Hedge Funds - Concept
Over the last 15 years, hedge funds have become increasingly popular with high net worth individuals, as well as institutional investors. The number of hedge funds has risen by about 20% per year and the rate of growth in hedge fund assets has been even more rapid.
A hedge fund is a private investment fund, charging a performance fee and is open to only a limited number of investors. These funds are like mutual funds, which collect money from investors and use the proceeds to buy stocks and bonds. They can invest on almost any type of opportunity; in any market where in good returns are expected with low risk levels.
Protecting capital and producing good return in all kinds of market conditions, while attempting to minimize the risk, is the main objective of most of the hedge funds.
Hedge funds have grown in size and have a great influence on public securities and private investment markets. Hedge funds are not currently subject to any direct regulation, unlike mutual funds, pension funds and insurance companies. They are limited only by the terms of contacts governing the particular fund.
Hedge funds may be either long or short assets and may enter into futures, swaps, and other derivative contracts. In this way, hedge funds are able to follow complex strategies, intending to profit from market volatility or from falling market.
Characteristics of Hedge Funds:
- A hedge fund generally uses several kinds of financial instruments to reduce risk and add more returns. It tries to reduce the correlation with equity and fixed income markets. Many hedge funds use short selling, leverage, derivatives such as puts, calls, options, futures, etc. to accomplish their goals.
- The nature of hedge funds differs a lot in terms of investment returns, instability and risk symptoms. Normally, hedge fund strategies intend to hedge against Markey fluctuations. However, this does not mean that all hedge funds can give great advantage in unfavorable market conditions.
- The hedge fund manager’s compensation is linked to his overall performance. This stimulates the fund managers to deliver their best. At times, hedge fund managers may invest their own money in the funds that they manage.
- Most of the investors in hedge funds such as pension funds, endowments, insurance companies, private banks, and high net worth individuals invest in hedge funds to minimize their overall portfolio risk and enhance returns.
- Many hedge funds can produce uncorrelated returns i.e. returns that are not dependant on market fluctuations. Such abnormal returns from hedge funds are a great advantage in difficult market conditions.
- Highly skilled, specialized and experienced fund managers manage hedge funds. They are disciplined and diligent and believe in doing everything within there are of competency and competitive advantage.
Hedge Fund Strategies:
Hedge funds use different types of strategies that reflect different kinds of risk and return trade-off:
- A macro hedge fund invests its fund assets in both the stock and bond markets. It can also invest in other investment avenues, such as currencies, in anticipation of benefits from the major shifts in some investments, such as global interest rates and nation’s economic policies.
- An equity hedge fund can invest in international markets or many concentrate on a particular domestic market. This helps the fund to invest, to hedge against the fluctuations in equity markets. This can be possible by selling overvalued stocks or stock indices in one market and buying the undervalued stock or stock indices in another market.
- A relative hedge fund tries to achieve a high return by exploiting the price difference or spread
Hedge Fund Risks:
Lack of transparency
Limited liquidity
Difficulty accessing quality hedge funds
Unreliable or incomplete return data
Valuation risk
Asymmetrical nature of Hedge fund returns distributions [SKEW]
Counterparty risk [Leverage]
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