Hedge Fund FAQs
What is a hedge fund?
A hedge fund pools investments like a mutual fund, but accepts a limited number of investors who co-own the fund as limited partners. Each hedge fund follows a set investment strategy, but fund managers are not bound by regulations to stay within the strategy and have the freedom to adjust to market changes and opportunities.
Hedge funds also may use a variety of hedging strategies, such as arbitrage, short-selling and other sophisticated techniques. Sometimes these techniques add risk, but they can also help fund managers control risk, boost returns and take advantage of market conditions.
What are the benefits of hedge funds?
Hedge funds offer many benefits, including the following:
- While there are never any guarantees in investing, many hedge funds consistently outperform the market.
- Hedge funds have attracted some of the best money managers because they provide an opportunity to invest without the restrictions of mutual funds.
- Hedge funds can be used to "hedge" investments. You can, for example, balance your investment portfolio by investing in a hedge fund that is likely to perform well even in a falling market.
- There are many different types of hedge funds. Given the variety of strategies employed and investments used, they can help diversify a portfolio even more than the typical mutual fund.
- Because fund managers have more flexibility than mutual fund managers over where they invest, they can adjust their investments to account for changing market conditions. Their flexibility also makes hedge funds ideal long-term investments.
What different types of hedge funds are available?
There are at least as many different types of hedge funds as there are different types of mutual funds. Some of the following are very high-risk funds, while others have relatively low risk funds.
Distressed Securities. The manager buys securities at a deep discount when companies are facing potential bankruptcy. Since most institutional investors cannot own securities that are rated below investment grade, the number of potential buyers is small and discounts may be more extensive than they otherwise would be.
Emerging Markets. These funds invest in equity or debt of emerging markets, which typically have high rates of inflation and tend to be politically unstable and economically volatile.
Equity hedge funds. These funds may be global or country specific. They typically short stocks or stock indexes they perceive to be overvalued as a hedge against downturns in equity markets.
Fund of Funds. A fund of funds pools investments in many hedge funds with different strategies and asset classes to create a more stable investment opportunity than a single fund could provide, and to diversify investments.
Growth and income. This strategy, which is used by Cutler Capital Management, relies on income from investments to reduce downside risk and add to total returns.
Macro hedge funds. Managers of these funds track economic policies, interest rates and other factors. Based on perceived opportunities, they typically leverage large investments in stocks, bonds, currencies, gold and other investment vehicles.
Market Neutral hedge funds. These funds seek to reduce market risk by investing in offsetting positions, often in different securities of the same company. They typically seek to invest with little or no correlation to either bond or equity markets.
Market Timing. While it's said that no one can predict what the market will do, some fund managers try. They invest based on short-term market expectations and perceived opportunities.
Multi Strategy. This investment approach incorporates a variety of strategies, emphasizing whatever fits current market conditions.
Opportunistic. Like a multi-strategy fund, an opportunistic fund's strategy is focused on current market conditions, but it uses only one strategy at a time.
Relative-value hedge funds. Managers of relative-value hedge funds use arbitrage to take advantage of perceived price or spread inefficiencies.
Short Selling. Managers sell shares they don't own with the expectation of buying them back at a lower price in the future.
What different hedging strategies do hedge fund managers use?
Hedge funds follow a wide variety of hedging strategies. Examples include:
- Arbitrage. An arbitrage strategy is based on identifying pricing inefficiencies in the market. For example, a money manager might buy long convertible bonds and short the underlying issuer's equity.
- Short-selling. Short selling is the practice of selling shares you don't own with the expectation of buying them back at a lower price in the future. This technique is often used to reduce portfolio risk as part of an arbitrage strategy.
- Leverage. The general partner borrows against the assets in the fund and invests the additional funds. When a fund is 100% leveraged, for example, every $1 increase in value results in a $2 return on equity. However, a $1 decrease in value would result in a $2 decrease in the return on equity.
- Derivatives. Fund managers trade in options and other contracts whose values are based on the performance of underlying equities or other financial assets.
Hedging strategies are typically used to reduce risk and volatility, or to boost returns by taking advantage of market opportunities.
What Are Some Common Misconceptions About Hedge Funds?
There are many misconceptions about hedge funds and their role for investors, including the following:
1. Hedge funds are just for mega-wealthy investors with millions to invest.
Hedge funds used to require minimum investments of millions of dollars - and some still do. Today, though, investors can become limited partners by investing as little as $100,000. Many require minimum investments of $250,000.
2. Hedge funds are risky.
Some hedge funds are very risky. Others carry less risk. The key is to find a hedge fund with an investment strategy that matches your tolerance for risk while also fitting your overall investment portfolio, financial goals and investment timeline.
Many investors use hedge funds to control risks. A hedge fund that is designed to perform best when the market turns down, for example, may be used to hedge investments against market risk.
3. Hedge funds have been plagued by scandals.
A very small number of hedge funds have been operated by unethical money managers who either cheated their investors or invested inappropriately. Likewise, a small number of mutual funds have been operated by unethical managers. Investors should perform due diligence and learn about a fund and its managers before investing in it.
How many hedge funds are available?
The Hedge Fund Association counts 8,350 active hedge funds totaling $875 billion in assets, with 20% growth a year. Most hedge funds and fund managers are now registered with the U.S. Securities and Exchange Commission.
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