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What are Hedge Funds? Definition, Risks and Investment

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What are Hedge Funds?

A Hedge Fund is basically a pool of money that accredited investors will invest to get a good return on investment. This pool of money is created using the money of accredited investors. These financial companies will generally have little or no investment in hedge funds and will only utilize the money of their clients to get a profit. Now, as the money in hedge funds is not really of the fund managing companies, the revenue they generate will also be split between the investors and the managing company. 

These accredited investors are also called institutional investors or private investors. They are generally large private firms, investment banks, insurance companies, etc. Hedge means to protect their clients’ money. So they invest in such a way that their initial investment doesn’t lose. 

Working of Hedge Funds

Investors who invest in hedge funds are giving the hedge fund managing companies the right to invest their money in the public market. On behalf of their clients, these companies will invest their money with certain agreements. Generally, the financial company will get a percentage cut from the profit revenue they generate overall. These funds tend to have a bad history due to their strange investment strategies. They are known for their risky bets as they bet on both types of positions. i.e. they can bet on long positions or on short positions to get higher profits. 

The fact that they are not regulated by the SEC  gives them more leverage in the stock market. That is why they are allowed to take positive as well as negative bets on the stock market. So, if they believe that a company will perform poorly in the future they will put on negative bets and if a company is going to perform really well then they will do positive bets.

Working of hedge funds
Working of hedge funds

Not all hedge funds follow the same investment strategies to get more profits. Some hedge funds only tend to invest in long positions, some might invest in real estate, some might be specialized in the debt market, some participate in PIPE deals, etc.

Short Selling:

In short selling, these hedge funds will invest in a company whose stock price will drop in the near future. To invest in such companies, they usually borrow securities from market makers and sell them in the public market at the current market price. Once the stock price of that company drops, they will purchase the equal amount of securities that they have borrowed, and will give back to market makers. During this process, the hedge funding company will get a huge profit. 

Also, short selling is very risky because the success of short selling depends on the drop in the share price of that company. If the company’s share price starts rising, they will face a huge loss. Now to hedge their losses, they are forced to purchase the stock at a higher price. This eventually can bring the stock price very high resulting in a short squeeze.

Long Selling:

Long selling is just the opposite of short selling. In this case, the hedge funds money will be invested in stocks of a company that they believe will rise in the future. They tend to take long positions, meaning they will hold their positions for a long period of time to get a high return on investment.

Hedge Funds vs Mutual Funds

Mutual funds are less risky investment funds as compared to hedge funds. Along with that mutual funds are regulated by the SEC and can also market themselves while hedge funds can’t. Hedge funds can invest in varying types of assets that mutual funds can’t such as real estate, debt-based investing, art, and currency. With mutual funds, the fee they take is the managing fee only but with hedge funds, they not only take a management fee but also a percentage cut on net profit.

Who can invest in Hedge Funds?

Retail investors cannot invest in these kinds of funds. Those investors who have a net worth of around 1 million dollars and are certified SEC investors can invest. These investors are also called institutional investors or accredited investors. As hedge funds are very risky and give very high revenue, only accredited investors who know what might be the consequences, have access to invest in these funds.

Who manages Hedge Funds?

These funds are managed by a hedge fund manager who is none other than a financial company. These hedge fund managers use competitive investment strategies to invest in different types of markets. These managers take management fees of around 1% to 2% from their client to cover their operating expenses and also a percentage cut of around 20% to 30% in the profit they make from the investment. 

Anyone who is willing to invest in these funds should invest with a minimum amount of money marked by the manager. This usually ranges from a hundred thousand dollars to 2 million dollars. From which a certain percentage will go to the managing company.

Hedge Fund Investment Guide

First of all, you need to be an accredited investor to invest in hedge funds and second of all, you should know what risks it bears when investing in these funds. Before you invest huge amounts of money in hedge funds, do proper research about the fund management firms and their history. If they have good disciplinary history you are good to go.

Another important point you need to understand is that you cannot redeem your investment whenever you want. Generally, you can redeem four times a year and the rest will be a lock-up period. Most of these fund managing companies have their own terms and conditions, so always try to read those and ask questions if you need to. 

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