Investing 101: What is a Hedge Fund in Simple Terms?

June 4, 2020 Posted by : Jorge Cardozo
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For many years, Hedge funds have had a not-so-good reputation not only for individuals or retail investors that associate this term with the financial crisis but also for some financial experts, who assure that hedge funds have not delivered what they are expected to deliver. 

A Hedge Fund in Simple Terms

For many people hedge funds could be like a Rubik’s cube: it might be hard or complex to understand at first, but once you are familiar with it, the whole world of investment unfolds in front of you.

Like private equity, hedge funds are solely for qualified investors (large institutions and wealthy investors). Hedge Funds form part of the universe of alternative assets, along with Private Equity and Real Estate.

Definition of Hedge Funds

Hedge funds “are alternative investments using pooled funds that employ different strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives. A derivative is a financial security with a value that is reliant upon or derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a contract between two or more parties..that derives its price from fluctuations in the underlying asset and leverages both domestic and international markets to generate high returns (either in an absolute sense or over a specified market benchmark). It is important to note that hedge funds are generally only accessible to accredited investors as they require less Security Exchange Commission's (SEC) regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles”

Types of Hedge Funds

The concept of a hedge fund was born (as its name suggests) with the purpose of financial hedging. This is where the long/short positions appeared. However, there are more hedge funds strategies today. Let's take the most common hedge fund investment strategies:

Short/Long Equity: When you buy a stock is because you expect the price to increase. The regular stock purchase is an example of long position. But you can decide to sell short, if you sell a stock you do not own, expecting the price to drop.  For example, assume that stock “A” is currently $50 per share. For one reason or another, you expect the stock price to decline so you decide to sell short to profit from the anticipated fall in price. 

Event-driven: Hedge funds managers buy the debt of companies that are bankrupt or are very close to going bankrupt. Hedge funds managers usually wait for a new structure within the company, so their strategy can be accomplished. It could be a matter of weeks or even years. 

Debt: Many hedge funds love arbitrage. Of course, they can do this with bonds or debt, especially in the high-level credit seniority. If a manager invests here is because a giant opportunity is expected. The investments can be through corporate bonds or Government bonds. The strategy on the former will vary slightly depending on the economic outlook and the interest rates forecast. 

Global Macro:

This strategy covers a wide range of financial instruments. It implies taking investment decisions based on the expectations and forecast of macro variables such as: interest rates, economic performance, inflation, etc. 

Pros and Cons

One of the highlights when using hedge funds is the return you might get. These investment strategies are used to bring hedging when volatility arises. However, the last premise has not always worked. In  2008, during the financial crisis, the reputation of hedge funds was questioned when many of the hedge fund managers did not deliver any positive results.  

Complexity is one of the major blockers for many investors. Sometimes, the strategies are not detailed or the range of things a fund can invest seem to be very broad. As these types of investments are not as regulated as mutual funds; they are not forced to make information public, in terms of returns, portfolio allocation, or any information. Other points to consider are costs, and in this matter hedge funds are not well regarded. They not only have huge management costs but sometimes they have upfront fees and performance fees that can take away a big portion of the potential returns. 

I acknowledge that this type of investment is far from being on the list of options for individuals or retail investors. However, I do consider it important to understand the vast world of opportunities when it comes to investing, especially if you want to start deciding what's appealing or not for you. The more you know the better your chances to have a good portfolio.

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About Author

Jorge Cardozo
Jorge Cardozo

Jorge has over eight years of experience in wealth management and economic research, managing more than 600 million USD. He has invested in all types of securities, ranging from traditional assets (fixed income securities and funds, global equity) to alternative assets (real estate, hedge funds, and private equity). Jorge holds an MBA from a top global program.

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