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what is a hedge fund?

Hedge Funds are a generic name for a fund or a pool of money invested in a particular strategy in a variety of financial products and markets with the sole aim of generating an absolute return. Hedge Funds were originally funds that had a lot of risks hedged, so theoretically, these funds will be lower risk than an average mutual fund or unit trust.

Nowadays, the term Hedge Funds can mean a variety of different fund strategies. Some examples include, Equity Long / Short, Commodities, Foreign Exchange, Arbitrage, Bond Funds, Special Opportunities, Derivatives, Derivative Arbitrage, Art funds, etc.

Hedge funds aim to achieve higher returns by taking riskier positions in their trades as higher risk equals higher returns. Most Hedge Funds are able to leverage as they have prime brokers who give them lines of credit, this enables the fund managers to take large positions to exploit small arbitrage opportunities. This can be highly risky if markets move unexpectedly and the leverage can leave a fund exposed like what happened with Long Term Capital Management.

Absolute Return means to make a positive return on the money you have invested, unlike a regular mutual fund or unit trust where the main aim of the fund manager is to beat a stock market index. For example, it a UK equity fund would probably be measured against the movement on the FTSE or in the US, a US equity fund will be compared to the Dow Jones Index. The fund managers will be applauded for beating the index, ie if the fund they are managing returned a performance of 17% over the index increase of 13% they have done a good job, even if the market went down, if they fund manager made -3% return instead of the market or index recorded a -5% drop, he fund manager has done well for producing a better result.

For the investor, they would have a 4% increase of return on capital invested in return for paying the additional cost of paying a management fee for the privilege of investing in that active fund. The alternative was to invest in a tracker fund, pick an index like the Dow Jones, buy a tracker fund or an Exchange Traded Fund (ETF), you pay very little or no management fee in comparison and you would have achieved a 13% gain.

With absolute return funds, the intention is to invest to achieve an absolute return, which means that you will always make a positive return on your investment. Hedge fund managers are usually paid a yearly management fee ranging from 1% - 3% and as a further incentive, they are paid a performance fee which can range from 10% to 30% or that excess return that was achieved. A lot of investors are willing and happy to pay for this higher set of fees for the higher returns that they can get from investing in a fund of this type.

In general, investing in Hedge Funds is for professional or sophisticated investors, and normally a minimum investment is in the range of US $100,000. Funds normally recommend that this $100,000 be less than 5% of your total investment portfolio as it recognises that this is typically a riskier position than other investments. For sophisticated investors, investing in a hedge fund is a good method for diversification of their investment portfolio and can provide an enhancement to that portfolio’s return. Recently, a few fund management firms have started to make hedge fund as an investment product to the man on the street, so do have a look around if you are interested. If you decided to invest in hedge funds, do take some advice from your banker or a financial advisor.

To read more about hedge funds, here are some online resources:

www.hedgefundintelligence.com

www.hedgefund.net

Other related articles about investing:

An Introduction to Day Trading
Managing and Eliminating Debt
Have you started investing for your retirement?
An Introduction to Stock Market Investing

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