What is a Hedge Fund?
A hedge fund pools together assets and is a type of alternative investment. They’re are pretty exclusive things in the investment world. They tend to have a limited list of clients allowed to invest, namely High Net Worth Individuals (people who already have substantial assets to their names) and institutional investors – the big fish in investment including organisations providing financial services to firms such as life insurance companies, mutual funds, pension funds and commercial banks. Hedge funds advertise their investment opportunities privately to these target clients, usually in the form of something called a Private Placement Memorandum (PPM).
These institutional investors are able to, and often do, invest in large volumes on the markets as they have the knowledge and the financial power to do so. They’re therefore generally deemed to be the most suited to the way a hedge fund works.
The aim of a hedge fund is to see high returns on investments by utilising a broader range of investment strategies than those that may be typically used in other types of funds. They try, for instance, to make money even when a market is down (when the demand and subsequently the price for stocks declines).
Hedge funds use some more risky investment strategies in order to see larger returns on investment for their clients. You might hear these strategies referred to as ‘aggressive’ in the business. As an example, they may use leverage: a strategy which uses borrowed money to invest. They also at times sell off some of their stocks with the intent of potentially buying them back at a later date when their price has declined (a technique known as ‘going short’). This can be pretty high risk – and could well result in big losses – so hedge funds are certainly not for the faint hearted. But if they do get the mix right, it can mean mega returns!
What makes hedge funds different?
One aspect refers to liquidity. It’s not always as easy for clients of a hedge fund to get access to their money when they want – it’s usually paid out to them in instalments. A mutual fund is more ‘liquid’’ it’s easier for them to pull out their money from the fund when they want.
There are many rules and restrictions in the investment game. One key difference when it comes to hedge funds is that there are actually fewer restrictions when it comes to making investments compared to something like a mutual fund (an institution which pools together clients’ money to use to invest, and provide returns for them – like a pension fund).
This allows them to use a much more diverse spectrum of investment strategies. Hedge fund managers are able to be more capricious in their strategies if and when they feel it’s necessary, so there can be a lot of chopping and changing here. Managers in mutual funds generally stick to their strategy.
The way hedge fund managers make their money also differs slightly to that of a portfolio manager at a mutual fund. Salary depends on the commission they earn from the returns on the assets they manager, so the bigger the return, the bigger the paycheque. But they also receive a percentage of the net value of the asset, so there is the potential to earn more here than in a mutual fund, where you have a set salary amount to do the job.