Finance

What are Hedge Funds?

WHAT ARE HEDGE FUNDS?

Hedge funds are pooled investments that use different strategies to earn returns, profits. It is an alternative investment intended to secure investment portfolios from market volatility, thus producing positive returns on both up and down markets. They are aggressively managed in the international as well as domestic markets with an aim to earn high returns. An important thing about them is that they are only available to sophisticated investors, such as institutions and individuals with significant assets. They generally require much less SEC regulations compared to other funds.

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Background:

The history of hedge funds ranges back to 1949. Alfred W. Jones was the first person to start a hedge fund by an interest in buying stocks and hedging their positions in short sales. Generally, they have a structure in which the managing partner keeps 20% of the returns. This type of structure makes it possible to receive high compensation. In 2005 at least 2 hedge funds earned at least $1 billion each. They seek inefficiencies in the market and attempt to correct them.

Key players:

Investment manager: An investment manager is a person who oversees, makes investments, manages the operations of a hedge fund. They specialize in an investment strategy, often earn above average compensation. To be successful, one must have a special methodology, efficient risk management strategy, etc.

Prime broker: The role of the prime broker is to trading operations in a hedge fund. It facilitates and coordinates with the investors in the trading of various financial instruments. Major investment banks provide these services. They also offer risk and performance analysis.

Auditors: An auditor is a specialist whose job is to review the accounting practices of a hedge fund. During the review time frame, the auditor will work with them to survey the valuation strategy of the fund. It will review the statements of profit and loss. Usually, the auditor works with the fund administrator as he is the one who has all the financial records of the hedge fund.

Characteristics of Hedge Funds:

  1. Hedge funds are illiquid.
  2. They have little to no regulatory sight
  3. They use an aggressive investment strategy
  4. Managers receive bonuses for fund performance
  5. These funds are secretive about strategy.

Benefits and Risks Involved:

Benefits: Unlike mutual funds, hedge funds are much more flexible. It can use strategies such as short selling, derivatives, leverages, to earn high returns. Hedge funds have the ability to add diversification into your investment and therefore reduce risk. It increases portfolio stability. Hedge funds use aggressive investment strategies thereby increasing your returns.

Risks: Most of the hedge funds have a fee structure known as 2 and 20 i.e. 2% in management fee and 20% to the fund manager. Hedge funds have high performance but let’s not forget the high risk involved in this. They use standard deviation tools to anticipate the risk of investing in a particular fund. This disadvantage of this tool is that it measures risk in the volatility of possible gains. It doesn’t include the overall picture of risk and returns.

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Conclusion :

Hedge funds play an important role in our economy as they couple both risk reduction as well as high returns at some time. They continue to give investors a solid alternative to traditional investment funds, which provides the likelihood of higher returns that are not associated with the equity and bond markets.

 

Author – Priyanshu Ahuja

About the author – I’m a first-year student from City Premier College, Nagpur, pursuing BBA. My interest includes financial markets and investment domain.

 

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