What are Hedge Funds? | History, Working, Pros and Cons

The market is full of opportunities for people who have an idea and wish to monetise it. The only thing that is needed is funding, and fortunately, the market has plenty of investment sources to provide funds. One of those investment capital sources is Hedge Fund.

A hedge fund is a type of alternative investment that pools capital from institutional and individual investors to make investments in a vast range of assets with the ultimate aim of generating high returns at reduced risks for its investors.

Formation of Hedge Fund

As financial partnerships, hedge funds comprise of mostly accredited investors. These are individuals or business entities that have been earning more than $200,000 for the last two years or have a net worth of more the $1 million leaving their principal residence.

They enter into a limited partnership by pooling in a substantial amount of minimum investment.

As hedge funds are accessible only to such high profile investors, very few regulations of the Securities and Exchange Commission, (SEC) apply to this investment vehicle.

Investments made in hedge funds tend to be illiquid as there is a lock-up period which entails investors to store their money in the funds for at least a year before they can start making bi-annual or quarterly withdrawals.

As a source of alternative investment, hedge funds may either act as offshore investment corporations or private investment partnerships.

How does Hedge Fund work?

Aggressive and risky are the two terms used to describe hedge funds, specifically when it comes to comparing them with mutual funds. It is because the returns from hedge funds mostly depend on the fund manager’s skills rather than the condition of the markets.

The fund manager is responsible for analysing the market conditions, predicting the market shifts and applying the appropriate investment strategies.

To generate higher returns with lesser risks, fund managers tend to employ both traditional and non-traditional investment strategies.

Some of the most significant investment manoeuvrings applied by hedge fund managers include:

  1. Utilising arbitrage: Hedge funds tend to invest in diverse markets, and when these markets exhibit incompetent or contradictory prices, they take advantage of such price difference.
  2. Sell short: Anticipating a price drop, the manager may decide to sell off a specific asset only to purchase it back at a lower price in future.
  3. Investing in securities providing a high discount rate: It entails investing in low-priced securities of promising but currently stressed companies.
  4. Investing in forthcoming business events: The prospects of business events like acquisitions, spin-offs, mergers and the like may determine a hedge fund manager’s financing decisions.
  5. Managing fund volatility: It is done by reorganising the management structure of a company or pushing for its sale.
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Besides using the situation appropriate investment manoeuvrings, hedge fund managers invest in different classes of assets, including the non-traditional ones. For example, real estate, land, derivatives, currencies, and other alternative assets.

In other words, hedge funds invest in almost anything, and this constitutes another feature that distinguishes hedge funds from mutual funds that primarily invests in bonds or stocks.

Furthermore, hedge funds invest in both international and domestic markets for diversification of assets and use leverage (borrowed capital) so that the market trends do not influence the returns.

Advantages of Hedge Fund

For the last twenty years, hedge funds have witnessed tremendous growth, and that is not without any reason. The following are some of the significant advantages of hedge funds.

  1. Diversification: Hedge funds tend to invest in a vast range of asset classes which helps in diversifying an investment portfolio.
  2. Not dependent on market conditions: Hedge funds can take both short and long positions. While short positions help them in gaining returns in declining market conditions, long positions enable them to get returns in rising market conditions.
  3. Focus on positive returns: Gaining positive returns is the primary goal of hedge funds, and for that, fund managers can apply almost all possible investment strategies.
  4. Top-rated investment managers: Hedge funds tend to provide their investors with the advantage of having access to some of the most capable investment managers. 

Disadvantages of Hedge Fund

Despite its benefits and ever-rising popularity, hedge funds like all other funds are not without risks. Here are some significant disadvantages of Hedge Funds.

  1. Dependence on the fund manager’s competence: Returns in hedge funds may not depend on market conditions, but it does depend on the fund manager’s investment choices. One wrong decision and almost everything can go down the drain.
  2. Risks related to robust investment strategies: Hedge funds engage in vigorous investment strategies which often puts them at the risk of experiencing massive losses.
  3. Illiquidity: Investors have to lock-up their investment in hedge funds for relatively more extended periods.
  4. Use of leverage: Hedge funds often use borrowed capital or leverage to generate higher returns. This practice often becomes a significant cause of small losses turning into a massive one.

References

  1. https://www.tandfonline.com/doi/abs/10.2469/faj.v60.n5.2657
  2. https://onlinelibrary.wiley.com/doi/abs/10.1002/fut.2102
  3. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.2008.01373.x
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