A hedge fund is an offshore investment fund that uses credit or borrowed capital. Hedging is also a term that is used to back up any potential loss that may be incurred. Hedge funds often use derivatives to achieve a hedge and can generate high returns if used effectively. In short, a hedge fund is a way of reducing the risk of a loss in an investment.
On the other hand, hedge funds require a good knowledge of investments and how to manipulate the stock market to achieve greater returns. If the hedging methods are not applied correctly then any gains in other investments could be lost or an initial loss could be maximized.
From a legal perspective, hedge funds are often a private investment limited partnership and initial investments require at least 1 year before it can be taken out which makes them relatively illiquid.
2 and 20 rule
Hedge funds are usually operated through the use of a hedge fund manager who often charges a premium for their services. This is often known as the 2 and 20 rule whereby the hedge fund manager charges 2% to place the hedge and 20% of the profits above a certain value which is called after upside. So, 2% premium with a 20% after upside.
Hedge Fund Strategies
There are 9 main hedge fund strategies which are:
- Equity Market Neutral – Long and short positions are established to reduce the underlying exposure (i.e. Using long and short options to reduce the risk)
- Convertible Arbitrage – Using mis-priced convertible securities and expecting the price to change to your benefit.
- Fixed-Income Arbitrage – Using overvalued or undervalued securities and hoping they will change to your benefit. This is established through market movement analysis.
- Distressed Securities – Distressed securities are invested in near bankrupt companies.
- Merger Arbitrage – Also “Deal Arbitrage”. Capturing the price spread of a valued company upon a successful takeover.
- Hedged Equity – Taking advantage of under-priced and over-priced equity securities.
- Global Macro – Taking advantage of moves in the financial and non-financial sector through the use of currency trading, futures and options contracts.
- Emerging Markets – Focusing on funds based in emerging and less mature markets
- Fund of Funds – Using a fund to invest in lots of other funds to try and reduce the risk of a loss.