So what is a hedge fund? Well … a hedge fund is just a fancy name for an investment partnership that has freer rein to invest aggressively and in a wider variety of financial products than most mutual funds; it’s the marriage of a professional fund manager, who is often known as the general partner, and the investors, sometimes known as the limited partners. Together, they pool their money into the fund.
With that in mind, let’s look at the basics of a hedge fund, which is just one of many alternative investment vehicles.
Hedge funds are financial partnerships that use pooled funds and employ different strategies to earn active returns for their investors. These funds may be managed aggressively or make use of derivatives and leverage to generate higher returns. Hedge fund strategies include long-short equity, market neutral, volatility arbitrage, and merger arbitrage. They are generally only accessible to accredited investors.
Aim and Characteristics of Hedge Funds
A common theme among most mutual funds is their market direction neutrality. Because they expect to make money whether the market trends up or down, hedge fund management teams more closely resemble traders than classic investors. Some mutual funds employ these techniques more than others, and not all mutual funds engage in actual hedging. For more information, you can also install helpful applications such as, say, the CARL – hedge fund investing app, which is good for beginners.
Several key characteristics set hedge funds apart from other pooled investmentsnotably, their limited availability to investors.
Advantages of Hedge Funds
Hedge funds offer some worthwhile benefits over traditional investment funds. Some notable benefits of hedge funds include:
- Investment strategies that can generate positive returns in both rising and falling equity and bond markets
- The reduction of overall portfolio risk and volatility in balanced portfolios
- An increase in returns
- A variety of investment styles that provide investors the ability to precisely customize an investment strategy
- Access to some of the world’s most talented investment managers
- Profits in rising and falling markets
- Balanced portfolios reduce risk and volatility
- Several investment styles to choose from
- Managed by the top investment managers
- Losses can be potentially large
- Less liquidity than standard mutual funds
- Locks up funds for extended periods
- The use of leverage can increase losses
Disadvantages of Hedge Funds
Hedge funds, of course, are not without risk as well:
- Concentrated investment strategy exposes them to potentially huge losses.
- Hedge funds tend to be much less liquid than mutual funds.
- They typically require investors to lock up money for years.
- The use of leverage or borrowed money can turn what would have been a minor loss into a significant loss.
The Bottom Line
A hedge fund is an official partnership of investors who pool money together to be guided by professional management firms – just like mutual funds. But that’s where the similarities end. Hedge funds aren’t regulated as much and operate with far less disclosure. They pursue more flexible and risky strategies in the hopes of netting big gains for investors, which, in turn, result in big profits for fund managers. But perhaps what sets them apart from mutual funds the most is that they have much higher minimum investment requirements.
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