Hedge Funds are a method of alternative investing. It is a form of investment where funds are pooled and invested using different investment strategies to generate profits in a financial partnership between the fund manager and investors.
The fund manager is referred to as the general partner and investors are known as limited partners. The role of the limited partners is the investment of funds and that of the general partner is managing them. The investors are provided a hedge prospectus which provides information regarding key aspects of the fund, such as the fund’s investment strategy, investment type, and leverage limit.
As the name implies, Hedge funds function in a manner to ‘hedge’ or avoid risks. So, we see that the objective of Hedge funds is profit maximization along with risk minimization. They are meant to generate profits irrespective of the fluctuations in the market. They minimize risk by offering the investors to go long or short stocks. Shorting implies making money when the stock drops.
An investment manager manages the funds through a company that is distinct from the hedge fund and its portfolio of assets. The investment manager uses the support of the following service providers:
Prime brokers
They help in clearing the trade, provide leverage and short-term financing.
Administrators
They provide services of operations, accounting, and valuation.
Distributors
They basically deal with distribution of securities. A distributor can be an underwriter, dealer or broker.
Investment strategies adopted can be classified as:
• Discretionary/Qualitative: These are strategies selected by the general partner or fund manager.
• Systematic/Quantitative: These are strategies suggested by a computerized system.
Characteristics of Hedge Funds:
• Available only to accredited investors
Investors need to have a certain net worth before investing in Hedge funds.
• Variety of Investment Options
It can be invested in various areas such as land, real estate, stocks, derivatives, currencies, etc.
• Use leverage
Borrowed money is often used to enhance returns.
• Fee
They charge a management fee and performance fee.
The main benefit of investing in Hedge funds is that the risk is lower than other types of investments. They can be said to be uncorrelated with market indices. However, the fact remains that they are prone to some amount of risk. Hence, it is a good approach to be aware of all the potential risks before investing. It is also essential to select a fund manager who is experienced in the field.