Money and finance tips: what are hedge funds?
Financial basics: what is a hedge fund and how to invest in them.
Hedge funds are a type of investment vehicle, one which is able to invest in ways which other funds cannot. They are typically for wealthy investors or institutions, not for individual private investors.
When we think of a typical investment fund we think of those that invest in a particular market or security. We can see real state funds, stock funds, bond funds and, of course, money market funds. When an investor buys into one of these they know what their money is going to be used for and can estimate the risk. If you want no risk and will accept low returns, then money market funds are good for you. If you want higher returns and will accept the greater risk, then perhaps stock funds are right.
A hedge fund does not simply buy an asset and wait for it to rise. As an example, here is the difference between a stock fund and a hedge fund. A stock fund will buy the stocks it thinks will rise and sell those that it thinks will fall. A hedge fund might invest in stocks but it would not do something as simple as buy or sell. It might short sell, that is sell something it does not own in the hope of buying it back cheaper in the future. More likely, it will play with options on the underlying stock. Imagine that a company’s results will be published next week. The hedge fund thinks that those results will be interesting, but they are not sure which way, good or bad. They might use options in what is known as a “butterfly spread”. The effect is that if the stock moves up or down the fund will make a profit. Only if the stock stays still does the fund lose money. You can see that this is both more complex and more risky than a traditional stock fund.
Hedge funds do not restrict themselves to one sector. They might invest in currencies, or commodities, real estate, whatever it is that they think will make them money. In all of these different sectors it is rare for them to make a simple investment. They are usually looking one or two steps ahead of the rest of the market. For example, real estate usually becomes more expensive when interest rates go down. So a hedge fund which thinks that interest rates are going down might buy real estate. Or they might buy stock in a company that owns a lot of real estate, or buy an option on some land to develop. The important point is that they think ahead to the more complex implications of whatever it is that is going on.
Hedge funds are always geared. Normal investment funds have the money that people have invested in them. Hedge funds take the money that was invested, then they borrow more. This entire sum is then invested in whatever markets they think will make a profit. This is known as gearing. When they make a profit, the returns to the investors are greater. However, if they make a loss then the loss to the investors is also magnified as the borrowed money must still be paid back.
Hedge funds are not subject to the same rules as normal funds. They are not overseen by the Securities and Exchange Commission, there are no limits on what they can invest in or how. They can invest all of their money overseas, or in the US, they can switch from one style of investment to another without telling anyone, even their investors. They also do not have to report their investments to anyone. In fact they usually claim that they could not do so as if they did then their competitors would see what they are doing.
Some hedge funds invest in what seem to be very strange ways. For example, there is one which specializes in the volatility of stocks. They do not buy and sell stocks. They do not invest in options on stocks. They do not actually care whether a stock or an option goes up or down. They are really investing in options on options. It might sound strange but they make money out of the speed at which a stock goes up or down, not whether it goes up or down.
We can see that a hedge fund is a secretive geared investment fund, one which is not subject to the same rules on investment and oversight as the more normal funds. A hedge fund invests in complex transactions, usually involving derivatives such as options and futures.