A hedge fund is a buzzword that you seem to be hearing more often than not when you switch on the TV. If you are in anyway linked to the finance field you would also be aware that there has been a tremendous growth in the number of hedge funds too, especially in the last decade. it is indeed good to know What is a hedge fund? and how it works so that you may consider making an investment when there is an opportunity. Being informed does matter!
What is Hedge fund?
Hedge fund as most people assume is not a single specific type of investment. On the other hand, it refers to a strategic use of pooled investments in different alternative investments to ensure the people who have invested in the hedge fund are able to ear an attractive return. As you know pooling of investments means that you should have a person to manage the pool of investments. In the case of the hedge funds, the registered investment advisor would be in charge of the hedge funds and developing effective strategies. They are also called money managers. The hedge fund management at present is being undertaken mostly by limited partnership firms or limited liability company.
Functioning of hedge funds
There would be a hedge fund manager. The manager raises funds from people interested in making the best investments. After this, he starts investing it in different ways depending upon the strategy he has drawn up and has promised to engage in. The promise could include
- Specializing in long-only equities. That is they would engage in buying only common stock and never sell short.
- Engaging only in private equity. This might involve buying or taking over the privately owned business firm to improve the operations and even going in for a public offering for the first time.
- Engage only in trading of junk bonds
- Dealing only with real estate
- Using hedge funds entirely for use in specialized asset classes which includes patents, music rights etc.
These are in no way an exhaustive list of how the hedge manager decides to and invests the money.
How does the hedge fund work?
Investing in hedge funds is like mutual funds investment except that the hedge fund is not as regulated as the mutual funds. Otherwise, just like the mutual fund companies the hedge fund companies too, engage in investing in diversified portfolios including start-ups, commodities, real estate, and any other investment horizon apart from shares and best stocks.
The common hedge fund strategies
Long or short on equity
This is an important strategy that involves taking a long or short position with respect to equities or equity derivatives. It is a strategy that is usually employed by start hedge funds and the investment is made after a number of fundamental and quantitative techniques are employed in the decision-making process. This type of hedge fund scores high on ease of investor withdrawals because of it is easy to liquidate the funds when required in this sort of a hedge fund.
There are again three categories within credit funds which includes
- Direct lending or offering credit directly
- Fixed income credit- this refers to funds invested in debenture, convertible notes, capital notes, government bonds etc which are all long-term investments with the goal of capital preservation as well as lower risk tolerance.
- Distressed debt- this involves investment in common as well as the preferred stock of distressed companies, investing in bank debts and corporate bonds. But hedge funds that invest in distressed debt have stringent rules regarding the lock-up time and terms of withdrawal.
This refers to the strategy employed by the company to buy and sell investments simultaneously. They are supposed to yield consistent returns with a lower risk level. But since the price changes between buying and selling are quite a small margin, the risk involved is more and you have examples of hedge funds that incurred monumental losses when there is an unexpected shift in the market. However, there are different types of arbitrages depending on what commodities the hedge funds are invested in.
This includes the process of exploiting the differences in pricing that occurs owing to specific corporate events. For one to succeed in this type of investment expertise in the field of fundamental modeling as well as analysis of corporate events is essential.
This involves the process of making hedge investments based on quantitative analysis. Technology-based algorithms and models are used extensively to attain the desired goal. Since the investors would have only bare minimum information about the investment strategy, it is also called the Blac box fund.
This refers to the development of an investment strategy for hedge funds based on the political and economic scenarios in the macro environment. Therefore, it includes investment in all possible categories and also includes taking advantage of changes in currency rates.
This refers to the use of not only various investment options but also the use of various strategies to achieve the expected goals of capital preservation and high returns on investment.
Hedge funds are open for investments only to accredited investors and to a limited number of sophisticated investors. See where you fit in if you wish to invest money in hedge funds.