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

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

A hedge fund is an alternative investment that pools capital from institutional and individual investors to make investments in a vast range of assets to generate high returns at reduced risks for its investors.

Key Takeaways

1. Hedge funds are private investment funds that pool money from wealthy investors and use complex strategies to generate high returns.
2. Hedge funds are less regulated than other investment funds, allowing them to pursue riskier investments and potentially earn higher profits.
3. While hedge funds can provide significant returns for investors, they also carry high fees, greater risk, and may lack transparency compared to more traditional investments.

Formation of Hedge Fund

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

They enter into a limited partnership by pooling a substantial 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 storing 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 act as offshore investment corporations or private investment partnerships.

How does Hedge Fund work?

Aggressive and risky are the terms used to describe hedge funds, specifically when 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 analyzing the market conditions, predicting market shifts, and applying the appropriate investment strategies.

Fund managers tend to employ traditional and non-traditional investment strategies to generate higher returns with lesser risks.

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

1. Utilizing arbitrage: Hedge funds tend to invest in diverse markets, and when these markets exhibit incompetent or contradictory prices, they take advantage of such price differences.
2. Sell short: Anticipating a price drop, the manager may sell off a specific asset only to purchase it back at a lower price.
3. Investing in securities providing a high discount rate entails investing in low-priced securities of promising but currently stressed companies.
4. Investing in forthcoming business events: The prospects of acquisitions, spin-offs, mergers, and the like may determine a hedge fund manager’s financing decisions.
5. Managing fund volatility: It is done by reorganizing the management structure of a company or pushing for its sale.

Besides using situation-appropriate investment maneuverings, hedge fund managers invest in different classes of assets, including 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 invest in bonds or stocks.

Furthermore, hedge funds invest in international and domestic markets to diversify 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 diversify an investment portfolio.
2. Not dependent on market conditions: Hedge funds can take short and long positions. While short positions help them gain 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 are not without risks like all other funds. 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 puts them at risk of experiencing massive losses.
3. Illiquidity: Investors must lock up their investment in hedge funds for relatively extended periods.
4. Use of leverage: Hedge funds use borrowed capital or leverage to generate higher returns. This practice becomes a significant cause of small losses turning into massive ones.

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