A hedge, by definition, is a boundary. You can, for example, surround your garden with a hedge. For this reason, the original idea of a hedge fund was to protect those who invested from uncertainty on the market; a hedge fund was intended to reduce risk. It was a private investment marked by a barrier.
Investors would typically pool a large amount of money in a fund to avoid negative changes in the market, with the expectation that their investment would eventually yield a healthy return. Nowadays, however, a hedge fund is often seen primarily as something that can enhance and maximize returns in a significant way. The idea that a hedge fund is something purely that reduces risk is becoming quite obsolete with major investors.
Hedge funds, like mutual funds, are headed by a hedge fund manager. The hedge fund manager has the incentive of creating returns on each investment because they will scoop a percentage of all profits. The greater their ability, the greater the profits. Because hedge funds are unregulated, the manager is able to fulfill his potential and utilize as many means and methods open to him in a bid to generate rewarding returns for investors.
The manager is essentially free to invest in numerous securities. These can take the form of traditional securities, such as stocks and bonds, but the techniques employed by the manager can often become complex and increasingly risky – such as leveraging.
A hedge fund is much more exclusive than a mutual fund (of which it bears similarities) because they are typically only used by wealthy investors who are able to make significant investments. The man on the street may have never heard of a hedge fund, and may never hear of one, because such investment isn’t necessarily open to him. Yet it is claimed that our financial world is now being more and more driven by the unseen world of hedge funds.
The fact that only wealthy individuals involve themselves in hedge funds is largely down to the types of investment. For example, a lot of hedge funds deal in leveraging, and because leveraging involves borrowed money, the risks are increased. There may be more to gain – but there can also be more to lose. Hedge funds are often associated with company takeovers, and the investors typically use leveraging as their means in this regard.
The investors will borrow a large amount of money to buyout an under-performing company, before selling its assets in an effort to quickly repay their debts. This kind of sophisticated investment is what sets hedge funds apart from the man in the street.
A popular form of hedging is the use of derivatives. A derivative is a contract whose value is determined by something else – usually the underlying asset, such as a stock or share. One type of a derivative is a future; financial futures can be bought on the premise that the investor will buy a financial instrument (in the future), such as a bond.
The investor will either profit handsomely from the rise in interest rates, or they may have to cut their losses. Although derivatives are an extremely popular form of hedging, often because they are seen as the chance for a quick profit, they have come under fire from many major investors who see them as needlessly risky, pointing to the early nineties when a large sum of investors lost billions of dollars after buying derivatives.
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Overview of how hedge funds are different than mutual funds