How Do Hedge Funds Work?

How do hedge funds work? This is a question a lot of people ask. These mysterious investments offer large gains and high risk. So why don’t more people invest in them? The answer is that most people can’t afford the initial investment which usually starts at about one million dollars. Hedge funds fall into two categories: Venture Capital funds and Private Equity funds. Here is a closer look at how these funds work.

Venture capital hedge funds invest in new or smaller firms. They have a fund manager who finds new or developing companies and seeks out to profit from a potential breakthrough idea that the company develops or its initial public offering, or an IPO. Here, the fund manager is hoping that the initial stock price skyrockets to return a huge profit. The hedge fund manager stands to gain 20 percent of the profit, but if the investment goes south, neither the hedge fund manager nor his investors will make any money. This is a high risk and high reward investment and not for the faint at heart.

Private equity hedge funds are the opposite of venture capital hedge funds. These funds invest in established yet undervalued companies. These companies tend to have a good product or service but might be experiencing difficult financial times. It is similar to a real estate investor who purchases a home at a huge discount because the owner is eager to sell and then the investor renovates the home and sells it for a significant profit. Private equity funds work the same way just on a much larger scale.

 Hedge funds have very few regulations. As a matter of fact, the fund manager does not even have to report his investment strategy. This alone adds to the mystery and risk. Many have made fortunes with hedge funds and some have lost money on the wrong calculation. Be careful and invest only what you can afford to lose.

Source: Kansas,Dave. "The Wall Street Journal. Complete Money & Investing Guidebook." Random House, 2005