ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel

How Does a Hedge Fund Work?

Updated on April 4, 2014

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

Disclaimer: Information in this and other linked articles is unregulated and for general information only and is not intended to be relied upon in making specific investment decisions. Appropriate independent advice should be obtained before making any such decision.

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

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

Please Leave Some Feedback

    0 of 8192 characters used
    Post Comment

    • profile image

      Veli 2 years ago

      Tool and here's a list of possible keodyrws around digital photography (Read my Market Samurai Review here):Market Samurai allows you to do a full keyword research for Long tail keodyrwsAs you can see, the

    • KathyZ1 profile image

      KathyZ1 4 years ago

      Thanks for your commenting and liking my lens on how to create and publish your eBook. It means a lot to me. I love reading your lenses.

    • robertred24 profile image

      robertred24 4 years ago

      Interesting lens!

    • profile image

      Andrew4M 4 years ago

      Good one, followed you

    • LauraCarExpert profile image

      LauraCarExpert 4 years ago

      Great info.....I love learning about finance

    • LauraCarExpert profile image

      LauraCarExpert 4 years ago

      Great info.....I love learning about finance

    • SusanAston profile image

      SusanAston 4 years ago

      You have a lot of great interests to share here.

    • Mr Criminology profile image

      Bigwas 4 years ago from Philippines

      nicely explained, substantially understood by a layman like me who only knew 4 basic investment vehicle which is insurance,stocks,mutual fund, and real property.

    • profile image

      ConvenientCalendar 4 years ago

      Great lens! Great info!

    • Constantimo profile image

      Constantimo 4 years ago

      Great lens, with a lot of top info on the subject. australianstockexchangeshareprices.com is a good site for info on asx share prices

    • SmallBizChampion profile image

      SmallBizChampion 4 years ago

      The well paid employees are generally highly educated, with professional qualifications (like CFA). Most professionals can get top salaries due to their qualifications and relevant experience. My goal inlife is to open my own Hedge Fund that will be open to retail investors (i.e minimum investment will be less than £100k). Watch this space. By the way, I am a CFA candidate.

    • profile image

      chickie99 4 years ago

      great intro info into hedge funds!

    • profile image

      anonymous 5 years ago

      So, a hedge fund is like hedging your bet to cover yourself for when the unexpected, which is expected, happens. My head is in a whirl on this information but if I need it down the road, I'll be looking to your expert advise. Very nicely done and I sorta understand what hedge funds are about a little more now...or a lot more because I didn't know anything at all.

    • profile image

      anonymous 5 years ago

      The Global X FTSE ASEAN 40 ETF targets the 40 largest companies in the five ASEAN countries: Singapore, Malaysia, Indonesia, Thailand and Philippines.

    • bushaex profile image

      Stephen Bush 5 years ago from Ohio

      Even Warren Buffett has hired someone with hedge fund expertise. The strategies of the early successful hedge funds made this look like easy money, but ultimately it has become more clear that some people are much better at this than others.

    • frugalfinance lm profile image

      frugalfinance lm 5 years ago

      I really enjoyed reading this lens, learnt a lot from it!

    • profile image

      ThadBong 5 years ago

      Great lens! Some sections of the media have painted hedge funds in a bad light, especially in the recent market collapses but in reality we're just a business looking to make good returns for our clients.

    • profile image

      oswaldosena_1 5 years ago

      I really enjoyed your lens!

    • profile image

      anonymous 5 years ago

      I need to spend some quality time on this lens. Too much information to internalize at one time.

    • profile image

      anonymous 5 years ago

      I need to spend some quality time on this lens. Too much information to internalize at one time.

    • profile image

      evansmall6 6 years ago

      Among the specific points you want to talk about with a private equity recruitment include: what their specific focus is when it comes to jobs (hedge fund jobs, personal fairness jobs, back office monetary companies), will they treat your resume in confidence and not shotgun blast it out to firms and through the web, do they concentrate on a particular geographical are, what's timeline to listen to again from them.

    • profile image

      dilipsvarma 6 years ago

      goo9d information

    • profile image

      adwords-marketing 6 years ago

      Good hedge fund information. I am also interested in finance. I have a lens on max pain investment strategy.

    • Countryluthier profile image

      E L Seaton 6 years ago from Virginia

      A layman can actually understand hedgefunds through your lens! Thanks for putting this lens together. CountryLuthier/@Mississippi2020

    • OhMe profile image

      Nancy Tate Hellams 7 years ago from Pendleton, SC

      Thank you for this information about Hedge Funds. There is so much that I do not know about investments.