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A hedge fund is an alternative investment vehicle usually available only to sophisticated investors, such as institutions and individuals with significant assets.
Like mutual funds, hedge funds are pools of underlying securities. Also like mutual funds, they can invest in many types of securities—but there are some differences between these two investment vehicles.
Hedge funds can invest in a wider range of securities than mutual funds can. While many hedge funds do invest in traditional securities, such as stocks, bonds, commodities and real estate, they are best known for using more sophisticated investments and techniques.
Hedge funds typically use long-short strategies, which invest in some balance of long positions (which means buying stocks) and short positions (which means selling stocks with borrowed money, then repurchasing them later when their price has, ideally, fallen).
Additionally, many hedge funds invest in “derivatives,” which are contracts to buy or sell another security at a specified price. You may have heard of futures and options; these are considered derivatives.
Many hedge funds also use an investment technique called leverage, which is essentially investing with borrowed money—a strategy that could significantly increase return potential, but also creates a greater risk of loss. In fact, the name “hedge fund” is derived from the fact that hedge funds often seek to increase gains, and offset losses, by hedging their investments using a variety of sophisticated methods, including leverage.
Hedge fund managers are typically compensated differently from mutual fund managers. Mutual fund managers are paid fees regardless of their funds’ performance. Hedge fund managers, in contrast, receive a percentage of the returns they earn for investors, in addition to having received a “management fee”, typically in the range of 1% to 4% of the net asset value of the fund. That is appealing to investors who are frustrated when they have to pay fees to a poorly performing mutual fund manager. On the downside, this compensation structure could lead hedge fund managers to invest aggressively to achieve higher returns—increasing investor risk.
As a result of these factors, hedge funds are typically open only to a limited range of investors. Specifically, U.S. laws require that hedge fund investors be “accredited,” which means they must earn a minimum annual income, have a net worth of more than $1 million, and possess significant investment knowledge.
Some of the more traditional hedge fund investment strategies are Activist, Convertible Arbitrage, Emerging Markets, Equity Long Short, Fixed Income, Fund of Funds, Options Strategy, Statistical Arbitrage, and Macro.
Hedge funds continue to offer investors a reliable alternative to traditional investment funds—an alternative that brings the possibility of higher returns that are uncorrelated to the stock and bond markets. As a result, hedge funds are likely here to stay.