Hedge Funds Definition, an Investment Option Designed to Get Great Returns

Learn the hedge funds definition, an investment option, long or short term, designed to get customers large returns.

The Hedge Funds Definition

A hedge fund is a type of bundled investment fund which trades relatively liquid assets. It is capable of making large-scale use of more sophisticated trading, portfolio-building, and risk-management techniques to try and increase returns, such as short-selling, leveraging, and derivatives. Each fund is different, and because hedge funds are less subject to regulations than conventional pooled investment vehicles like mutual funds, the assets that they purchase and strategies that they adopt may differ greatly. Managers typically employ sophisticated strategies. These would include leverage, short positions, and derivatives like options, and managers can invest in a wide range of markets, including stocks, bonds, commodities, real estate, cryptocurrency, and others.

Assets under management can include stocks, bonds, real estate, commodities, currencies, derivatives, and other alternative assets, many of which are not liquid. Managers can use derivatives to hedge or leverage positions. They may purchase more illiquid assets, such as artwork or private real estate, may sell short, and may utilize debt. Most hedge funds buy (and/or short) publicly traded stocks, but they may also make use of alternative assets–such as art, real estate, currencies, cryptocurrencies, and even patents–in their money-making strategies.

Pooled Investments

Hedge funds use pools of money from qualified investors to chase outsized returns, usually by employing risky strategies like using leverage in investing, shorting stocks, or taking concentrated positions. Hedge funds that employ global macro investment strategies hold large positions in stocks, bonds, or currency markets, anticipating global macroeconomic events, to produce risk-adjusted returns. One of these strategies is global macro, in which a fund takes long and short positions in major financial markets according to the views affected by economic trends.

Follows Regulatory Requirements

The funds managers make assumptions about central bank policies, economic growth, consumer spending, trade relations, and regulatory changes. They then construct long and short positions based on their assumptions. Rather than reflecting actual hedge fund performance, they adopt a statistical approach of analyzing historical hedge fund returns. They use such to build a model for how hedge fund returns respond to movements in different investment assets.

For instance, an investor may be attracted to a specific hedge fund due to its managers reputation, the particular assets that the fund invests in, or the unique strategies that it adopts. While each hedge fund will have its own particular investment strategy, the idea behind a hedge fund comes from the ability of a funds managers (or common partners) to execute specific trading tactics, such as shorting stocks (if they expect a market downturn) or covering themselves by going long (if they expect the market to go up). Here, the aim of the fund manager is to minimize market risk through investments in long/short equity funds, convertible bonds, arbitrage funds, and fixed-income products.

Investment Fee for Fund Manager

This structure is a little difficult to sell to many investors because the fund manager gets an asset management fee — that can be millions — no matter how the funds performance. If the fund does not turn a profit, that fee is waived, but the fund managers 2 percent of each clients investment is still paid each year, no matter what. In this example, participants paid a 2 percent annual fee on their investments in the fund, with 20% taken out of any gains.

This is a fee that clients pay to fund managers to (ideally) beat the market by a wide margin through their diligent research and trading decisions. Because taking is such a powerful incentive for fund managers to assume excessive risks, the government has heavily restricted the types of investors that are allowed to be involved with hedge funds. A This model has also led to staggeringly large bonuses for those fund managers (even $1 billion-plus), which is a hotly debated topic. Because the differences between prices are typically small, funds following this strategy typically use leverage to make larger trades relative to the total assets they manage in order to make large gains.

These funds follow classical trend-following strategies, which may yield large gains, but also large losses. Funds such as macro funds are typically very diverse and typically employ large amounts of leverage in order to maximize returns. You must therefore make careful investment decisions, as there can be high return but also high risk.

Can be Structured like Mutual Funds

Funds of funds are usually created for retail markets, and can in some jurisdictions be structured like mutual funds or investment trusts with similar characteristics. A hedge fund is also considered distinct from private-equity funds and other closed-end funds in that hedge funds typically invest in relatively liquid assets, and are typically open-ended, meaning they allow investors to periodically invest and withdraw money according to the funds net asset value, while private-equity funds typically invest in illiquid assets and return the money only after some years. There are more specific characteristics that define a hedge fund, but basically, since hedge funds are private investment vehicles allowing only high-net-worth individuals to invest, hedge funds are free to pretty much do whatever they please, provided that they disclose their strategies upfront to investors.

Designed for the Wealthy

Hedge funds usually require a higher minimum investment and are open to only accredited investors, like wealthy individuals, as well as institutional investors, like pension funds and insurance companies. Hedge funds are required to file Form PF if they have an investment adviser registered with, or required to register with, the Securities and Exchange Commission (SEC), operate one or more private funds, and manage at least $150 million of assets in the private funds. The mandate would restrict the amount of leverage fund managers may employ, the markets they may invest in, and the maximum amount of exposure they may have in any single instrument or industry.

CTAs, or Commodity Trading Advisors, and managed futures funds employ systematic trading strategies that aim to capitalize on secular trends in indexes and commodities futures, as well as in currencies.

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