WHAT'S A HEDGE FUND?
WHAT'S A HEDGE FUND?
A hedge fund is an aggressively managed portfolio, similar to a mutual fund. It differs from a mutual fund in that a hedge fund can use a wide range of trading strategies and take on a more diverse set of investments. Hedge funds are usually set up as a series of private partnerships, where the hedge fund manager often invests his own funds. The fund manager also often charges a management fee based on the size of the fund and a performance fee based on the fund’s performance.
TYPES OF HEDGE FUNDS
Most hedge funds are focused specifically on one part of the market or one specific type of trade. These are some common hedge fund strategies.
Global Macro - A global macro hedge fund focuses on the “big picture” analysis of the world’s economy. A hedge fund using this strategy will take large positions in foreign bond markets or currency, expecting to take advantage of worldwide trends. Some of these funds will also invest in commodities.
Directional - Hedge funds using a directional investment strategy are looking for market trends or individual stocks that are mispriced. Many of these funds are long/short funds, meaning that they hedge their long positions with short positions in other stocks. Some of these funds specialize in emerging markets or use heavily quantitative strategies.
Event-Driven - Event-driven strategies focus on special stock situations such as reorganizations, mergers, bankruptcies, or liquidations. There is a wide variety of event-driven investment styles. Some funds will focus on distressed companies that are facing bankruptcy or liquidation, and look to buy very cheap bonds with the expectation that more money will be returned. Other event-driven funds take on what is called risk arbitrage, where they analyze the likelihood of a merger or a reorganization and determine if the expected change will increase the value of the potential investment.
Relative Value - also called “neutral” funds, take advantage of relative pricing differences. These funds specialize in arbitrage. Their goal is to find similar securities that have different prices and make trades based on the expectation that those prices will converge over time. For example, a common arbitrage involves a stock that is traded in Europe and in the US. If the price of that same stock is different in each market, the fund manager will place a trade designed to profit when these prices eventually equal out.
Fund of Funds - where the fund manager is examining the performance of different funds and different types of funds in an attempt to increase diversification and maximize performance. This type of fund is focused on investing in great fund managers more than finding great investments. Investors who use a fund of funds are also charged twice, once for the management fee included in the fund of funds, and for each of the management fees in the individual funds.