What Are Hedge Funds - And How They Benefit You

By: Gen Wright

A hedge fund is a private investment fund where the fund managers can buy or sell any assets and make highly speculative trades on rising or falling assets. Investors who choose to invest in hedge funds usually pay a recurring management fee, as well as performance fees.

Due to its exemption from various regulations that otherwise apply to mutual funds, brokerage firms or investment advisors, hedge funds are usually used to invest in more complex and risky funds than a regulated public fund. However, in recent years, hedge funds have been outperforming the stock market.

As the name implies, the primary function of a hedge fund is to offset any potential losses in the principal markets they invest in, using a variety of trading methods. The concept of a hedge fund originally started off as a method to reduce risk. However, hedge funds have evolved to include high risk investment funds with higher potential returns.

As hedge funds usually trade with proprietary investment methods, and are only accessible to certain accredited investors, they often appear secretive to the general public. As they are largely unregulated, they are not required to disclose full details. When compared to public funds, the requirements for disclosure are less stringent.

For these reasons, hedge funds are now commonly used by accredited investors to gain access to trading strategies and closed funds that would otherwise have been off limits to the general public.

Accredited investors may choose to invest in hedge funds to:

1) Reduce risk by using proprietary trading methods in hedge funds such as short selling.

In finance, short selling or "shorting" is the practice of selling a financial instrument that is not owned by the seller. This is done in the hope of profiting should the price of a security such as a stock or a bond falls. Short selling is also commonly used as a blanket term for all investment strategies that allow an investor to gain from a decline in price.

For example, in a bullish market, an investor may decide to "go long", purchasing a stock in the hope that the price will rise. But to hedge against a sudden market downturn, the investor may choose to participate in a calculated amount of short selling.

2) Provide a rate of return in an economic environment where other traditional stock and bond investments cannot achieve.

In both scenarios, there is always a risk-return trade off. The objective is to tip the balance of the existing portfolio so that financial goals can be achieved within an expected time frame.

Many sophisticated investors have come to recognize the benefits of hedge funds. These benefits are usually exclusive to hedge funds due to its flexible nature. In fact, many of the trading strategies used by hedge fund managers are unconventional and highly sophisticated.

As it is the nature of hedge funds to be more secretive due to less stringent disclosure requirements, investors are advised to take a prudent approach when investing in hedge funds. Be sure to enquire more about the investment strategies that the fund managers use, and the assets that the funds are trading in.