Hedge Fund

A hedge fund is pooled investment fund that employs a number of investment strategies in a variety of liquid asset classes.

What Is a Hedge Fund?

A hedge fund is pooled investment fund that employs a number of investment strategies in a variety of liquid asset classes. Hedge funds work on complex strategies and have a limited number of skilled managers trained to execute them. They are also considered illiquid where investors are obligated to not perform withdrawals for a year. They also work on a higher minimum investment limit making wealthy individuals and institutions more viable to use them.

Understanding Hedge Funds

Hedge funds employ complex investment strategies with the sole purpose of generating higher returns on the money by taking risks. They are run by professional fund managers who are experts in their fields and have a good understanding of executing various strategies and reading market trends.

The target audience of such funds is usually wealthy individuals with pools of money or investing organizations. The minimum investment is higher to accommodate the risk factor. There are also management and performance fees associated making the overall fee higher as well. The management fee is used to cover operational costs and is usually deducted directly from the assets being managed. The performance fee is calculated based on the profit brought in.

Hedge Funds vs Mutual Funds

Hedge funds are known for their use of more sophisticated and complex investment strategies than traditional mutual funds. They have fewer restrictions on their investment activities in comparison. 

Some of the common strategies used by hedge funds include:

  • Long Equity: Investing in the positions which are forecasted to increase in value over the duration of time. For example, if the manager buys 100 shares of a stock, they have a long position in that stock. If the stock price goes up, the value of the manager’s investment will also go up, and they can sell the stock for a profit.
  • Short Equity: Investing in the positions which are forecasted to decrease in value over a duration of time. For example, the manager borrows shares of the stock and sells them, with the hope of buying them back later at a lower price. If the price does go down, the manager can buy back the shares, return them to the lender, and pocket the difference between the sale price and the lower purchase price.
  • Event-Driven: Using corporate events such as mergers, acquisitions, and bankruptcies to generate returns.
  • Arbitrage: Taking advantage of price differences between two similar securities in different markets to generate returns.
  • Macro: Investing in a variety of assets, including stocks, bonds, commodities and currencies, based on macroeconomic trends and market conditions.

Hedge funds are subject to less regulation than traditional mutual funds, but they are still subject to various laws and regulations that govern the investment industry and are often required to provide regular reports to their investors to provide transparency.

Working of Hedge Funds

From formation to liquidation, here is how hedge funds operate:
  • Formation: A hedge fund is created when an investment manager or group of managers decides to start a fund and raises capital from investors.
  • Fundraising: The hedge fund manager then raises capital from accredited investors, such as wealthy individuals, pension funds and endowments, by selling shares in the fund. The minimum investment is usually a substantial amount.
  • Investment strategy: The hedge fund manager uses the capital raised from investors to implement their investment strategy. This can involve taking positions in various assets, such as stocks, bonds, currencies and commodities, using a variety of investment techniques.
  • Risk management: The hedge fund manager closely monitors the fund’s investments and manages risk by adjusting positions as market conditions change.
  • Reporting: The hedge fund provides regular reports to its investors, which typically include information on the fund’s performance, portfolio holdings and risk management activities.
  • Fees: The hedge fund charges fees to cover its operating expenses and compensate its managers which fall under the management and performance fees respectively.
  • Liquidation: The hedge fund may be liquidated when the fund manager decides to close the fund or when the fund is unable to meet its investment objectives. In the event of liquidation, the fund’s assets are sold, and the proceeds are distributed to the investors.

Example of Hedge Funds

A real-life example of a hedge fund is Bridgewater Associates, which is a famous hedge fund managing over $150 billion. They use a strategy known as Pure Alpha, which involves investing in a wide range of asset classes that are not correlated to one another.

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