A hedge fund is a professionally managed portfolio of investments that is typically open to a limited range of sophisticated investors. Because of this hedge funds are rather unregulated and not subject to numerous of regulations that apply to mutual funds. We can think of hedge funds as mutual funds for wealthy investors. They require very large amount for initial investment often $500,000 or $ 1million or more. Besides hedge funds require investors keep their money in the fund for at least one year. Hedge funds usually charge very high fees however, what lure investors is the possibility of very big returns. Standard fees for hedge include 2% management fee and up to 20% incentive fee which allows funds managers to keep 20% of all investment gains. In the theory hedge funds should have a positive return when the market is up, down or even sideways.
Hedge fund strategies
Hedge funds usually use advanced investment strategies to increase returns. While mutual funds are designed to have stable investment strategy in a given class, hedge funds are much more flexible. Manager of hedge funds have the ability to frequently change their investment strategies and types of assets that they trade. The most common strategies used by manager are:
- Short selling - borrowing over-valued stock from the custodian or prime broker and selling on the market in hope that we will be able to purchase stock at lower price in the future and make a profit on the transaction.
- Leverage - borrowing money to increase effective size of a portfolio. This led to the increase of risk and profit potential.
- Arbitrage - taking advantages of different price in different markets.
- Brav, A., Jiang, W., Partnoy, F., & Thomas, R. (2008). Hedge fund activism, corporate governance, and firm performance. The Journal of Finance, 63(4), 1729-1775.
Author: Katarzyna Wierzbinska