Definition: The Hedge Funds are the investment funds that pool the resources of wealthy investors to reinvest these into an array of complicated financial instruments, using the wide range of investment techniques to generate higher returns for a given level of risk.
The term “hedge” is derived from the word “hedging” which means “to reduce risk”. Therefore, the primary objective of the hedge funds is to outperform the market and generate high returns irrespective of what the market does.
Key features of Hedge Funds that make them unique from other investment vehicles are:
- Only the accredited investors who meet the certain net worth can invest in these funds. Often, the investments are made by the significant and wealthy investors.
- The fund manager focuses on absolute returns rather than the returns relative to the index, thereby offering the investors to earn even if the traditional markets are observing the downfall.
- Unlike mutual funds, the hedge funds can invest in anything, such as real estate, land, stock, currencies, and derivatives while the former can invest only in stocks or bonds. Thus, hedge funds have a wider array of securities.
- The hedge funds charge not only the expense ratio (a cost to operate a mutual fund) but also charges the performance fee. This fee structure is called as Two and Twenty, i.e. 2% asset management fee and 20% of gains generated.
The fundamental belief among the investors is that there is a direct relationship between the risk and return, i.e. the returns would be higher for those funds which are riskier; then how the hedge funds contradict this connotation?
Well, the fund manager looks for varied ways to get rid of the risks and, therefore, make use of several derivatives and leverages the price differentials in both the domestic and international markets with the intent to generate higher returns for the investors. Also, he tries to reduce the correlation between the hedge funds and equity or bond markets.