What is a Hedge Fund? Examples, Types, and Strategies (2022)

What Is a Hedge Fund?

A hedge fund is a limited partnership of private investors whose money is managed by professional fund managers who use a wide range of strategies, including leveraging or trading of non-traditional assets, to earn above-average investment returns.

Hedge fund investment is often considered a risky alternative investment choice and usually requires a high minimum investment or net worth, often targeting wealthy clients.

Key Takeaways

  • Hedge funds are actively managed alternative investments that commonly use risky investment strategies.
  • Hedge fund investment requires a high minimum investment or net worth from accredited investors.
  • Hedge funds charge higher fees than conventional investment funds.
  • Common hedge fund strategies depend on the fund manager and include equity, fixed-income, and event-driven goals.

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Introduction To Hedge Funds

Understanding the Hedge Fund

The term "hedge fund" defines this investment instrument as the manager of the fund often creating a hedged bet by investing a portion of assets in the opposite direction of the fund's focus to offset any losses in its core holdings.

A hedge fund that focuses on a cyclical sector such as travel, may invest a portion of its assets in a non-cyclical sector such as energy, aiming to use the returns of the non-cyclical stocks to offset any losses in cyclical stocks.

Hedge funds use riskier strategies, leverage assets, and invest in derivativessuch as options and futures. The appeal of many hedge funds lies in the reputation of their managers in the closed world of hedge fund investing.

An investor in a hedge fund is commonly regarded as an accredited investor, which requires a minimum level of income or assets. Typical investors include institutional investors, such as pension funds, insurance companies, and wealthy individuals.

Investments in hedge funds are consideredilliquidas they often require investors to keep their money in the fund for at least one year, a time known as thelock-up period.Withdrawalsmay also only happen at certain intervals such as quarterly or bi-annually.

Types of Hedge Funds

Hedge funds target select investments and pools of securities primed for gains. Four common types of hedge funds include:

  • Global macro hedge funds are actively managed funds that attempt to profit from broad market swings caused by political or economic events.
  • An equity hedge fund may be global or specific to one country, investing in lucrative stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices.
  • A relative value hedge fund seeks to exploit temporary differences in the prices of related securities, taking advantage of price or spread inefficiencies.
  • An activist hedge fund aims to invest in businesses and take actions that boost the stock price which may include demands that companies cut costs, restructure assets or change the board of directors.

Common Hedge Fund Strategies

Hedge fund strategies cover a broad range of risk tolerance and investment philosophies using a large selection of investments, including debt and equity securities, commodities, currencies, derivatives, and real estate.

Common hedge fund strategies are classified according to theinvestment style of the fund's manager and include equity, fixed-income, and event-driven goals.

A long/short hedge fund strategy is an extension of pairs trading, in which investors go long and short on two competing companies in the same industry based on their relative valuations.

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A fixed-income hedge fund strategy gives investors solid returns, with minimal monthly volatility and aims for capital preservation taking both long and short positions in fixed-income securities.

An event-driven hedge fund strategy takes advantage of temporary stock mispricing, spawned by corporate events like restructurings, mergers and acquisitions, bankruptcy, or takeovers.

How Do Hedge Funds Make Money?

Australian investor Alfred Winslow Jones is credited with launching the first hedge fund in 1949 through his company,A.W. Jones & Co. Raising $100,000, he designed a fund that aimed to minimize the risk in long-term stock investing byshort-selling, now referred to as the long/short equitiesmodel.

In 1952, Jones converted his fund to alimited partnership,added a 20%incentive feeas compensation for the managing partner, and became the firstmoney managerto combine short selling, the use of leverage, and a compensation system based on performance.

Today, hedge funds employ a standard "2 and 20" fee system, a 2% management fee, and a 20% performance fee.

The management fee is based on the net asset value of each investor's shares, so an investment of $1 million garners a $20,000 management fee that year to cover the operations of the hedge and compensate the fund manager.

The performance fee is commonly 20% of profits. If an investment of $1 million increases to $1.2 million in one year, $40,000 is the fee owed to the fund.

Hedge Fund vs. Mutual Fund

Hedge funds differ from mutual funds and hedge funds are not as strictly regulated by the Securities and Exchange Commission (SEC) as mutual funds are.

Mutual funds are a practical cost-efficient way to build a diversified portfolio of stocks, bonds, or short-term investments and are available to the general public and average investor.

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Hedge funds can only accept money from accredited investors which includes individuals with an annual income that exceeds $200,000 or a net worth exceeding $1 million, excluding their primary residence. These investors are considered suitable to handle the potential risks that hedge funds are permitted to take.

A hedge fund can invest in land,real estate, stocks,derivatives, and currencies while mutual funds use stocks or bonds as their instruments for long-term investment strategies.

Unlike mutual funds where an investor can elect to sell shares at any time, hedge funds typically limit opportunities to redeem shares and often impose a locked period of one year before shares can be cashed in.

Hedge funds employ the 2% management fee and 20% performance fee structure. In 2021, the average expense ratio across all mutual funds and exchange-traded funds was 0.40% for the average investor.

What to Consider Before Investing

As investors research to identify hedge funds that meet their investment goals, they often consider the fund or firm's size, the track record and longevity of the fund, the minimum investment required to participate, and the redemption terms of the fund.

According to the SEC, investors should also do the following when deciding to invest in a hedge fund:

  • Read the hedge fund’s documents and agreements which contain information about investing in the fund, the strategies of the fund, the location of the fund, and the risks anticipated by the investment.
  • Understand the level of risk involved in the fund’s investment strategies and that they equate with personal investing goals, time horizons, and risk tolerance.
  • Determine if the fund is using leverage or speculative investment techniques which will typically invest both the investors’ capital and the borrowed money to make investments.
  • Evaluate potential conflicts of interest disclosed by hedge fund managers and research the background and reputation of the hedge fund managers.
  • Understand how a fund’s assets are valued as hedge funds may invest in highly illiquid securities and valuations of fund assets will affect the fees that the manager charges.
  • Understand how a fund's performance is determined and whether it reflects cash or assets received by the fund as opposed to the manager’s estimate of the change in the value.
  • Understand any limitations to time restrictions imposed to redeem shares.

Examples of Hedge Funds

As of 2022, the most notable hedge funds include:

  • Elliot Management Corporation with a 55-year-long history and over $50 billion in assets under management (AUM). Its core holdings are in the energy sector.
  • Bridgewater Associates is a global leader, with more than $235 billion in assets AUM, and a rate of return of 32% for the first half of 2022.

• Man Group offers a mix of long/short equity funds, private market funds, real estate funds, multi-asset funds, and fixed funds and its core value is responsible investing, which it achieves through its funds’ compliance with environmental, social, and governance ESG investing goals.

What Tools Do Investors Use to Compare the Performance of Hedge Funds?

Investors look at the annualized rate of return to compare funds and reveal funds with high expected returns. To establish guidelines for a specific strategy, an investor can use an analytical software package such as Morningstar to identify a universe of funds using similar strategies.

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How Do Hedge Funds Compare to Other Investments?

Hedge funds, mutual funds, and exchange-traded funds (ETFs) all are pools of money contributed by many investors that aim to earn a profit for themselves and their clients.

Hedge funds are actively managed by professional managers who buy and sell certain investments with the stated aim of exceeding the returns of the markets, or some sector or index of the markets. Hedge funds aim for the greatest possible returns and take the greatest risks while trying to achieve them. They are more loosely regulated than competing products, with the flexibility to invest in options and derivatives and esoteric investments that mutual funds cannot.

Why Do People Invest in Hedge Funds?

A wealthy individual who can afford to diversify into a hedge fund might be attracted to the reputation of its manager, the specific assets in which the fund is invested, or the unique strategy that it employs.

The Bottom Line

Hedge fund investment is considered a risky alternative investment choice and requires a high minimum investment or net worth from accredited investors. Hedge fund strategies include investment in debt and equity securities, commodities, currencies, derivatives, and real estate. Hedge funds are loosely regulated by the SEC and earn money from their 2% management fee and 20% performance fee structure.

FAQs

What are hedge fund strategies explain with example? ›

Hedge funds are versatile investment vehicles that can use leverage, derivatives, and take short positions in stocks. Because of this, hedge funds employ various strategies to try to generate active returns for their investors. Hedge fund strategies range from long/short equity to market neutral.

What is an example of a hedge fund? ›

Some examples of hedge funds include names like Munoth Hedge Fund, Forefront Alternative Investment Trust, Quant First Alternative Investment Trust and IIFL Opportunities Fund. There are others such as Singlar India Opportunities Trust, Motilal Oswal's offshore hedge fund and India Zen Fund.

What is the main strategy of hedge fund? ›

The most prevalent of the hedge fund strategies, equity strategies hedge funds take long positions in stocks perceived as undervalued and short positions in stocks considered overvalued. Equities' correlation with macroeconomic factors mean they are seen as a riskier class for investment than cash and bonds.

What is hedge funds and types of hedge funds? ›

A hedge fund is a limited partnership of private investors whose money is managed by professional fund managers who use a wide range of strategies, including leveraging or trading of non-traditional assets, to earn above-average investment returns.

What are the main characteristics of hedge funds? ›

Key characteristics distinguishing hedge funds and their strategies from traditional investments include the following: 1) lower legal and regulatory constraints; 2) flexible mandates permitting use of shorting and derivatives; 3) a larger investment universe on which to focus; 4) aggressive investment styles that ...

What are multi strategy hedge funds? ›

Multi-strategy hedge funds are the most diverse portfolios in the hedge fund universe. Multi-strategies combine different single hedge fund strategies in one portfolio and differentiate considerably from each other. Most often, such portfolios include a variety of long-short, relative value and event-driven strategies.

Why is it called hedge fund? ›

The term 'hedge fund' originally derives from the investment strategy of 'hedging' against market movements, maximizing returns and eliminating risks by choosing either long (buy) or short (sell) positions within the market – the aim being to profit regardless of market direction.

What is the structure of hedge funds? ›

Most hedge funds use one of the following organization structures: 1) a single entity fund, 2) a master feeder fund, 3) a parallel fund, or 4) a fund of funds. For purposes of this IPS unit, we will be focusing on master feeder funds as they are more common in International tax examinations.

What is the purpose of hedging? ›

Hedging is a strategy that tries to limit risks in financial assets. It uses financial instruments or market strategies to offset the risk of any adverse price movements. Put another way, investors hedge one investment by making a trade in another.

What are long short strategies? ›

Long-short equity is an investment strategy that seeks to take a long position in underpriced stocks while selling short overpriced shares. Long-short seeks to augment traditional long-only investing by taking advantage of profit opportunities from securities identified as both under-valued and over-valued.

What is equity hedge strategy? ›

Hedged equity involves buying equity in some form, as an underlying investment, and then securing a hedge to potentially offset losses connected to market risk (i.e., the whole market sells off or the economy slows due to unpredictable events, like COVID-19 or a mortgage crisis).

What is your investing strategy? ›

What Is an Investment Strategy? The term investment strategy refers to a set of principles designed to help an individual investor achieve their financial and investment goals. This plan is what guides an investor's decisions based on goals, risk tolerance, and future needs for capital.

How many hedge fund strategies are there? ›

It has 4 major types, i.e., Forwards & Futures, Options, Warrants, & Swaps. read more. Thus, the fund manager will purchase the stocks they feel are undervalued and Sell those who are overvalued. A wide variety of techniques are employed to arrive at an investment decision.

What are 4 types of investments? ›

There are four main investment types, or asset classes, that you can choose from, each with distinct characteristics, risks and benefits.
  • Growth investments. ...
  • Shares. ...
  • Property. ...
  • Defensive investments. ...
  • Cash. ...
  • Fixed interest.

What are 3 types of mutual funds? ›

Different Types of Mutual Funds
  • Equity or growth schemes. These are one of the most popular mutual fund schemes. ...
  • Money market funds or liquid funds: ...
  • Fixed income or debt mutual funds: ...
  • Balanced funds: ...
  • Hybrid / Monthly Income Plans (MIP): ...
  • Gilt funds:

What are the benefits of hedge funds? ›

Hedge funds help protect investors from market volatility and downturns better than other investment benchmarks. towards fixed income assets to produce reliable returns and meet financial obligations.

Who regulates hedge funds? ›

Many hedge funds operating in the U.S. are also regulated by the Commodity Futures Trading Commission (CFTC), including advisers registered as Commodity Pool Operators (CPO) and Commodity Trading Advisors (CTA).

What do hedge funds invest in? ›

Hedge funds are alternative investment funds. They pool money from professional investors and invest it with the intent of making a profit, also known as realizing a return on their investment.

What is macro strategy? ›

A global macro strategy is a hedge fund or mutual fund strategy that bases its holdings primarily on the overall economic and political views of various countries or their macroeconomic principles. Holdings may include long and short positions in various equity, fixed income, currency, commodities, and futures markets.

Do hedge funds invest or trade? ›

How do Hedge funds work? These funds use different types of trading techniques because of the securities and assets they invest in. They invest in equities, debt and also derivatives.

What is event driven hedge fund strategy? ›

Event-driven investing or Event-driven trading is a hedge fund investment strategy that seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as an earnings call, bankruptcy, merger, acquisition, or spinoff.

How do hedge funds make money? ›

Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM). Funds typically receive a flat fee plus a percentage of positive returns that exceed some benchmark or hurdle rate.

Do hedge funds control the market? ›

Some hedge funds manipulate stock prices on key reporting dates. The authors find that the returns of stocks with significant hedge fund ownership exhibit an increase of 0.30% on the last day of the quarter and a decrease of 0.25% the following day.

Is hedge fund private equity? ›

Hedge funds are alternative investments that use pooled money and a variety of tactics to earn returns for their investors. Private equity funds invest directly in companies, by either purchasing private firms or buying a controlling interest in publicly traded companies.

Who leads a hedge fund? ›

A hedge fund manager is firm or an individual who manages, makes investment decisions, and oversees the operations of a hedge fund. Managing a hedge fund can be an attractive career option because of its potential to be extremely lucrative.

How many investors can a hedge fund have? ›

A 3(c)(1) hedge fund can have up to 99 investors. Generally these investors will need to be “accredited investors” although some funds will choose to have up to 35 non-accredited investors.

How did hedge funds start? ›

Hedge funds are mostly unregulated investment pools that can only issue securities privately to qualified investors. Alfred W. Jones is generally believed to have started the first hedge fund in 1949, pursuing a strategy of buying stocks and hedging the positions with short sales.

What are the 3 common hedging strategies? ›

There are several effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators.

What are the types of hedging? ›

Types of hedging
  • Forward exchange contract for currencies.
  • Commodity future contracts for hedging physical positions.
  • Currency future contracts.
  • Money Market Operations for currencies.
  • Forward Exchange Contract for interest.
  • Money Market Operations for interest.
  • Future contracts for interest.
  • Covered Calls on equities.

What is the best hedging strategy? ›

Long-Term Put Options Are Cost-Effective

As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments.

What is equity strategy? ›

Equity strategies are investment strategies either for an individual portfolio or a vehicle of pooled funds such as Mutual funds or hedge funds. This strategy has a focus exclusively on equity securities for the purpose of investment, whether it is a listed stock, over-the-counter stocks, or private equity shares.

What is short hedging? ›

A short hedge is one where a short position is taken on a futures contract. It is typically appropriate for a hedger to use when an asset is expected to be sold in the future. Alternatively, it can be used by a speculator who anticipates that the price of a contract will decrease.

What is long strategy? ›

Long/short equity is an investment strategy generally associated with hedge funds. It involves buying equities that are expected to increase in value and selling short equities that are expected to decrease in value.

Is hedging a good strategy? ›

Hedging protects an investor's portfolio from loss. However, hedging results in lower returns for investors. Therefore, hedging is not a strategy that should be used to make money but a strategy that should be used to protect against losing money.

Do hedge funds use options? ›

Hedge funds may purchase options, which often trade for only a fraction of the share price. They may also use futures or forward contracts as a means of enhancing returns or mitigating risk.

What is a fundamental hedge fund? ›

Fundamental Hedge Funds. Fundamental Hedge Funds invest in securities based on the underlying performance of the Business behind the security they purchase (Bond, Stock, Options, etc.).

What are the three investment strategies? ›

Three Investment Income Strategies
  • Higher-Yielding Bonds. The first place investors usually turn is bonds with longer maturities, lower credit ratings or some combination of both. ...
  • Dividend-Paying Stocks. ...
  • Total-Return Portfolio.

What are value strategies? ›

What Is a Value-Based Pricing Strategy? Value-based pricing is a means of price-setting wherein a company primarily relies on its customers' perceived value of the goods or services being sold—also known as customers' willingness to pay—to determine the price it will charge.

What strategies do quant funds use? ›

Quant funds rely on algorithmic or systematically programmed investment strategies. As such, they don't use the experience, judgment, or opinions of human managers to make investment decisions. 3 They use quantitative analysis rather than fundamental analysis, which is why they're also called quantitative funds.

How would you select an appropriate hedge fund strategy? ›

Here are Hogan's top 10 tips for choosing a hedge fund:
  1. Consider your motivations for investing. ...
  2. There are no shortcuts in selecting a hedge fund. ...
  3. Make sure the hedge fund has significant investments from fund managers. ...
  4. Know the manager. ...
  5. Understand the investment objective. ...
  6. How liquid is the fund? ...
  7. Understand the risks.

What is relative value hedge fund strategy? ›

Relative Value Hedge Funds. The relative value hedge fund strategy is predicated on the realization of a valuation discrepancy in the relationship between multiple securities. In doing so, the strategy seeks to take advantage of price differentials by simultaneously buying and selling different securities.

What is event driven hedge fund strategy? ›

Event-driven investing or Event-driven trading is a hedge fund investment strategy that seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as an earnings call, bankruptcy, merger, acquisition, or spinoff.

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