Hedge Fund

A Hedge fund is a general, non- legal term that was originally used to describe a type of private and unregistered investment pool that employed sophisticated hedging and arbitrage techniques to trade in the corporate equity markets. Hedge funds have traditionally been limited to sophisticated, wealthy investors. Over time, the activities of hedge funds broadened into other financial instruments and activities. Today the term “hedge fund” refers not so much to hedging techniques, which hedge funds may or may not employ, as it does to their status as private and unregistered investment pools.           

The first hedge fund was set up by Alfred Jones in 1949. Jones was the first to use short sales and leverage techniques in combination. In 1952, he converted his general partnership fund into a limited partnership investing with several independent portfolio managers and created the first multi- manager hedge fund.

Classification of Hedge Funds

Hedge funds are classified into aggressive growth, distressed securities, emerging markets, fund of funds, income, macro, market neutral- arbitrage, market neutral- securities hedging, market timing, opportunistic, short selling, and value.

Hedging strategies

It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same- investment returns, volatility and risk vary enormously among the different hedge fund strategies. Knowing and understanding the characteristics of the many different hedge fund strategies is essential to capitalizing on their variety of investment opportunities. A wide range of hedging strategies is available to hedge funds which include selling shares without owning them, seeking to exploit pricing inefficiencies between related securities using arbitrage, trading options or derivatives, investing in anticipation of a specific event, investing in deeply discounted securities.

The infamous 2 and 20 Hedge Fund Arrangement

The 2 and 20 formula basically means that the hedge funds operating agreement calls for the hedge fund manager to receive 2% of profits each year. That means that even if they lose money, they are at least guaranteed the 2% return with little or no hurdle rate.

Benefits of Hedge Funds

Many hedge funds have the ability to generate positive returns in both rising and falling equity and bond markets. Hedge funds provide an ideal long- term investment solution, eliminating the need to correctly time entry and exit of markets. By including hedge fund in a balanced portfolio, it reduces the overall portfolio risk, volatility and increase returns. Adding hedge funds to an investment portfolio provides diversification and choice for the investors. Academic research proves hedge funds have higher returns and lower overall risk.

Questions:

• What are hedge funds?
• What are the different hedging strategies that are available?