Hedge Funds

Definition

Hedge funds are pooled investment funds that employ diverse strategies to earn active returns for their investors. These funds are typically open to a limited range of investors and may engage in a variety of tactics including long and short positions, leverage, derivatives, and arbitrage. Hedge funds are recognized for their flexibility and can invest in a wide range of assets, contributing to their role as a significant type of alternative investment.

5 Must Know Facts For Your Next Test

1. Hedge funds can have high minimum investment requirements, making them accessible mainly to accredited or institutional investors.
2. They are less regulated than mutual funds, allowing them greater freedom in trading strategies but also leading to higher risk levels.
3. Hedge funds aim to generate absolute returns regardless of market conditions, often using strategies like short selling and hedging.
4. The fees for hedge fund management typically include a management fee and a performance fee, often structured as '2 and 20'—2% of assets under management and 20% of profits.
5. Due to their complex strategies and structures, hedge funds can offer diversification benefits to portfolios by reducing overall risk.

Review Questions

• How do hedge funds differentiate themselves from traditional investment vehicles like mutual funds?
  • Hedge funds distinguish themselves from traditional investment vehicles such as mutual funds through their flexible investment strategies and fewer regulatory restrictions. Unlike mutual funds that primarily focus on long-only investments in public equities and are heavily regulated, hedge funds can engage in a variety of tactics including short selling, leverage, and derivatives. This flexibility allows hedge funds to pursue absolute returns in both bullish and bearish markets while also requiring higher minimum investments from accredited investors.
• Discuss the role of leverage in hedge fund strategies and its implications for both potential returns and risks.
  • Leverage plays a crucial role in many hedge fund strategies by allowing fund managers to amplify their investments beyond the capital they have on hand. This can lead to higher potential returns when investments perform well; however, it also significantly increases the risk exposure. If investments do not perform as expected, losses can be magnified, potentially leading to substantial financial distress. This dual nature of leverage makes it a powerful but dangerous tool within the hedge fund context.
• Evaluate how hedge funds contribute to portfolio diversification for investors seeking alternative investments.
  • Hedge funds contribute to portfolio diversification by offering access to unique investment strategies and asset classes that traditional investments do not typically provide. By including hedge funds in a portfolio, investors can gain exposure to various markets and employ techniques like arbitrage or short selling that may reduce overall portfolio risk. Additionally, the less correlated returns of hedge funds compared to traditional assets can help smooth out volatility during market downturns. This characteristic makes hedge funds an appealing choice for sophisticated investors looking to enhance their investment diversification.

Related terms

Alternative Investments: Investments outside of traditional asset classes like stocks, bonds, and cash, often including hedge funds, private equity, real estate, and commodities.

Leverage: The use of borrowed capital to increase the potential return of an investment, which can also amplify risks.

Fund of Funds: An investment strategy that involves investing in other hedge funds or alternative investment funds, rather than directly in securities.