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Hedge Fund: What is it all about?

Hedge Fund is an alternative investment vehicle available only to sophisticated investors, such as institutions and individuals with significant assets.

Today we will discuss to you all about hedge fund. As a trader you might have heard some investors use this term in the field of investing.

Hedge Fund on Keyboard with a Finger and a Key

Let us now learn about this investment vehicle!

What is Hedge Fund?

Hedge funds are alternative investments using pooled funds, which use various different strategies to earn active return, or alpha, for their investors.

Moreover, hedge funds may be aggressively managed or make use of derivatives and leverage in domestic and international markets with the goal of making high returns.

Hedge fund usually uses the long-short strategies. Long positions means you have to buy stocks. Meanwhile, short positions means you have to sell stocks with leverage, then buy them back later when their price decreases.

It is important for you to know that hedge funds are only accessible to qualified investors as they are the one who require less SEC regulations than the other brands.

However, there is one aspect that has set the hedge fund industry apart. It is the fact that hedge funds are facing fewer regulations than mutual funds and other investment vehicles.

Hedge funds can invest in a wider range of securities, including stocks, bonds, commodities, and real estate unlike mutual funds. Hedge funds is best known for using a more sophisticated investments and techniques.

See also: The Difference between Stocks and Bonds

Hedge Fund infographic

The History of Hedge Fund

To know more about hedge funds, let’s go back in time and learn where the word hedge fund came from.

The former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co., launched hedge fund in 1949.

In 1948, a year before hedge fund was launched, Jones was inspired to try managing money through his own hands. He raised about $100,000 and set forth to try to lessen the risk in holding long-term stock positions by short selling other stocks. As of now, this investing innovation is referred to as the classic long/short equities model.

In addition to that, Jones also used leverage to enhance returns.

Then in 1952, Jones changed the structure of his investment vehicle. He converted it from a general partnership to a limited partnership and added a 20 percent incentive fee as a compensation for the managing partner.

Jones was known as the father of hedge funds in the investing history. He was the first money manager to merge short selling, use leverage, shared risks through  a partnership with other investors and a compensation system based on investment performance.

Characteristics of Hedge Fund

There are many specific characteristics that define a hedge fund. However, since it is a private investment vehicle, hedge fund can do whatever the wealthy individuals want as long as they disclose the strategy upfront to investors.

Below we will walk you through some of the key characteristics of a hedge fund.

  • It is Only Open to “Accredited” Investors – hedge fund is only allowed to take money from qualified investors who have an annual income that exceeds $200,000 for the past two years.
  • Hedge Fund Offers a Wide Investment Latitude – it can invest in anything, such as land, stocks, real estate, currencies, and derivatives.
  • It Uses Leverage All the Time – hedge fund is frequently using borrowed money to boost their returns.
  • Hedge Fund Has a Fee Structure – this investment vehicle charges both expense ratio and performance fee. This fee structure is known as “Two and Twenty”—a 2% asset management fee and then a 20% cut of any gains generated.

On the other hand, there are some risks that come with hedge fund. Here are some risks that you should know about.

  • Concentrated investment strategy exposes hedge fund to possibly massive losses.
  • The use of leverage can turn a minor loss to a significant loss.
  • This investment vehicle requires investors to lock up money for a period of year.

 Two People Shaking Hands

Hedge Fund Strategies

We will now discuss to you the strategies for this investment vehicle. There are various strategies, but today we will show the general overview of common strategies.

  1. Fund of Funds – FOF is a fund that invests in a number of underlying hedge funds. A typical FOF invests in 10 to 30 hedge funds and some are even more diversified. However, investors of FOF can gain diversification among hedge funds managers and strategies. They have to pay two layers of fees; one for the manager of FOF and the hedge fund manager.
  2. Equity Market Neutral – this fund attempts to identify overvalued and undervalued equity securities as it neutralize the portfolio’s exposure to market risk by combining long and short positions.
  3. Emerging Markets – these funds are focused on the emerging and less mature markets. Although, you should remember that short selling is not allowed in most emerging markets and futures and options may not be available.
  4. Convertible Arbitrage – this tactic attempt to exploit mispricing in corporate convertible securities: convertibles bonds, warrants, and convertible preferred stock. Managers in this category will buy or sell these securities and then hedge part all of the associated risks.
  5. Global Macro – this strategy is trying to take advantage of systematic moves in major financial and non-financial markets through trading in futures, currencies, and option contracts.
  6. Distressed Securities – the portfolios of distressed securities are invested in the debt and equity of companies that are in or facing bankruptcy.
  7. Fixed-Income Arbitrage – this fund seeks to identify overvalued and undervalued fixed-income securities.
  8. Long-Short Equity – this is one of the most used strategies for hedge fund. It involves taking long and short positions in equity and equity derivative securities.

Conclusion

Remember that hedge fund is an investment vehicle that some investors use.

And as an investor, you should have the knowledge about the characteristics of this investment vehicle and some of the risks that comes with it.

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