How Does a Hedge Fund Work?
How Does A Hedge Fund Make Money in Any Market?
Hedge Funds are often in the news, but what they actually do to make their rich clients lots of money no matter what the stock market is doing is a little mysterious; details of their holdings and what they do with them are not very visible. So what is a hedge fund and how can I invest in one?
The first hedge fund was set up in 1949 by Alfred Winslow Jones and consisted mostly of long-only buy-and-hold investments, but with performance enhanced with leverage (borrowed money to enhance returns) and short-selling to make money when markets fell. There are now thousands of funds using more than 30 different strategies (including classic Long/Short Equity Hedge, Credit or Debt Arbitrage, Convertible Arbitrage, Momentum and trend based strategies (i.e. chart based) or Macro driven strategies) See below for more details
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What is a Hedge Fund?
Hedge Fund Strategies
There is no accurate definition of what a hedge fund is and so-called hedge funds can invest in a wide variety of asset-classes in a variety of different ways, but there are many sub-classes of hedge fund, such as the long-short equity hedge or arbitrage hedge funds for which there is a defined strategy. One common-feature that should exist (to justify the name) is that they should hedge against market risk i.e. protect themselves against big falls in market prices and keep making money no matter what.
Regulated (i.e. non-hedge) funds such as unit trusts were prevented from using derivatives or short-selling to hedge against market risk, because it was deemed to be too risky to allow them access to such potentially high risk instruments (if used incorrectly), but that restriction was lifted a couple of years ago so now many mainstream funds are effectively hedge funds. The main difference now is that real "hedge funds" are unregulated. The other differences are they charge huge fees, usually with extra performance fees if they actually manage to reach what ever target they set; they often have a high minimum entry requirement like $100,000 or $1,000,000 minimum investment and they have very rich employees (because they charge such huge fees)
So. That didn't really answer the question, but what should a hedge fund be?
Long Short Equity Hedge
This is what I think of as a classic hedge fund: Buy shares in one company that you like, e.g. BP and short-sell another, that you think is less good, of the same total value e.g. Shell and if you are correct that BP outperforms Shell you will make money (otherwise you will lose money) no matter what the market does. If both shares go up, but BP by more than Shell you make a profit on BP and a smaller loss on shell, if both go down you make a loss on BP, but a bigger profit on Shell. i.e. an absolute return.
Arbitrage strategies (e.g. Debt Arbitrage, Convertible Arbitrage) involve buying one asset and shorting another both of which are effectively the same or highly correlated to each other but one you think is over priced and one relatively under-priced. With Debt Arbitrage this may be taking advantage of anomalies in the governement bond markets and Convertible Arbitrage anomalies in the pricing convertible shares versus ordinary or other classes of share.
Hedge Fund Books
For more insight into the strategies used by Hedge Funds here are a few books on the subject
Hedge Fund Strategies
Generally hedge fund strategies are referred to as absolute return, so they claim to make money in any market. This can be because they are "market neutral", such as the "Long-Short Equity Hedge" described above, or "directional" in which market trends or anomalies are exploited. The directional variety is less of a "true" hedge fund (in my opinion) because it is usually using the unregulated nature of hedge funds to allow higher risk taking: e.g. using derivatives and/or short selling to increase the leverage in the direction the market is expected to move (something that would usually not be allowed in a regulated, retail investor fund, due to the potential to lose a lot of money if the manager gets it wrong)
Where Are The Customers' Yachts?
Where Are The Customers' Yachts?: A Classic Book about the excesses of Wall Street
Invest in Gold - Hedge against financial disaster
Gold coins and bars are a good way of protecting your wealth