A hedge fund was originally an investment fund that sold some stocks short, and bought other stocks long. Using this strategy, the overall value of buying and selling should balance itself out, thereby potentially avoiding heavy losses due to market fluctuations. Profits from a hedge fund are achieved by choosing the right stocks and trading them when the opportunity is good.
These days, the term hedge fund is applied to funds that do not actually ‘hedge’ their risks but rather increase them because they expect to generate a much higher return for their investors. Traditionally, a hedge fund was basically a managed portfolio of investments that was usually open to a limited range of wealthy investors. As the name suggests, these funds ‘hedge’ their bets by offsetting potential losses using different approaches, the most popular one being what is called short selling.
One very common strategy for hedge fund investment is to buy shares in a company that is in the midst of a merger or an aquisition. This is because there is a guaranteed profit if the merger does succeed, with the only risk being that the acquisition will fail. This strategy, often used in tandem with selling shares of the company doing the acquiring, is known as risk arbitrage.
Hedge funds seek positive returns, irrespective of the sector performance or the market benchmark whereas Mutual funds invest in a certain sector or use a specific approach. To determine whether a mutual fund has been performing well, its returns are usually compared to a the market benchmarks.
One constant complaint against hedge funds is that they are very lightly regulated, certainly in comparison to mutual funds which are regulated under the Investment Company Act of 1940. Hedge funds do not fall under this act because they participate in ‘private offerings’ to sophisticated investors alone unlike ‘public offerings’ of mutual funds.
During the financial market crisis of 2008-2009, the short-selling of the financial stocks by the hedge funds were blamed by many to be one reason why the crisis escalated. This has led to the demand for tighter regulation of hedge funds as little is really known about the actions of the money managers of these funds.
Find out more about Hedge Funds from Max Gottschalk of Gottexholdings.com