Definition of 'Hedge Fund'
Hedge funds are high-risk investments that taps into collaborated funds and uses leverage to boost returns. Investors are charged higher fees due to the an increased ROI in order to cover operational costs. Other fees are performance fees, which are paid to the fund manager if the fund outperforms the projected outcome. Fee caps may be instituted to deter managers from being too risky.
TheStreet Explains ‘Hedge Fund’
One of the main characteristics of a hedge fund is the aggressive nature in which it is managed. Created as a private investment with exclusive partnerships, hedge funds are typically only open to a small number of investors contributing a substantial initial investment. Hedge fund withdrawals are rigid; only allowed quarterly or bi-annually, so funds are considered to be illiquid. Although the term “hedging” is typically associated with hedge funds, today the activity of hedging, or reducing risk, is not practiced. Instead, managers hedge risk through a variety of approaches where risk is not significantly reduced since managers make speculative investments.
Hedge funds are only available to high net worth individuals, closing medium to low-income investors out of the loop. To reduce unscrupulous vetting, laws require fund investors be accredited, meaning they must earn a minimum net worth of $1 million in addition to deep investment knowledge.
A number of hedge fund types include equity market neutral, convertible arbitrage, fixed income arbitrage, distressed securities, merger arbitrage, hedged equity, global macro, emerging markets and funds of funds.
Equity market neutral essentially neutralizes a portfolio with funds that are overvalued or undervalued. This style offers a risk-free rate of return. Rather than neutralizing over or undervalued funds, convertible arbitrage simply takes advantage of pricing inefficiencies between a convertible and stock. Fixed-income arbitrage is when managers identify fixed-income securities that are under or over valued. Distressed securities is used when a company is on the verge (or has already) of declaring bankruptcy.
Otherwise known as the deal arbitrage, merger arbitrage is the difference between the current priced corporate securities and their value once the merger or takeover has been completed. Also known as long or short equity strategy, hedged equity does not break portfolios into market, industry, dollar or sector structure. Hedged equity seeks over and undervalued equity securities.
The global macro strategy focuses on major markets instead of individual market trends. This strategy trades in currencies and futures, but also in bond markets and traditional equity arenas. Emerging markets may produce a higher return rate, but comes with considerable risk due to market volatility. Fund of funds (FOF) invests in 10 to 30 highly diversified hedge funds. FOF are more liquid and more available to the individual investor.
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