130/30 strategy.
These type of funds are also known as vulture funds. These type of funds usually invest by carefully analysing the relationship between two entities in the market where one of them could fall into the hands of bankruptcy, and other would gain from it or just before a merger and acquisition, restructuring, reorganisation of a venture where the prices of a particular company would rise.
As the name suggests macros invest in commodities that are global such as currencies, interest rates, commodities or foreign economies. These funds usually take directional bets and therefore do not analyse individual companies.
Relative Value (Arbitrage)
When a hedge employs this strategy, they not only see the financial statements of a particular company but they see the companies in that sector. Let’s say if you want to invest in Google then you would take a look at Microsoft and Apple Inc.
Not only financial statements relevant footnotes, management commentary, and industry and economic data are also assessed to estimate the stock’s value, relative to its peers.
Making The Right Choice
Hedge funds due to their diverse area of investment and promise of huge profits they invest in portfolios which are risky and volatile and therefore hedge funds are usually more suited to ultra-rich individuals who want to be safe from the unforeseen crashes of the traditional stocks and bonds.
The risk involved is too high for a normal investor with the worst case being 0 return.
With such high risk and uncertainty involved, it is not advisable for an investor looking for long-term gains and stability.
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