What You Need to Know About Hedge Funds

Reviewed: November 14, 2014
By FinanceWeb

What are Hedge Funds?

Hedge funds are private partnerships between asset managers and qualified investors to pursue high rates of return on large investments by using aggressive techniques and strategies. Investment strategies have been the key distinction between hedge funds and other forms of investment. First recognized as a form of business in about 1950, hedge funds used a model that broke away from traditional approaches. It applied bold strategies that produced high returns including selling short, selecting undervalued securities and using leveraged assets. Today, there are many rules that limit or define the roles of investor and asset manager. However, the industry is largely unregulated and lacks detailed reporting and oversight found in most regulated securities activities.

How Do Hedge Funds Operate?

The structure of hedge funds is straightforward, and it is efficient. Its basic structure is a partnership with each investor that establishes terms of participation in profits costs and expenses. The typical structure includes legal advisors, brokers and accounting functions. Credit management and trading assets are major functions along with the decision-making process of selecting targets for investment. Hedge funds are part of a broader classification called alternative investments; however, the essential difference is in the methods used, and the amount of risk involved. Hedge funds are aggressively managed funds, and they accept and manage risk in order to generate above market average returns.

Who Can Participate?

Participation in hedge funds is limited to qualified persons and organizations. Individual participants must qualify as accredited investors, and organizations must prove they are qualified purchasers. An accredited investor is a person that meets one of the three following criteria. They must have an income of $200,000 per year over a period of years, or net worth in excess of $1 million or a total of $5 million in investments or investable assets. A qualified purchaser is an entity with no less than $5 million in total assets, or with $25 million or more in investments, or in investable assets. Surveys indicate that approximately two-thirds of hedge fund investors are qualified purchasers and the balance, or one-third, are individual investors. Qualified purchasers include university endowments, pension funds, and non-profit organizations and funds.

The Role of Hedge Funds

Using aggressive techniques and information based approaches such as macro analysis and program trading, hedge funds play an important role for large investors. Their capacity to produce over-market average yields is important to a class of $1 billion and larger investors. These include college endowments, non-profits endowments, and retirement and pension funds. For example, university endowments have critical and expanding needs as they attempt to provide funds for educational opportunity and institutional development at major research and educational institutions. For these classes of qualified purchasers, gaining access to the advanced risk management and aggressive growth strategies of hedge funds is a major part of their operations.

Advantages of Hedge Funds

Millions of Americans have assets under hedge fund management through their employers, retirement funds, and pensions. The advantages of hedge funds are in their separation from market equity trends such as the S&P 500 or Dow Jones Industrial Average. Hedge funds use unusual approaches like derivatives and leveraged assets to shape investment opportunities. They employ aggressive investment strategies such as arbitrage and merger strategies, global macro analysis, and event-driven methods. They allocate investments into situations that have manageable risks and outstanding profit potentials. Many large investors use hedge funds to balance and diversify portfolios. Through the use of actively managed risks, investors can stabilize their overall portfolio and meet challenging financial goals. Hedge funds can work extensively in narrow areas including emerging markets, commodities, and vital sectors like healthcare.