What is a Hedge Fund?

A hedge fund is an actively-managed financial instrument that can potentially earn a higher than average return for the investor, albeit with a relatively high degree of risk. Hedge fund managers create a hedged bet by investing most of the investor’s assets in one direction, but investing a portion of assets in the opposite direction to potentially offset losses.

They are highly eclectic, investing in all kinds of assets from real estate to Forex, stocks and derivatives. However, investors tend to have relatively few opportunities to redeem their shares, with most locked in for a minimum term of one year.

Hedge funds are classed as an alternative investment strategy due to their level of risk. They tend to have very high barriers to entry as they require a substantial level of investment. As such, fund managers tend to target high-net-worth individuals with lots of experience to invest. These are known as ‘experienced investors’ in the UK and ‘accredited investors’ in the US. They tend to have substantial and diverse investment portfolios and therefore have relatively high-risk tolerance.

Types of hedge fund

There are several types of hedge funds. Each focuses on a slightly different pool of investments and securities.

These include:

• Equity hedge funds: These invest in lucrative stocks in one or more countries while hedging against downturns in stock value by shorting overvalued stocks

• Relative value hedge funds: These take advantage of fluctuations in the relative values of related securities

• Activist hedge funds: Here, fund managers invest in companies and take actions that actively boost the value of the company’s stock

• Global macro hedge: These aim to profit from fluctuations in market value caused by large-scale events or political changes that affect the broader economy.

Hedge fund strategy

A fund strategy refers to the managerial style of the fund manager and the goals of the investor. There are numerous hedge fund strategies to cater to different investors’ goals and risk tolerance.

Common hedge fund strategies include:

• Fixed income strategy: These take long and short positions on fixed-income securities in order to minimise volatility and mitigate risk, providing consistent returns

• Long and short strategy: This hedge fund strategy involves taking a long position on one company and a short position on another company in the same industry

• Event-driven strategy: This capitalises on the temporary mispricing of stock that takes place when companies merge, restructure, get taken over or go bankrupt

Hedge fund FAQs

What is the difference between a hedge fund and a mutual fund?

Like hedge funds, most mutual funds are also actively managed. The difference, however, is that mutual funds have much more focus on stable long-term growth. They are less eclectic than hedge funds and focus on investment in stocks and bonds to grow investments slowly but consistently over time. Unlike hedge funds, mutual funds enable investors to cash in their shares anytime.

How do fund managers make money from hedge funds?

Fund managers make money from hedge funds by charging two fees. The first is a 2% management fee based on the value of the investment. The second is a 20% performance fee based on the profits the investment makes.

Why are hedge funds appealing to investors?

Most investors will consider hedge funds either inaccessible or too risky to be palatable. However, some very wealthy individuals that can tolerate the inherent risk find them appealing as they can be leveraged to yield substantial returns in a relatively short space of time.