World of Hedge Funds
Hedge funds are amongst the fastest growing types of investment funds, both in terms of worldwide assets under management, as well as the number of private and institutional investors. Hedge funds differ significantly from traditional investment portfolios with respect to their structure, asset allocation, legal status, performance, and investment strategies. There is, however, no widely accepted definition as to what hedge funds are. According to textbooks, hedge funds can be thought of as ‘privately organized, loosely regulated and professionally managed pools of capital not available to the public’. This definition is however not exclusive to hedge funds; it applies to most forms of alternative investments, such as venture capital or private equity funds. While it is not easy to give a clear definition of hedge funds, the following summary shows some of the core differences between hedge funds and traditional investments:
Hedge funds seek to realize absolute positive returns in downward, sideways, and rising markets. In order to achieve exceptional risk-adjusted returns, hedge funds use derivatives, short-selling, and considerable leverage as part of their strategy to maximize performance.
With the use of options, futures, and forward rate agreements (FRAs), hedge funds can generate profits even in falling markets. Fund managers hedge downward risks by correctly estimating developments on the future markets.
Most hedge funds are not subject to any legal restrictions regarding asset allocation, the degree of leverage, or the use of derivative instruments. Contrary to many traditional funds, hedge funds do not publish information or performance reports on a regular basis. Because of low reporting standards and favourable legal frameworks, hedge funds tend to be more flexible when investing into different markets.
Lock-up periods and high-initial-investment amounts have turned hedge funds into an exclusive investment vehicle for corporate or high-net-worth private clients. More recently, certificates and Fund of Hedge funds have allowed a broader clientele indirect access to hedge funds.
In general, one can distinguish between two main strategies of hedge funds. Directional strategies depend on the development of international equity, bond, commodity, or currency markets. Directional hedge funds enter long or short positions in lucrative markets and hedge some of their downward risk exposure with derivatives. For directional strategies, the hedge ratio is below one. Hence, only part of the original investment can be recovered if the markets develop differently to the fund manager’s expectation. The success of directional strategies rests with market timing and diversification of risks.