Hedge Funds: What Are They?

You might hear the word "Hedge Funds" and ask, Hedge Funds: what are they? how do they work? and how do you invest in them?. As you gain more experience with investing, you will likely run across the term hedge funds. As an investor, it is your responsibility to know and understand all investment types so you can make the best decisions for your portfolio. As such, you must understand how hedge funds work and what they are.

In essence, hedge funds are just another type of investment whose investors are hoping for a return. Like mutual funds, hedge funds invest in a variety of underlying assets; the value of those assets determines the value of and return to the hedge fund. Unlike mutual funds, hedge funds can invest in more than just stock and bonds; they can also contain currencies, commodities, mortgages, options, derivatives, and limited partnerships as part of their portfolio.

Hedge funds get their name from their original purpose, which was to hedge against the risk of the investments in their portfolio. This remains the intent of most hedge funds today – to maintain a portfolio of investments, and to engage in activities that reduce the risk of those investments while maintaining an appropriate rate of return. To hedge risks, hedge funds will engage in a variety of activities including taking long and short positions, using arbitrage, purchasing or selling derivatives, and participating in the futures and options markets.

Similar to mutual funds, all hedge funds are not alike. A prospectus details the makeup of a hedge funds portfolio and its general trading strategy. Today, hedge funds can be found with all sorts of objectives, from beating the equity markets to providing a stable rate of return regardless of what the equity or bond markets are doing. Savvy investors identify what a hedge fund’s strategy is, understand what the underlying assets in the portfolio are, and analyze the trading strategy of the fund before investing in the fund.

Unlike the stock market, bond market, and the mutual fund market, hedge funds typically limit the types of investors they allow. Because advanced trading strategies are involved, federal regulations require that anyone investing in these funds be a Qualified (or Accredited) Investor or an Institutional Investor. Qualified Investors are defined as persons who have a net worth exceeding $1 million or earn an individual income greater than $200,000 per year in each of the last 2 years (and expect to maintain the same level of income). Allowing only Qualified Investors and Institutional Investors opens up a range of investments and trading possibilities prohibited by most mutual funds.

Hedge funds are simply another type of investment that may be appropriate for an individual’s or an institution’s portfolio. Hedge funds are allowed to invest in assets most mutual funds are not due to the strict requirements they place on their investors. The goal of most hedge funds is to hedge against the risk of the assets in their portfolio, providing a more stable return to their investors with less risk.

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Hedge Funds