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Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Because hedge funds may have low correlations with a traditional portfolio of stocks and bonds, allocating an exposure to hedge funds can be a good diversifier.

Breaking Down 'Hedge Fund'

Each hedge fund strategy is constructed to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and thus are often classified according to investment style. There is substantial diversity in risk attributes and investment opportunities among styles, which reflects the flexibility of the hedge fund format. In general, this diversity benefits investors by increasing the range of choices among investment attributes.

Legally, hedge funds are most often set up as private investment limited partnerships that are open to a limited number of accredited investors and require a large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.

The first hedge fund was established in the late 1940s as a long–short hedged equity vehicle. More recently, institutional investors – corporate and public pension funds, endowments and trusts, and bank trust departments – have included hedge funds as one segment of a well-diversified portfolio.

It is important to note that "hedging" is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market. (Mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk." In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.

Investing in Hedge Funds

For the most part, hedge funds (unlike mutual funds) are largely unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.

Hedge fund managers are compensated in two ways: a fee for assets under management (AUM) and an incentive fee, which is a percentage of any profits. A typical fee structure may be 2 and 20, where the AUM fee is 2% and the incentive fee is 20% of profits. Often times, fee limitations such as high-water marks are employed to prevent portfolio managers from getting paid on the same returns twice. Fee caps may also be in place to prevent managers from taking on excess risk.

Hedge Fund Strategies

Many hedge fund styles exist; the following classifications of hedge fund styles is a general overview.

  • Equity market neutral: These funds attempt to identify overvalued and undervalued equity securities while neutralizing the portfolio’s exposure to market risk by combining long and short positions. Portfolios are typically structured to be market, industry, sector, and dollar neutral, with a portfolio beta around zero. This is accomplished by holding long and short equity positions with roughly equal exposure to the related market or sector factors. Because many investors face constraints relative to shorting stocks, situations of overvaluation may be slower to correct than those of undervaluation. Because this style seeks an absolute return, the benchmark is typically the risk-free rate. (For more, see: Getting Positive Results With Market-Neutral Funds.)

  • Convertible arbitrage: These strategies attempt to exploit mis-pricings in corporate convertible securities, such as convertible bonds, warrants, and convertible preferred stock. Managers in this category buy or sell these securities and then hedge part or all of the associated risks. The simplest example is buying convertible bonds and hedging the equity component of the bonds’ risk by shorting the associated stock. In addition to collecting the coupon on the underlying convertible bond, convertible arbitrage strategies can make money if the expected volatility of the underlying asset increases due the embedded option, or if the price of the underlying asset increases rapidly. Depending on the hedge strategy, the strategy will also make money if the credit quality of the issuer improves. (See also: Convertible Bonds: An Introduction.)

  • Fixed-income arbitrage: These funds attempt to identify overvalued and undervalued fixed-income securities (bonds) primarily on the basis of expectations of changes in the term structure or the credit quality of various related issues or market sectors. Fixed-income portfolios are generally neutralized against directional market movements because the portfolios combine long and short positions, therefore the portfolio duration is close to zero.

  • Distressed securities: Portfolios of distressed securities are invested in both the debt and equity of companies that are in or near bankruptcy. Most investors are not prepared for the legal difficulties and negotiations with creditors and other claimants that are common with distressed companies. Traditional investors prefer to transfer those risks to others when a company is in danger of default. Furthermore, many investors are prevented from holding securities that are in default or at risk of default. Because of the relative illiquidity of distressed debt and equity, short sales are difficult, so most funds are long. (For more, see: Activist Hedge Funds: Follow The Trail To Profit and Why Hedge Funds Love Distressed Debt.)

  • Merger arbitrage: Merger arbitrage, also called “deal arbitrage,” seeks to capture the price spread between current market prices of corporate securities and their value upon successful completion of a takeover, merger, spin-off, or similar transaction involving more than one company. In merger arbitrage, the opportunity typically involves buying the stock of a target company after a merger announcement and shorting an appropriate amount of the acquiring company’s stock. (See also: Trade Takeover Stocks With Merger Arbitrage.)

  • Hedged equity: Hedged equity strategies attempt to identify overvalued and undervalued equity securities. Portfolios are typically not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated. For example, the value of short positions may be only a fraction of the value of long positions and the portfolio may have a net long exposure to the equity market. Hedged equity is the largest of the various hedge fund strategies in terms of assets under management. It is also know as the long/short equity strategy.

  • Global macro: Global macro strategies primarily attempt to take advantage of systematic moves in major financial and non-financial markets through trading in currencies, futures, and option contracts, although they may also take major positions in traditional equity and bond markets. For the most part, they differ from traditional hedge fund strategies in that they concentrate on major market trends rather than on individual security opportunities. Many global macro managers use derivatives, such as futures and options, in their strategies. Managed futures are sometimes classified under global macro as a result.

  • Emerging markets: These funds focus on the emerging and less mature markets. Because short selling is not permitted in most emerging markets and because futures and options may not available, these funds tend to be long.

  • Fund of funds: A fund of funds (FOF) is a fund that invests in a number of underlying hedge funds. A typical FOF invests in 10–30 hedge funds, and some FOFs are even more diversified. Although FOF investors can achieve diversification among hedge fund managers and strategies, they have to pay two layers of fees: one to the hedge fund manager, and the other to the manager of the FOF. FOF are typically more accessible to individual investors and are more liquid. (For more, see: Fund of Funds: High Society for the Little Guy.)

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