Brenner’s FYI: Hedge Funds

Definition: a hedge fund is a limited partnership of investors that uses high risk methods, such as investing with borrowed money, in hopes of realizing large capital gains.

What is a ‘Hedge Fund’

Hedge funds are alternative investments using pooled funds that employ numerous different strategies 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). It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles.

What Does a Hedge Fund Do?

Within a hedge fund, the hedge fund manager raises money from outside investors and then invests it according to whatever strategy he or she has promised to use. There are hedge funds that specialize in “long-only” equities, meaning they only buy common stock and never sell short. There are hedge funds that engage in private equity, which is the buying of entire privately held businesses, often taking them over, improving operations, and later sponsoring an initial public offering. There are hedge funds that trade junk bonds.

Hedge Funds vs Mutual Funds

Key Differences

Hedge funds are managed much more aggressively than their mutual fund counterparts. They are able to take speculative positions in derivative securities such as options and have the ability to short sell stocks. This will typically increase the leverage – and thus the risk – of the fund. This also means that it’s possible for hedge funds to make money when the market is falling. Mutual funds, on the other hand, are not permitted to take these highly leveraged positions and are typically safer as a result.

Another key difference between these two types of funds is their availability. Hedge funds are only available to a specific group of sophisticated investors with high net worth. The U.S. government deems them as “accredited investors” and the criteria for becoming one are lengthy and restrictive. This isn’t the case for mutual funds, which are very easy to purchase with minimal amounts of money.