What Are Hedge Funds?

Hedge funds are similar to mutual funds but with several important differences. First, hedge funds are private funds that are typically only open to wealthy, experienced investors. Second, these funds generally take on higher risk using a variety of strategies with the goal of gaining a higher return than mutual funds. Third, hedge funds are not regulated by the U.S. government, giving them more flexibility but less transparency to the public.

Hedging Definition
The word "hedge" in hedge funds is somewhat misleading at the present time. Hedging is a way to reduce risk in an investment. The first hedge fund was created around 1949, with the idea of reducing the overall market's affect on a single asset. Whether the market goes up or down, the value of the hedged asset should not change very much, ideally. However, modern hedge funds do not necessarily reduce risk or use hedging methods. They may use the added leverage of hedging techniques to hope for very large gains. This, of course, can also lead to higher losses.

Example of Hedging
One way to "hedge your bets" on a stock is by going long on Company A and short selling Company B in the same industry, with the same dollar amount invested in each one. That way, if the industry gets upgraded, A and B will both go up in price. The value of investment A goes up but the value of investment B goes down because of the way short selling works and effectively cancels out the upgrade news. The same idea would be true of a downgrade. Keep in mind this is a theoretical idea and market prices often do not match what the public would expect. In this example, A and B might not exactly cancel each other out because one company would move more than the other, which could be good or bad.

Hedge Fund Varieties
Now that you have an idea of how hedging works, it is important to note that there are hundreds or thousands of ways to use hedging to reduce risk and/or increase potential profits. That is why there are an estimated 8,000 or more hedge funds around the world, each with unique strategies and risk levels. These funds invest in a wide variety of instruments, including, but not limited to, stocks, commodities, futures, options, and even other hedge funds.

Who Can Join Them
Not everyone can join a hedge fund. They commonly require the investor to have a net worth of $1 million or more, extensive investment experience, and an acceptance of high risk. These requirements make the funds sound like strict, exclusive investment clubs, but there is a good reason for it. The U.S. government has many regulations on investment firms, which would normally prohibit some of the trading techniques used by hedge funds. However, there are some exceptions to these regulations, and hedge funds operate the way they do by legally taking advantage of these exceptions. So the funds' requirements are often no more than the government's requirements for these special situations.

Transparency
Since hedge funds are not really regulated by the government, they are not required to make their activities public knowledge. When the investor joins the fund, he or she is given documentation on the fund's goals and strategies. After that, the value of the shares or interests in the fund are usually not updated on a daily basis but they may be requested on a regular basis. A profit or loss is not locked in until the shares or interests are sold back to the investment manager, and dividends are not usually paid either. Also noteworthy is that the shares or interests are usually not exchanged between investors in a fund. Finding a list of hedge funds might also be difficult because the U.S. government has restrictions on the marketing the funds can perform, which makes it even more difficult for investors to find a good one. The good news is that several major financial publications often list the top known hedge fund performers on a regular basis.

Risk and Reward
Given the fact that there is little public knowledge about hedge fund performance, it is difficult to say what the average profit or loss is every year for the industry. Compounding this problem is the fact that troubled funds often shut down completely and start up again under a different name. One main goal of hedge funds is to deliver a higher return than mutual funds. Whether that is achieved or not on a regular basis by the average fund is difficult to say because of this lack of transparency. The amount of risk could also be much higher than a mutual fund because of the leveraging techniques used and the lack of government regulations. This is why the investors are required to have plenty of money and a willingness to lose a lot of it.

Nicholas Swezey helps people Find Stocks on his site, http://www.HowTheMarketWorks.com

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