Debt Dictionary

Hedge Funds

Investment Dictionary -> Hedge Funds

What is a Hedge Fund?

Nowadays, hedge funds play a significant and influential role in the financial world and command a great deal of attention. They are usually formed as private partnerships by large-scale investors with stable financial record and high professional skills and reputation. They are obliged to meet specific criteria, set up by each fund, in order to participate. As a rule, the initial investment is substantial and cannot be withdrawn for at least a year. In return, participants receive a performance fee and are able to take advantage of the lighter regulations in comparison to those in an ordinary investment fund. Although the hedge funds, as their name suggests, apply different methods to reduce potential risks, their main prerogative is to maximize the return on the investment as much as possible, using a wide range of strategies. Hedge funds operate in domestic and international markets, aiming to generate higher returns on the investment.

Hedge Fund Strategies

Before investing in a hedge fund, it is crucial to know the investment strategies used in a hedge fund. The type of strategy has an impact on the level of risk, the profit return, and the predictability of future results. Some of these strategies are:

• investing in emerging markets – this is a risky strategy because high levels of inflation and rapid changes are typical for such markets;
• aggressive growth – investing in equity which has the potential to increase the growth of earnings per share. The level of risk is substantial as earning from these funds are highly dependent on the stock market and the current economic situation;
• distressed securities – purchase at a considerable discount; buying the debt of companies that face potential bankruptcy or are already in default;
• macro – the investment is influenced by fluctuations in the global economy and takes place in all major markets;
• discretionary macro – the investments are chosen and run by investment managers;
• systematic macro – the investments are a result of software program selection;
• fund of funds – collaboration between hedge funds and other pooled investment vehicles, aiming (via the use different strategies) to lower the risk and maximize the profit in the long term.

What Are the Potential Risks while Investing?

Although the subsequent profit could be considerable, investing in a hedge fund is sometimes a risky business because of certain characteristics such as:

• short selling – the sale of assets that are borrowed from a third party. The idea is to purchase new ones later and at a better rate, returning the borrowed asset to the original lender. The risk of loss is high, especially if the price before the new purchase rises;
• lack of regulation – the hedge funds’ management is subject to less supervision from financial regulators than the regular funds;
• appetite for risk – hedge funds are more likely to be involved in high-risk investments, such as distressed securities, collateralized debt obligations, etc.;
• leverage – except for the initial investment, hedge funds usually borrow additional and even greater amounts of money.

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